Regulating Vertically Integrated Utilities When Transfers are Costly but Revenues are Beneficial

This paper considers regulating a vertically integratedutility under asymmetric information about efficiency gainsdue to integration. The benchmark case – benevolentregulation – implies a divestiture of a technically efficientintegration, unless the cost savings due to integrating aresubstantial. This highlights how private information causes adeviation from the standard perfect information framework.This result is at odds with the worldwide experience withpublic utilities that remained integrated almost throughoutthe 20th century despite that integration offered meager or nosavings as now becomes evident. Of course, this divergencebetween normative analysis and facts is no surprise for publicchoice. Indeed, a rather mild kind of a Leviathan motive –regulators dislike transfers to the utility, and by symmetry,like revenues – coupled with the `secrecy' only integrationoffers due to private information explains why a regulator hasan interest to keep even economically inefficiently integratedfirms integrated. This is in line with Crew and Rowley (1988)that public regulation serves to `milk' rather than to imposeefficiency.