Risk Allocation

Risk is borne by different parties depending on the nature of the formal (or implicit) contracts linking the parties. One principle of efficient risk allocation is that those parties best able to mitigate the risk (through portfolio adjustments or behavioral responses) should be assigned (or allocated) the risk. Price cap regulation tends to transfer (or allocate) commercial and production risk to investors-leading to a higher required return on their investment. Rate of return regulation tends to allocate more risk to consumers-leading to lower required returns for investors (but greater risk borne by customers).