Risk, regulation and behavioural modelling

Executive summary The right incentives are vital to the success of economic regulation. Without them, companies may act in ways that are contrary to the regulator's aims, which may be contrary to the interest of consumers and in the longer term to those of the companies themselves and society more widely. The modern science of behavioural economics is being used increasingly by marketing departments and advertising agencies to understand consumer behaviour. David Cameron has created a policy unit in the Cabinet Office to draw on its insights. These ideas are just as relevant to the behaviour of companies and regulators. Indepen and Volterra have recently undertaken research into the use of behavioural economics and agent based modelling to help design better incentives. The work was focused on the water industry and, the results so far suggest it is very useful Two examples of benefits are: The process of developing the model involved explicit consideration of motivations and responses. This was an interactive process involving the modelling team and senior people from the regulator and the regulated businesses. The process provided a constructive basis for dialogue and improved understanding of how incentives will work.  The model and the interaction that was involved in its creation and use allow for experiments on incentive designs at no risk to customers and investors. This will be of particular value when regulatory reform is under consideration and there is a need to develop incentive packages that are consistent with better and risk-based regulation. These benefits have the capacity to change how regulatory engagement and incentives work and if it is applied effectively, will help to reduce regulatory risk and unintended consequences, creating better outcomes for customers. Modelling of this kind will be of value wherever relationships between incentives and outcomes are complex so that enhanced understanding from both sides is needed to ensure that unexpected outcomes do not occur. The art of behavioural modelling is to create a model sufficiently realistic to be useful and sufficiently simple for the results to be understood. The balance is key to engagement which in turn is essential to creating a strong regulatory framework with the right incentives.-Limits the need for accurate forecasts in an uncertain world by enabling us to explore those policies which are robust and generate benefits across a range of outcomes  Allows companies and regulators to get a handle on potential unintended consequences …