Regulating investments when both costs and need are private

Large-scale infrastructure investments are often carried out in settings where their eventual usefulness or importance is difficult to predict. This paper studies optimal incentives for investment when the agent undertaking the investment has superior information on two dimensions: the cost of investment and the likelihood it is useful or beneficial to the principal. Usefulness eventually becomes public, but punishments are limited as the regulator aims at ensuring the agent earns non-negative profits irrespective of eventual usefulness. We characterize the optimal screening mechanism and show that the optimal mechanism depends heavily on the degree of asymmetric information about usefulness. When the asymmetry of information about usefulness is severe, the optimal mechanism can feature upward distortions in investment and rent for all agent types.