Regulating local Public Utilities by Profit-Sharing

This paper concerns "profit-sharing" within an incomplete regulatory contract where a municipality delegates a risk-neutral firm to manage a local utility. Together with a price cap regulation (PCR) mechanism, the contract envisages the possibility of the municipality revoking the contract if the firm's profits are percieved "excessively" high. We show that when this threat is credible and the cost of exercising it is not too high, a long-term efficient equilibrium arises which guarantees the firm with an appropriate level of profits. The consequent regulation timing consists of an endogenous regulatory lag where the regulation has a PCR nature, followed by a period of ROR in which the firm is motivated to adjust its price downward to avoid contract recall. We also show that excessive revocation costs make the firm an unregulated monopolist with an infinite regulatory lag where ROR looks like a pure PCR.