A model for incentive regulation utilizing the RRC-rule with a hierarchical incentive mechanism

We employ residual income as performance measure in a regulatory context utilizing the relative replacement cost rule (Rogerson, 2008, 2011). We find, in line with Rogerson (2008, 2011), that overall welfare is maximized if the regulator is aware of the data required to parameterize the model. Assuming that the required data is not available and conservative data proxies are applied results in gold plating (Westfield, 1965) and the Averch-Johnson effect (Averch & Johnson, 1962). To avoid these drawbacks we propose a hierarchical self-regulating incentive system to increase overall welfare. The advantages over traditional incentive systems are the mitigation of commonly known problems, such as the ratchet effect and the empirical problems associated with the X-factor in a price/revenue cap regulation and cost of capital, whilst at the same time increasing overall welfare