Using Forward Contracts to Reduce Regulatory Capture

Optimal incentive regulation uses transfers. If the regulator is corruptible, the regulated firm can benefit by manipulating the regulator's assessment regarding the distribution of payoff relevant variables, which determine the structure and size of optimal transfers. We show how substituting outcome‐contingent transfers by an obligation to sell simple financial contracts to well informed financial investors can reduce the scope for manipulation. A possible application would be an electricity transmission network operator whose actions can affect electricity prices. In a simple moral hazard model, first‐best outcomes can be implemented by forcing the network operator to auction off forward contracts on the electricity price. We study the optimal mixture of financial instruments and regulatory transfers given different informational assumptions and imperfections of financial markets.