Modelling and understanding regulatory fit

Abstract

Understanding how regulatory interventions shape electricity markets is essential. We posit that regulation is a behavioural adaptive process, influenced by internal and external forces. We develop a system dynamics model to explore the interdependencies between regulators' reactivity, their willingness to initiate major regulatory overhauls, and market reactivity. This creates an improved understanding of the behavioural aspects of regulation, thereby putting regulators in a better position to avoid misfits often observed in the regulation of infrastructure. The model highlights the dilemma regulators face when deciding when and how to intervene. While frequent regulatory changes are detrimental, creating a constant level of uncertainty, opting for fewer, larger, changes increases the volatility of the uncertainty perceived by the market participants. The former seems preferable, with a constant level of moderate uncertainty becoming a new normal: market participants can learn to work in this environment, without having to worry about large unpredictable changes. This stylised model thus provides a better understanding of the problems facing regulators, both in the electricity sector and in other regulated industries characterised by significant lags between a changing reality and the regulatory consequences.