5 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.