Although regulators gather and study financial data to at least partially overcome the information asymmetry between the operator and the regulator, the financial information provided by the operator reflects the extent to which the operator is willing to show the regulator how efficiently it can operate. The operator’s innate ability to be efficient and the amount of effort the operator exerts to be efficient are called private or hidden information because the regulator cannot directly observe it. The regulator often tries to peer into this hidden information by collecting financial information, conducting prudency reviews, and performing management audits, but these approaches involve second-guessing the operator and require the regulator to become somewhat of an expert on managing an operator.
Two dangers exist when the regulator relies only on his ability to overcome information asymmetries through information gathering. The first danger is that the regulator will never have the resources to fully understand the service provider’s operations, with the result that the service provider is inefficient. The second danger is that the regulator over-steps her knowledge and does not allow the operator to recover from customers the costs that truly are prudent and used and useful. This situation encourages the operator to become inefficient by being overly cautious in its business decisions and to limit cash outflow in an effort to provide investors with a positive NPV.
To overcome these two dangers, the regulator generally adopts some form of incentive regulation, which rewards the operator with the opportunity to keep extra profits if the operator reveals its ability to operate efficiently, exerts the optimal amount of effort to be efficient, or both. This is not to imply that incentive regulation is a substitute for gathering information and learning about the operator. Indeed incentive regulation works best when the regulator has engaged in extensive data gathering and analysis. Price Level Regulation examines these incentive techniques.