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Public utility regulation is a government-imposed mechanism for controlling the terms and conditions at which certain services of a public utility are provided to its customers. Most public utilities are natural monopolies, so that there are no alternative suppliers providing close substitute services. The transactions cost economics (TCE) approach to public utility regulation identifies, as the central issue, the need for customers to make a sunk or irreversible investment to extract the most value from the public utility service. However, both sides recognise that, in this context, there is a need to manage the threat of "hold up" - the risk that the service provider will raise its prices ex post to extract the buyer's surplus. This threat is managed through governance arrangements. In some cases - e.g., where there are few, easily-identified buyers or where the interests of buyers can be effectively represented in a single entity - this threat can be managed through long-term contracts or vertical integration. However, where buyers are numerous, small, and/or not all able to negotiate at the outset, some additional mechanism is required. This could take the form of government provision of the service (a form of vertical integration) or government contracting for the service, as in public-private partnerships for the provision of services.
According to this view, public utility regulation should be viewed as a government-imposed long-term contract designed to protect and promote sunk investment by both the buyers and the service provider. It has many similarities to its closest relative: long-term government contracts such as concessions, franchises, or public-private partnership agreements, and some similarities to a somewhat more distant cousin: private long-term arrangements. Public utility regulation differs from both in that it is imposed by decree rather than voluntarily entered into. However, that basic objective of all of these mechanisms is the same: the protection and promotion of sunk investment by the service provider and the buyers. According to this approach, public utility regulation should be designed and carried out in such a way as to replicate the long-term arrangement that the parties would have written if they could have costlessly negotiated before either made any sunk investment.