4.1 Bridging the gap between regulation and corporate governance
A starting-point for structuring the problem of incentive channeling is transaction cost economics. Transaction cost economics belongs to New Institutional Economics, but qualifies as a bridge to insights of the behavioral theory of the firm as well as to New Sociological Institutionalism (Nee
2005).
Transaction cost economics analyzes different modes of coordination that range between markets and hierarchies, thereby appreciating bounded rationality of agents and culture as important underlying for theory building (for an overview, see Williamson
1998). The notion of bounded rationality has led to sometimes fierce debates, whether transaction cost economics is alienable with neoclassical thinking (Furubotn and Richter
2005) and whether bounded rationality is a valuable concept at all (Posner
1993). Here it is not possible to discuss all arguments of that debate, however one can conclude that transaction cost economics has triggered a sort of “sociological turn” in economics, motivated by difficulties in explaining institutions within the framework of neoclassical economic theory (Nee
2005; Furubotn and Richter
2005).
In the epicenter of transaction cost economics is the “transaction”, which may be broadly understood as every kind of exchange between two or more agents. Transactions are a part of all kinds of contracts or binding arrangements, including purchase contracts, employment contracts, corporate law or regulations. Those contracts belong in turn to the entire institutional environment, which might be comprised of the judicial system, the political system or the set of informal rules mediated by culture (for an overview see Nee
2005). In addition, transactions depend on the technological specifics of goods and services—for example, whether a transaction demands sunk investments or not (Williamson
1998). In any event, transactions produce costs, and the question is which governance mode minimizes those costs. That is, whenever a transaction via the market mechanism fails, than hierarchical coordination may be in order because hierarchical coordination may save transaction costs (Williamson
1998).
In the case of energy firms, one has to determine the governance mode that minimizes the transaction costs of coordinating the energy supply chain. A hierarchical coordination of activities is given, if there is a bundling of the production, distribution and sale of energy in a legal entity, which serves as a parent company (e.g. a management holding) making all strategic decisions along the value chain. It can be argued that this governance mode is the most transaction cost-saving for energy firms because there are significant sunk costs associated with the power grid and substantial expenditures related to its technical operation, as well as the coordination between the production of energy and its transmission via the grid (Joskow
2006). More generally, the exploitation of synergies and complementarities between the production, distribution and sale of energy calls for integrated hierarchical coordination (Stieglitz and Heine
2007).
But, putting the energy supply chain under the control of integrated management raises a dilemma: On the one hand, integrated management may reduce transaction costs, bring forward synergies and enhance productivity; on the other hand, the power grid is a natural monopoly that may be abused to leverage monopoly power from the distribution of energy toward the production and sale of energy. For example, an integrated energy firm may impede access to the grid for competitors by giving priority to its own operations and run short the capacity of the grid. In effect, reducing the capacity of the grid retains monopoly profits and causes welfare losses.
At first glance, the described trade-off seems trivial, but it is of the utmost importance because it underpins the hypothesis that corporate governance is essential for attaining efficiency of energy supply. However, such efficiency depends not only on corporate governance but also on regulation. That is, only the simultaneous fine-tuning of corporate governance and regulation will enable an efficient energy supply.
There is no clear empirical evidence, whether the distortive effects on competition or the gains from synergies of an integrated supply chain of energy are larger. However, empirical studies indicate that the welfare gains from increased competition in case of ownership unbundling probably outweigh potential disruptions of synergies (Pollitt
2008). Thereby Steiner (
2001) highlights the point that unbundling is superior to integration, when there is an advanced competition policy in place, which backups the (de-)regulation of the energy sector. Insofar ownership unbundling alone may not lead to welfare gains but have to be seen as a part of a whole package for restructuring energy markets.
The picture becomes complete, if one considers that there may exist a continuum of combinations of corporate governance modes and regulations. For example, Monteverde and Teece (
1982) have shown that Ford and General Motors have adopted a pattern of vertical integration, which fits into the legal-institutional environment of the United States and which protects rents from the firms’ knowledge-base, like specialized human capital or patents. In Japan car manufacturers have adapted to another pattern of vertical integration, whereby a different culture of industrial relations, which is based on trust, protects the firms’ knowledgebase. The important insight of this study is that governance modes are path dependent and they co-evolve together with their institutional environment. Thereby different combinations of corporate governance and regulation may attain equal levels of efficiency. With respect to incentive channeling on energy markets one can conclude from this study that it is highly likely that there will be not only one way, in order to facilitate incentive channeling, but depending on the unique institutionalization and history of energy markets in each country the appropriate regulatory measures may vary.
It is apparent that transaction cost economics seemingly has a lot to contribute to the understanding of the interrelation between corporate governance and the regulation of energy firms, as well as to the appropriate design of corporate governance and regulations of the energy sector. Amazingly enough, public policy has remained by and large unaffected by the insights of transaction cost economics. This appraisal has been underpinned by Paul Joskow (
1991, p. 77): “However, while transaction cost economics has played a role in the debates about vertical restructuring in these industries, and the precise form that such restructuring should take, it is my sense that the direct role of transaction cost considerations in influencing the direction of public policy has, so far, been quite modest.”
In order to analyze the behavior of agents in vertically integrated energy firms or unbundled grid firms in more detail, one can ask whether the processing of external incentives through the corporate governance of regulated firms is different from that of firms in unregulated markets. An important difference between the two kinds of firms exists with regard to their selection environment. Under the conditions of workable competition, market forces select firms. If a firm cannot satisfy the preferences of consumers, it has to face bankruptcy (Alchian
1950). That is, incentives are going straight from consumers via the corporate veil to decision-making agents. These market-driven incentives are high-powered and lead to an efficient outcome. In other words, in order to survive competition, firms will have to adapt corporate governance structures which lead to a minimization of transaction costs. As a result, firms may experiment with new forms of corporate governance or may institutionalize a sort of corporate culture that supports the channeling of incentives. The decentralized discovery procedure of competition (Hayek
2002) automatically reveals which firms have the best ideas in order to tackle the problem of incentive channeling (Kole and Lehn
1997,
1999; for a recent survey of the literature see Love
2010).
In regulated markets, there is no such automatism. Instead, the regulator artificially forms the selection environment by granting monopoly and simultaneously regulating prices and quality. The point is that consumers cannot freely choose between different products and services but have to take the offers that have been pre-specified by the regulator. This implies an important consequence: While in ordinary markets, firms have to look at the preferences of consumers, the regulated firm looks at the statutory requirements and tries to capture the regulator (Mueller
2004; Peltzman
1976; Etzioni
2009). A financial analyst has aptly pictured this concept: “When you buy the securities of a utility, you’re buying the public utilities commission” (Business Week
1979, p. 114). To put it another way, there is a close relationship between the regulator and the regulated firm, and it seems plausible that this sort of embeddedness of the regulated firm in the framework of regulation makes a strong imprint (Stinchcombe
1965; Johnson
2007) on the formal and informal governance of regulated firms. For example, studies of the US electricity industry have shown that tight regulatory oversight leads to a more formal organization of electricity firms, reduced entrepreneurial initiative and paternalistic working relationships (Russo
1992). One might argue that the mindset of the public regulation authority is copied into the organizational routines of the regulated firm.
However, imprinting has another effect that is as important as the transfer of organizational routines from the regulator to the regulated firm. Organizational routines are often persistent or path-dependent (Nelson and Winter
1982; Narduzzo and Warglien
2008; Russo
1992). That is, one cannot easily switch from one mode of corporate governance to another or intensify incentives in order to promptly develop an efficient output of regulated firms. For example, if a public utility has no performance-based career system, such a career system will not emerge overnight. Instead, there will be a period of transition before external incentives become mirrored by organizational routines and external incentives can pass through corporate governance structures.
The implementation problem is non-existent in neoclassical economics. However, the imprinting, institutionalization and path dependence of organizational routines are important building blocks for a better understanding of the working of external incentives in the corporate governance structures of regulated firms (for a general discussion see Santos and Eisenhardt
2005).
In summary, in energy markets it cannot be assumed that the corporate governance structures of firms adapt automatically to the transaction cost minimal solution. On the contrary, the market failure of natural monopoly is mirrored in the governance structure of either power grid firms or vertically integrated energy firms. From this follows that the regulation of energy markets involves both external and internal regulation, as well as the complementary fine-tuning of external and internal regulations. Thereby a division of labor between different theoretical branches is looming: (1) Neoclassical economics yields insight into the kind and degree of market failure, as well as which part of the supply chain of energy firms contains market failure; (2) transaction cost economics informs about the efficient design of vertical coordination between the different parts of the supply chain and highlights potential conflicts with antitrust issues; and (3) theories of organizational behavior produce a nuanced account of the motives and attitudes of decision-making agents within given corporate governance structures. While in the previous chapters neoclassical economics and transaction cost economics were center stage, the next chapter will highlight insights from organizational behavior and New Sociological Institutionalism.
4.2 Looking inside the “black box”: the working of incentive regulation within energy firms
The corporate actor framework makes it possible to combine insights from New Institutional Economics with New Sociological Institutionalism by thinking of firms as constitutional contracts of individual actors, which are constrained by external regulations. Thereby the constitutional contract of the firm builds up the firm’s corporate governance. However, the constitutional contract is incomplete and leaves room for individual decisions of agents, who may behave not in accordance with rational choice theory. In addition, there may be informal rules in play, which are not embraced by formal rules of corporate governance and which cannot be changed easily by will, but are subject to larger processes of societal and cultural development.
External regulation, like incentive regulation, has to take into account both, the consequences of the incompleteness of the firm’s constitutional contract as well as the existence of informal rules, which may belong to the firm level (corporate culture) as well as to the level of whole societies. In the following this will be elucidated in more detail by highlighting some important problems, which have been until now largely neglected in the literature on incentive regulation. The aim is to set up a research agenda, which pops up when the “black-box” of energy firms is opened.
4.2.1 Clarity and comprehensibility of incentives
It can be assumed that incentive schemes work more properly if the targeted results are well defined and the causal link between incentives and the subsequent (re)actions of energy firms are verifiable. Verification as an important ingredient of incentive schemes on energy markets is in accordance with findings in research on organizational behavior and social psychology (Kahneman et al.
1982; London
2003; Léon
1997) as well as in New Institutional Economics (Furubotn and Richter
2005; Ritz and Sager
2010). That is, even if the relation between the regulator and the regulatee is complex and outcomes are opaque, all kinds of behavior control should be complemented by a sort of outcome control (Verma et al.
1999; Eisenhardt
1985). The reason is that clear-cut defined regulatory outcomes, or at least verifiable outcome proxies, may help to prevent a subtle deviation from the initially defined regulatory aims. Such deviations are likely because the sometimes strong ties between the regulator and the regulated firms may allow energy firms to influence the regulator and to obtain relaxations of initial regulations. For example, former managers of energy firms frequently become members of the regulation authority. This allows former managers to thwart regulation and to conserve the monopoly profits of energy firms (Knittel
2006). This “regulatory capture” (Stigler
1971) may be prevented if the aims of regulation are made transparent and verifiable by the public.
Another point is that incentives should be straightforward and comprehensible (Pfeifenberger and Tye
1995). This requirement, again, is in line with findings in research on organizational behavior and social psychology (Kahneman et al.
1982; Léon
1997). Straightforwardness and comprehensibility are important ingredients of incentive schemes because the recipients of incentives will more easily adapt to those incentives. That is, only if the regulatee understands the workings of the incentive scheme will he be able to respond properly and fulfill the aims of regulation. In addition, a plain and clear-cut incentive scheme is also advantageous for the regulator, because it is easier to control energy firms if the yardstick of regulation is not ambiguous and subject to different interpretations. However, at first glance, from the perspective of New Sociological Institutionalism, this seems not to be evident. Straightforwardness and comprehensibility is seen more as a sort of rationalized procedure that creates the image of rational choices rather than the reality. Or, to put it in the words of Meyer and Rowan (
1991, p. 53): “… organizational success depends on factors other than efficient coordination and control of productive activities.” Thus, the emphasis placed by rational-choice theorists on formal procedure as a means to produce more rational decisions becomes undermined by New Sociological Institutionalism. However, New Sociological Institutionalism does not completely disregard technical efficiency. In case that organizational output is easily measurable, when productive technologies are well defined, and when criteria of success are unambiguous, then technical efficiency matters (Carruthers
1995). In this respect Meyer and Rowan (
1991) explicitly mention public utilities, and one may conclude that a straightforward and comprehensible design of incentive regulation is also a worthwhile aim from the perspective of New Sociological Institutionalism.
Clarity and comprehensibility of incentive schemes seem to be evident or even trivial requirements of incentive regulation. However, in reality, these requirements are frequently ignored (Pfeifenberger and Tye
1995; Buechner and Katzfey
2006). For example, the British regulation of electricity grid firms employs an incentive formula that aims to considering numerous characteristics of grid firms in order to determine the optimal incentive. The formula is supposed to establish optimal incentives for grid firms, leading to an increase in productivity. In addition, the formula aims to cover the costs of running the grid and ensuring a secure supply of energy (for the complete formula, see OFGEM
2008).
Every term in the formula for the British “revenue cap” has its justification and has been discussed at length in academic and political circles, as well as by the scientific board of the OFGEM (Office of Gas and Electricity Markets). However, one can ask whether the complexity of the formula and the manifold data needed to feed the formula may thwart the aim of setting optimal incentives and achieving efficient regulatory outcomes. What is still missing in the debate on incentive regulation is a more detailed discussion of other straightforward instruments of incentive regulation. Those other instruments of incentive regulation may not be as sophisticated as the current incentive schemes, yet these other incentive schemes might be highly effective (for an early statement see Pfeifenberger and Tye
1995).
A strong candidate for such a clear-cut and comprehensible instrument is the length of the regulation period. The longer the regulation period, the stronger is the incentive for cost reduction, as energy firms have a longer amount of time to capture the difference between the price ceiling (price or revenue cap) and the true costs (Joskow
2006; Baumol and Klevorick
1970; Vogelsang
2002). For example, statistical estimations for Austrian grid firms point to a sharp increase in the incentive to reduce costs when the regulation period is extended from 5 to 10 years. If the regulation period is 5 years, then there is an incentive to reduce costs by about 28%, while a regulation period of 10 years produces an incentive to reduce costs of about 49% (Groenli and Haberfellner
2002). Therefore, it may be advantageous to grant longer regulation periods and simultaneously to simplify the regulation formula in order to have a more focused incentive to reduce costs. In addition, this may block opportunities for energy firms to bargain for cost categories, which are exempted from incentive regulation. That is, the aim of incentive regulation becomes much clearer, and energy firms have a strong impetus to pass incentives through the corporate governance structure.
Finally, it is interesting that the European Commission has recently taken steps which aim at an improvement of clarity and comprehensibility of regulation by drafting a proposal on energy market integrity and transparency (European Commission
2010). Even though this proposal is not directly concerned with incentive regulation, it is stated in this paper that “citizens, business and authorities must have confidence in the integrity of these wholesale energy markets” (European Commission
2010, p. 2). For this aim the Agency for the Cooperation of Energy Regulators (ACER), which has been newly founded (EC No 713/2009), will collect relevant data of energy markets and make them centrally available for the public. In addition, under the heading “Clear and consistent rules” the proposal states that the clearness and consistency of the ruling against abusive market practices are important aims of energy regulation. However, the future will reveal, if these intentions of the Commission become implemented by the national regulators and whether the clarity and comprehensibility of regulation will be improved.
4.2.2 Incentive compatibility
Another important point on the research agenda is compatibility between the “external” incentives of energy regulation and the aims of decision-makers “within” the firm. Two examples may clarify the importance of incentive compatibility:
1.
“Legal Unbundling” commands a governance structure that grants managers of grid firms a widely unaffected management of the grid. The underlying idea is that managers of grid firms should care about the efficient supply of grid services and should not discriminate between the different customers of the grid (Brunekreeft and Ehlers
2006). That is, incentive compatibility requires that parent companies of grid firms do not interfere into the decision-making of grid firms—for example, into the allocation of grid capacity or investments in the grid. To put it simple, under a legal unbundling regime, corporate governance must shield grid firm managers against the direct or indirect intervention of parent companies. This legal shield against interventions has to be rather strong, because market forces do not automatically correct undue interventions by parent companies. In normal markets, undue interventions by a parent company into the operations of an affiliated company may lead to the bankruptcy of the affiliation, whereas in regulated markets, those interventions may only result in a loss of efficiency—the monopoly position will secure profits anyway.
2.
Incentive compatibility demands that decision-makers can satisfy their individual preferences and reach their goals within the constraints of corporate governance structures. If external regulation does not respect individual preferences, then regulation may produce unintended consequences (Verma et al.
1999). For example, under a “legal unbundling” regime, the career of a grid manager may depend on the manager’s contribution to the overall profit of the holding company. However, if there is the legal obligation to give non-discriminatory access to the grid for competitors of the holding company, then the manager of the grid firm faces a severe trade-off. On the one hand, the manager may comply with regulation, taking into account the possibility that his career may deteriorate. On the other hand, the manager can apply sophisticated tools of discrimination in order to derogate the competitors of the holding company, which may increase his career chances but may also expose him to the risk of being punished by the regulator. To be clear, whether grid managers decide on one or the other option depends on a multitude of factors, but the trade-off points again to the crucial interdependence of corporate governance and external regulation when one means to regulate energy firms effectively.
In order to attain incentive compatibility between “external” regulations and the goals of managers one has to design the corporate governance of grid firms adequately. An appropriate economic tool box for shaping corporate governance and to align the goals of regulation and the goals of managers is provided by “mechanism design” (Groves and Ledyard
1987), which in recent years has got a lot of attention for a proper regulation of energy markets (Silva et al.
2001; Battle and Perez-Arriaga, Batlle and Perez-Arriaga
2008). The idea is to “manipulate” the institutional environment of managers in a way that they behave in a manner that is compatible with the aims of regulation. However, mechanism design relies strongly to the assumption of rationality and selfishness of agents (Groves and Ledyard
1987), which may be seen as an obstacle to applying this concept to real world problems, when agents often deviate from rational behavior (McFadden
2009). Therefore it is useful to analyze the problem of incentive compatibility also from the perspective of New Sociological Institutionalism, which does not rely on the rationality assumption. From that perspective an agent will align the goals of regulation with his own goals, if there is sense-making possible (Weick et al.
2005). Sense-making is possible, if the agent can attribute to regulations, corporate governance or other institutions an inherent logic and legitimacy as well as he can link his experience to the challenges of regulation. If institutional settings make sense, then the agent is more willing to accept regulations and to adapt his behavior to the logic of institutional constrains. For example, incentive regulation may be obeyed more easily, if the regulation scheme makes sense not only from the perspective of cutting the costs of the power grid, but also if incentive regulation is in accordance with environmental protection and if cutting costs does not threat the jobs in the energy sector.
As it turns out, New Sociological Institutionalism may be a helpful tool to get deeper insight into the sense-making of energy regulation, if the proper behavior of managers depends on the concerted interplay between “external” regulations and corporate governance.
4.2.3 Magnitude and reliability of incentives
Managers of grid firms will be more likely to comply with regulations if the magnitude of regulations is strong and if regulations are reliable. This proposition is intuitive and has been recently proved by experimental studies of mechanism design (McFadden
2009).
The design of corporate governance has a significant effect on the magnitude of regulatory incentives because corporate governance rules decide, which incentives are eligible and which are not. For example, under a regime of “legal unbundling” the regulator may decide that the profits of the grid firm have to be reinvested into the power grid and should be not transferred to the parent company. Such a legal obligation diminishes the incentive to disinvest into the grid and to lower the net capacity, while it strengthens the incentive to allocate the capacity of the power grid efficiently. Or, the regulator might forbid bonus wage systems for power grid firms, which are linked to the overall profit of the parent company. That is, grid managers should not indirectly profit from discrimination against competitors. If a bonus wage system is installed, then it seems to be more reasonable for that system to refer to the increase in productivity of grid firms per period. In that case, it is more likely that incentives become properly channeled through the corporate body of grid firms.
Under a regime of “ownership unbundling” the incentive for managers of grid firms to disinvest into the power grid may be even higher, in order to obtain—at least for a short term—a high rate of return. Therefore, even stronger legal obligations seem to be in order to counterbalance the incentive to disinvest into the grid capacity. Also the bonus wage system should not refer to the rate of return of the grid firm, because that would incentivize disinvestment. Otherwise, discrimination between suppliers of energy seems to be no problem under a regime of “ownership unbundling”.
It becomes clear that the design of corporate governance leads to different weights of the various incentives that are in play, and that the regulator has to pick appropriate regulations which press grid managers to behave in accordance with the aims of regulation.
The reliability of regulations is also of great importance to the targeting of incentives (Stern
1997; Hall et al.
2000). This point entails several aspects. The first is that incentives have to be enduring and must be repeated so that decision-makers can adapt their behavior. The second is that incentives must not be subject to renegotiations. That is, managers should make an effort to adapt their behavior and not attempt to manipulate regulations. The third aspect is that rewards from regulatory compliance must follow promptly, in order to underscore the causal link between regulatory compliance and rewards.
The magnitude and reliability of incentives mirror a well-known pair of parameters in economics that has especially been applied in the economic theory of crime (Becker
1968). The first is the level of punishment, and the second is the likelihood of detection. While the magnitude of the incentives may be interpreted as the level of punishment, the reliability of the incentives can be interpreted as the likelihood of one’s becoming detected in committing a crime. The stronger the magnitude of the incentives and the higher the reliability of the regulation, the more compliance with regulation can be expected. Even if one is of the opinion that organizational behavior is not the result of such a simple calculus, the magnitude and reliability of incentives are important parameters for the design of corporate governance of grid firms. In addition, it seems that different mixes of magnitude and reliability of incentives may yield in the end the same regulatory result.
However, one can ask whether New Sociological Institutionalism can add insights to the interplay of governance structures and the magnitude and reliability of regulation of grid firms. In this regard an important argument is coined by DiMaggio and Powell (
1983, p. 152). They hold that organizations “tend to model themselves after similar organizations in their field that they perceive to be more legitimate or successful.” That is grid firms may adapt their organizational structure in response to corporate governance rules and certain regulations, however the realized organizational form may be not the result of a firm’s considerations how to improve its economic efficiency. The organizational form may be more influenced by “mimetic” processes that focus on well established and legitimized organizational routines and structures of an industry. If that argument by DiMaggio and Powell were true, then aspects of organizational legitimization must be taken into consideration, when one is out to determine the efficient mix of the magnitude and reliability of incentives. For example, bonus wages which are linked to the overall profit of the parent company may lead to economically inefficient behavior of grid managers. However, this sort of bonus wage system may be seen as the legitimate one, and to forbid this system may provoke counter actions of managers, in order to circumvent the prohibition. That is New Sociological Institutionalism points out that a sort of “command and control” regulation has limitations, if it is not embedded into an organization’s social context.
4.2.4 Authorization
Managers have to be authorized to take all appropriate measures in order to react to incentive regulation in a coordinated manner. For example, under a regime of incentive regulation grid managers have to decide on two important things: (1) The access price for using the grid and (2) the budgeting of investments into the grid. It is obvious that these two tasks are highly interrelated. The access price, in combination with the grid capacity, determines the potential profit of the grid firm. On the other hand, the grid capacity depends on the investments into the grid. Therefore, the management of access prices and investments into the grid should be bundled as part of the same division, in order for there to be integrated management of grid capacities and access prices. In addition, this sort of integrated management points to the need for a fine-tuned accounting system that mirrors the requirements of incentive regulation on the one hand and provides all information necessary for the management to react in a concerted way on the other.
If the authority to react to incentive regulation is split (for example, if the planning of investments into the grid occurs in the finance division while the determination of access prices occurs in the sales division) there may occur severe frictions, which complicates proper reaction to incentive regulation. The external incentive will be diffused in the corporate governance structure of grid firms, and incentive regulation may provoke contradictory reactions. The finance division may plan for an extension of the net capacity, while the sales division may plan with a constant net capacity. Although it is somewhat overstated, this simple example makes clear that the allocation of authority plays a crucial role not only in the proper processing of incentive regulation in corporate governance structures but also in deriving a consistent strategy for how to react on incentive regulation.
Therefore it seems pretty clear that grid firms should strive for an allocation of management tasks, which leads to a concerted management of activities. Regulation should avoid that a proper managerial planning of the power grid becomes hampered. This requirement is by no means trivial as the case of “accounting unbundling” shows. One can certainly imagine economically efficient modes of “accounting unbundling”. However, in practice it is not sure that those systems become implemented. This may trace back to opportunistic actions of agents, but may be also explained by processes of institutionalization of corporate governance: Energy firms may adapt to that sort of internal accounting system which has the greatest legitimacy in the energy sector, irrespective of the consequences for economic efficiency.
4.2.5 Legitimacy
As already mentioned legitimacy plays an important role in the implementation of incentive schemes. By the term “legitimacy” in general is meant a procedural quality of corporate governance that relates to democratic accountability (participation), the separation of powers, transparency, and the rule of law (Coglianese
2007). That is, an organization is seen as legitimate if it is in accordance with the basic principles of the social organization of men, or, in terms of New Sociological Institutionalism: Corporate governance is legitimate if it is embedded in the larger institutional context of societal living (Aguilera and Jackson
2003; Granovetter
1985) and if there are no contradictions between societal and organizational rules. Legitimacy does not have to be in conflict with economic efficiency. However, there can be conflicts if organizational rules enforce efficient behavior but this sort of behavior is not in accordance with the moral frame or accepted routines of society. In such a case, efficient behavior is seen as illegitimate.
The point is that economic consequences of incentive regulations that are regarded as illegitimate may provoke organizational behavior that runs against the proper working of incentive regulation. A good illustrative case can be found in Germany. In the past, German energy firms were quasi state-owned by the German federal states (like, for example, Bavaria or Saxony) and local communities. However, after the deregulation of the energy markets, there still exists strong engagement in energy firms on the part of the German federal states, which are holding large shares of equity. Additionally, often boards and other committees are staffed with (former) politicians. Therefore, there is still a high degree of direct and indirect political influence on energy firms in Germany such as RWE or EON.
In the past, German energy firms granted ample extra benefits to their employees, like high wages, generous pension plans, broad social security programs, child care for children of employees, etc. In addition, energy firms supported communal events like music festivals or sporting events. With the advent of the deregulation of the energy sector and the beginning of incentive regulation, all these extra costs have come under scrutiny because such costs are not directly related to the production, distribution and sale of energy. However, cutting these extra costs is regarded as illegitimate by workers and other beneficiaries, like local communities, because these extra benefits are seen as social achievements that are important components of worker-oriented and democratic firms (Mitbestimmung
2006). Therefore, labor unions and shareholding communities exert pressure on executive managers via the board to preserve these extra-social benefits by emphasizing the corporate social responsibility of energy firms.
Also in New Zealand legitimacy played a role, when (local) grid firms which are owned by consumer trusts, were exempted from incentive regulation. It was said, that in case of trust ownership all benefits will accrue automatically to consumers. In addition, it was assumed that consumers will feel responsible for a proper working of management. That is consumers can directly participate in a grid firm’s decisions and the management is directly accountable to consumers. Hence a redundant control of those grid firms by the regulator was seen not only to be unnecessary, but an additional layer of regulation was considered as illegitimate (Lewis and Meade
2007). However, today also trust owned grid firms are subject to incentive regulation, which has triggered a public debate about the legitimacy of the regulator’s interventions.
In general, legitimacy points to the important fact that besides efficiency also other normative considerations play a role, if one is out to regulate an industry. Disregarding legitimacy issues may hamper the proper implementation of incentive regulation severely.
4.2.6 Corporate culture
Corporate culture and work attitudes also play an essential role in the effectiveness of incentive channeling. In the past, energy firms were seen as vertically integrated natural monopolies that were coordinated mostly by the commands of civil servants. The influence of civil servants had a strong imprinting effect on the corporate culture of energy firms, which adopted a corporate culture very similar to that of the regulating bureaucracy (Russo
1992).
The interconnection of energy firms with the regulating body put forth a sort of corporate culture less oriented to the needs of consumers, but to the needs of politics. In addition, corporate culture of energy firms does not regard competition as an important part of a market economy but instead is strongly adapted to the accuracy of bureaucratic procedures (DiMaggio and Anheier
1990). Therefore, incentive regulation must cope with a corporate culture that processes incentives not like a market, but like a bureaucratic sub-unit. In addition, in the past, key positions of energy firms were occupied by engineers who were more interested in a secure supply of energy than in cutting costs. As a consequence, the changes to more market-oriented regulation have often been hampered by engineers in management positions (Mueller and Carter
2007). The bureaucratic culture of energy firms has been amplified in the past by the application of cost-plus regulation. Cost-plus regulation has led to a situation in which energy firms could not make any profits but also would not see any losses. That is, profit-making did not have the same importance in the energy industry that it did in other industries, or else it was not seen as relevant at all. This situation had a lasting imprinting effect on the corporate culture of energy firms, too (DiMaggio and Anheier
1990). A grid firm, which is not profitable under incentive regulation, may not be put under pressure to become more efficient, because the management of the parent company may “forgive” the management of the grid firm. Managers of parent companies of grid firms are more likely to forgive inefficiencies, because they often contain the old routines of cost-plus regulation within themselves (Russo
1992), although cost-plus regulation has come to an end.
In sum, corporate culture and work attitudes constitute a set of important but complex problems that are of the utmost importance when one is aiming to make incentive regulation work. Even if one is of the opinion that, in the end, the corporate culture of energy firms will converge towards that of firms in ordinary markets, the corporate culture of energy firms represents a set of special problems that have to be overcome in the transition period from highly regulated markets to deregulated ones. Although it is intuitively clear that culture in general as well as corporate culture in particular play an eminent role for the proper implementation of incentive regulation, the economics approach is not well equipped to integrate cultural reasoning into its considerations (for a recent discussion see for example Guiso et al.
2006, 2009). One of the problems of the economics approach is the insufficient integration of history (North
1990; David
1985; DiMaggio and Anheier
1990), which plays an important role for the transformation of regulatory regimes. The approach of New Sociological Institutionalism can contribute to a better understanding of the cultural embeddedness of energy regulation by highlighting the historical path of regulations (DiMaggio and Anheier
1990).