Police-powers, regulatory takings and the efficient compensation of domestic and foreign investors

In customary international and public law, “takings” resulting from regulations designed to protect the public good are generally excluded from compensation rules; this exclusion is known as a police powers carve-out (PPCO). Increasingly, this PPCO is being challenged, particularly in international investment law. This paper analyzes the efficiency properties of a PPCO in a model with endogenous regulation, investment and entry. We design a one-parameter family of carve-out/compensation schemes that induce efficient regulation and firm level investment even when the regulator suffers fiscal illusion and the social benefit from regulation is private information to the regulator. We show that offering a carve-out reduces the subsidy to risky industry implicit in compensation rules; thus, a carve-out can mitigate the entry problem.