05 May 2011

Regulatory risk and uncertainty

EF asks:
How do you incorporate regulatory risks into your model of what to do, if you are running a business or water utility? Also say something on the effect of uncertainty in regulatory risk on innovation and the economy, especially as that relates the actions by politicians.
There are two words that matter here:

Risk can be quantified, as in the risk of getting 49 heads out of 100 coin tosses. Uncertainty cannot be quantified. That's like the uncertainty that a Japanese reactor will get into trouble and the German chancellor will shut down German reactors.

By these definitions, you can estimate the scale of risk and its impacts. You may even be able to buy insurance against risk. If that's the case, then you merely pass along the price of risk to your customers. If/when the risk environment improves, your insurance will fall and prices to customers will fall.

It's obvious from the question and reality that uncertainty is a bigger problem. Uncertainty cannot be quantified (very well), so it's necessary to either reduce activities vulnerable to uncertainty ("nobody ever got fired for buying IBM") or prepare for uncertainty by hedging operations or finances.

In the former case, innovation and experimentation will be reduced. In the latter case, excess reserves of capacity or cash will reduce efficiency.

This is the perspective of the business or regulated utility.

From the bureaucrat's or politician's perspective, favoring risk will make you more popular with businesses while reducing your power (100 percent risk turns you into a coin flipping machine). From this insight, we see that favoring (or signalling) uncertainty makes businesses more anxious and less happy. It also gives you more power, which is handy if you are corrupt enough to demand bribes (or campaign contributions) or like it when people bow before you.

These stylized facts help us see how a country may move from uncertainty (arbitrary changes in policy and/or penalties) to risk (clear and well-understood rules). That same movement represents the move from arbitrary power to the rule of law, from developing to developed.

Bottom Line: Good regulation and governance serves businesses and the people; poor regulation and governance serves corrupt politicians and bureaucrats.


  1. David,
    What is the reference for your definitions of 'risk' and 'uncertainty'?
    These are not the definitions that statisticians, such as me, use.

  2. When you regulate there is also another type of risk - the risk of capture by those being regulated. But Capture Theory of regulation ignores another type of risk: capture by the regulators themselves for their own purposes. So instead of regulating you get bureaucracies that exist for themselves. After issuing five water bonds for about $18 billion (with interest), California has next to nothing to show for it - no storage reservoir or Delta solution. And now the regulators want to impose a retail water tax under SB 34 that would for the first time allow regulators to tax and to reap the rewards of those taxes! So much for democracy and the separation of powers. Bureaucracy makes for Certainty but there are always risks that can't be managed or hedged.

  3. This is a great topic. There are many more aspects of uncertainty than can be addressed in a few blog posts.

    "Fooled by Randomness", by Nassim Taleb offers quite a few thoughts on the differences between risk and uncertainty.

    An aspect of public policy and regulation that has always interested me is the time effect of policies that try to reduce risk, and how those policies frequently seem to increase long term risk and uncertainty.

    An example is fixed exchange rates. Short term, fixing rates allows international trade and money flows to be less risky. However, if (when) economic fundamentals change and the exchange rates come under pressure the adjustments (devaluations) are tyically large and disruptive. Like an earthquake. I think we are seeing this effect in the Euro Zone today. Different countries have followed different fiscal and tax policies that would have resulted in different currency valuations, but the independent countries were tied to a common currency.

    Bottom Line: Short term "solutions" can lead to long term problems.

  4. @Eric -- Knight, Frank (1921) Hart, Schaffner & Marx, but Jay's also right.

    @Wayne -- you are using "risk" as I often do, but that's technically "uncertainty here," as in regulatory or political uncertainty.

  5. Heck, if you make nukes in the US you just bribe enough politicians to pass the risk of anything going wrong off on all the American taxpayers. Privatize any profits, socialize any risks or costs. What a country!


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