How Much Discretion for Risk Regulators?

We analyze the regulation of firms that undertake socially risky activities and can reduce the probability of an accident inflicted on thirdparties by carrying out nonverifiable effort. Congress delegates the regulatory task to an Agency, though they may have have different preferences towards the industry. We determine the optimal level of discretion left by Congress to the Agency, showing a trade-off between two effects: the Agency can tailor discretionary policies to its expert knowledge on potential harm, but it implements policies which are too “pro-industry”. Although the Agency should be given full discretion when the firm’s moral hazard problem is socially costless, partial (and sometimes no) discretion is preferred when moral hazard requires that liability rents be left to regulated firms. Discretion is more valuable with, among other things, less significant conflict of interest between Congress and the Agency, more uncertain distributions of damages in the sense of Blackwell, and when higher-powered incentive regulations are required. We also study how this degree of discretion changes with the political landscape (uncertainty on the Agency’s preferences, and strategic appointment by the Executive).