The Contamination Problem in Energy Regulation#

Abstract: This paper formally examines the implications of an electricity utility’s diversification into an unregulated industry. In our framework, the electricity utility is the most efficient provider in the unregulated industry (up to a particular capacity) and, as such, there is no question about the desirability of allowing it to operate in that market. Nevertheless, the risk faced by a diversified utility is greater than the risk faced by a utility that operates only in a regulated market. This additional risk can potentially affect the diversified utility’s credit rating and, therefore, increase the cost of capital for the regulated business that will be recovered from ratepayers. We show that by allowing a regulated firm to diversify into an unregulated market, the energy regulator faces a trade-off: a lower cost in the unregulated market versus a higher cost in the regulated market. If the regulator only cares about welfare in the regulated market, then a ring-fencing requirement is optimal subject to implementation costs not being substantial. Of course, the ring-fencing requirement effectively prevents the firm from achieving a lower cost in the unregulated market. Therefore, if the regulator cares about welfare in both regulated and unregulated markets, ring-fencing may no longer be optimal. JEL Classification: L51 Key-words: multi-utility regulation; utility diversification; ring-fencing; risk ratin