Policy Oct 7, 2013

Look­ing Good for the Regulators

Efforts to avoid reg­u­la­tor scruti­ny come with downsides

Based on the research of

Severin Borenstein

Meghan Busse

Ryan Kellogg

No one wants to make a mis­take — par­tic­u­lar­ly not one that will be painful­ly evi­dent to his or her boss the next day, week, or quar­ter­ly review. But while mak­ing a mis­take is bad, peo­ple tend to avoid the mere appear­ance of mak­ing a mis­take just as vigilantly.

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Employ­ees are often focused on what are known as career con­cerns. Since pro­mo­tions, rais­es, or oth­er ben­e­fits fre­quent­ly depend not just on a person’s per­for­mance but on what her boss thinks about her abil­i­ties based on that per­for­mance, employ­ees con­sid­er their pro­fes­sion­al rep­u­ta­tion when mak­ing deci­sions. The famil­iar cov­er your pos­te­ri­or” strat­e­gy kicks in: peo­ple stick with the safe option rather than tak­ing a smart risk that could go poor­ly and make them seem less competent.

Career Con­cerns for Entire Com­pa­nies?

Meghan Busse, an asso­ciate pro­fes­sor of man­age­ment and strat­e­gy at the Kel­logg School of Man­age­ment, want­ed to find out if career con­cerns might play out on a larg­er scale. Can the desire to cov­er one’s back­side alter the actions of entire com­pa­nies the way it changes the behav­ior of indi­vid­ual employees?

Busse and her col­leagues, Sev­erin Boren­stein at the Uni­ver­si­ty of Cal­i­for­nia Berke­ley and Ryan Kel­logg at the Uni­ver­si­ty of Michi­gan, looked at firms in the nat­ur­al gas indus­try. ComEd, PG&E, and oth­er local util­i­ties com­pa­nies buy gas and deliv­er it to con­sumers; reg­u­la­to­ry bod­ies called pub­lic util­i­ties com­mis­sions over­see the com­pa­nies, ensur­ing that they buy enough gas to keep con­sumers stocked, and at a rea­son­able price. If a com­mis­sion thinks a local util­i­ty com­pa­ny is behav­ing impru­dent­ly — pay­ing too much for gas, for instance — it can call the util­i­ty before a reg­u­la­to­ry review, much as a boss might call an under­per­form­ing employ­ee in for a per­for­mance review.

Dur­ing a review, Busse explains, reg­u­la­tors are essen­tial­ly going to Mon­day morn­ing quar­ter­back and decide if the dis­trib­u­tor made the right choice in any par­tic­u­lar cir­cum­stance. That’s going be painful and unpleas­ant because in 20/20 hind­sight, every­thing looks clear­er.” The pos­si­bil­i­ty of a review might fos­ter career con­cerns, thought Busse, encour­ag­ing com­pa­nies to focus less on mak­ing the smartest deci­sions — even if they come with risks — and more on avoid­ing actions that might look like mistakes.

Avoid­ing the Appear­ance of Impru­dence

So Busse and her col­leagues inves­ti­gat­ed how util­i­ties buy and sell gas. Local util­i­ties buy much of their gas through long-term con­tracts. To han­dle short-term changes in demand, the firms can either buy more gas or sell their sur­plus on two timescales: dur­ing the last week of each month, in what is called the for­ward mar­ket,” or the day before they need it, in what is called the spot market.”

If career con­cerns are guid­ing util­i­ties’ strate­gies, Busse hypoth­e­sized, the sit­u­a­tion they would most want to avoid would be sell­ing their extra gas in the for­ward mar­ket, only to face a spike in demand and have to buy it back — at a much high­er price — in the spot mar­ket. This would be espe­cial­ly true in tight mar­kets, when demand, and prices, are high. Even if prof­it­ing from a sur­plus seems like a good idea at the time, sell­ing it off only to buy it back for more counts as impru­dent behav­ior that can trig­ger a review. It would be easy for reg­u­la­tors to home in on the utility’s mis­step dur­ing that review, Busse explains. They can point the fin­ger and say: You made a mis­take. You made the wrong judg­ment about how much gas you were going to need.”

But if util­i­ties refrain from sell­ing gas on the for­ward mar­ket and still have to buy more on the high­er-priced spot mar­ket, this does not nec­es­sar­i­ly look like a mis­take. Some­times there are lim­its to what can be pur­chased on the for­ward mar­ket, so per­haps the util­i­ty had sim­ply been unable to buy as much as it need­ed. That’s a plau­si­ble sto­ry because that’s some­times true,” Busse says. The reg­u­la­tor can’t say you messed up, because you haven’t tak­en an action they can point to and know for sure is a mistake.”

When the mar­kets were tight, they saw a for­ward price premium.

Busse and her col­leagues ana­lyzed spot and for­ward mar­ket prices and trad­ing vol­ume data from more than 100 local nat­ur­al gas mar­kets across the U.S. from Feb­ru­ary 1993 to March 2008. With these data, they could not look direct­ly at whether indi­vid­ual com­pa­nies were act­ing as expect­ed. They could, how­ev­er, look for larg­er trends that would result from many util­i­ties behav­ing this way: when demand is high, there should be few­er trades and high­er prices dur­ing the for­ward mar­ket than would be expect­ed based on the per­for­mance of the spot mar­ket, evi­dence that util­i­ties were hes­i­tant to sell their gas and risk a mistake.

After con­duct­ing regres­sion-based analy­ses of the data, the researchers indeed found this evi­dence. When the mar­kets were tight, they saw a for­ward price pre­mi­um such that a $1 rise in the expect­ed spot price would cause a $1.25 to $1.27 rise in the expect­ed for­ward price. A high­er spot price was also linked to a decrease in trad­ing vol­ume: that same $1 increase in expect­ed spot price leads to an 8.9% decrease in trad­ing vol­ume in the for­ward mar­ket. Oth­er poten­tial expla­na­tions for the trends — such as com­pa­nies pay­ing a pre­mi­um to lock in a sup­ply of gas or to avoid the risk of pay­ing a still high­er price on the spot mar­ket — can­not explain the entire pat­tern of results.

Inef­fi­cient Mar­kets

These trends in com­pa­ny behav­ior could make whole mar­kets less effi­cient. You have inef­fi­cient out­comes when you have some­body who real­ly needs gas, and is will­ing to pay a high price, can’t get some­one to sell them the gas at that price,” Busse says. If a local dis­trib­u­tor in one region like­ly has more than enough gas to see them through the month, they would, in most mar­kets, sell the extra gas to a dis­trib­u­tor in a region where it is get­ting cold­er and demand for gas is high. But if the mar­ket is tight, the first dis­trib­u­tor might not sell — just in case its own area gets cold and it has to buy back gas at a high price. They’re not will­ing to sell because they don’t want to take on the risk that they’re going to end up need­ing it and then be in this real­ly unpleas­ant pru­den­cy review,” she says. 

This result built on the ear­li­er research that showed indi­vid­ual career con­cerns — employ­ees doing what is best for their own pro­fes­sion­al rep­u­ta­tions — could lead to inef­fi­cient choic­es with­in a com­pa­ny. But as far as the researchers know, this is the first paper that demon­strates how career con­cerns can actu­al­ly pro­duce inef­fi­cient markets.

The same thing like­ly hap­pens in oth­er sec­tors as well, Busse sus­pects. There’s a new input sup­pli­er, but pur­chas­ing man­agers don’t buy from them because they don’t want to be the ones who tried out some­thing new and derailed the pro­duc­tion process,” Busse says. Maybe this is actu­al­ly a bet­ter input, but nobody will try it. And there­fore what would be a mar­ket inno­va­tion doesn’t hap­pen because nobody’s will­ing to take the risk and go first.”

Featured Faculty

Meghan Busse

Associate Professor of Strategy

About the Writer

Valerie Ross is a science and technology writer based in New York, New York.

About the Research

Borenstein, Severin, Meghan R. Busse, Ryan Kellogg. 2012. “Career Concerns, Inaction and Market Efficiency: Evidence from Utility Regulation.” The Journal of Industrial Economics. 60(2): 220–248.

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