Regulating Local Public Utilities by Pro fi t-Sharing ∗ Michele Moretto and Paola Valbonesi † October 2001 Abstract This paper concerns “profit-sharing” within an incomplete regu- latory contract where a municipality delegates a risk-neutral firm to manage a local utility. Together with a price cap regulation (PCR) mechanism, the contract envisages the possibility of the municipality revoking the contract if the firm’s profits are percieved “excessively” high. We show that when this threat is credible and the cost of exer- cising it is not too high, a long-term efficient equilibrium arises which guarantees the firm with an appropriate level of profits. The con- sequent regulation timing consists of an endogenous regulatory lag where the regulation has a PCR nature, followed by a period of ROR in which the firm is motivated to adjust its price downward to avoid contract recall. We also show that excessive revocation costs make the firm an unregulated monopolist with an infinite regulatory lag where ROR looks like a pure PCR. Key words: Public utilities, Regulatory contracts, Profit- sharing, Stochastic games. JEL: C73, L33, L51 ∗ This study is part of a research project financed by the Italian Ministry of University and Research (MURST 40%; 1999-2000) and the University of Padova (Progetto Ateneo 2000). An earlier version of this paper appeared in the Fondazione ENI, Nota di lavoro FEEM, no.51/2000. We benefitted from discussion with Cesare Dosi, Gerard Mondello and seminar participants at Universities of Bologna and Padova, and EARIE Conference 2000, Losanna. The authors alone are responsible for any remaining errors. † Department of Economics, University of Padova, Via del Santo 33, Italy, E-mail: moretto@decon.unipd.it ; valbonesi@decon.unipd.it 1