Regulation and Contract Design: the Impact of Relationship Specific Investment

Abstract: Firms often make relationship specific investments, that is, investments that are heavily specialized to their buyers or suppliers but expose the investing firm potentially to a loss if they are utilized outside of their intended purpose. Such investments occupy a central role in explaining contractual choice, among other economic arrangements. Demonstrating the causal chain from investments to contract choice, is difficult, however, as investment and contracting decisions are decided simultaneously and selectively. To address the problem, I study 20 years of coal procurement information for electric utilities in the US. I argue that the Clean Air Act Amendment came in as an exogenous shock to investment strategies of the utilities. By requiring plants to reduce emissions, engineers were forced to alter their boilers to accommodate a larger variety of coal, and thus lowering the level of specialized investment. I exploit two exogenous sources of variation - policy induced, as the Amendment placed separate limits on Phase I and Phase II plants, and geographical, as plants closer to western coal mines are more inclined to engage in boiler retrots - to define a simple difference-in-difference model. I find that Phase 1 plants in the Midwest were more likely to change their pricing arrangements and adopt shorter duration contracts, in line with theoretical prediction. This result is robust to alternate definitions of the dependent variable, sample specification and other regulatory changes enacted over the period of study. I therefore provide strong evidence for one of the central predictions of incomplete contract theory, even after controlling for the choice of investment.