Critical Infrastructure Protection and the Private Sector: The Crucial Role of Incentives

The blackout of 2003 has underscored concerns about the vulnerability of our nation’s critical infrastructure to both accidents and deliberate attack, providing an immediate connection to the nation’s homeland security efforts. But the blackout may offer a deeper lesson beyond the vulnerability of the nation’s electricity grid to terrorist attack. In particular, a common explanation for the problems facing the electricity system is that private firms have had inadequate incentives to invest in distribution lines.

The important point is that market incentives are extremely powerful. For that very reason, however, it is essential that they be structured properly. As Patrick Wood, chairman of the Federal Energy Regulatory Commission, has put it: “We cannot simply let markets work. We must make markets work.”

In homeland security, private markets do not automatically produce the best result. We must therefore alter the structure of incentives so that market forces are directed toward reducing the costs of providing a given level of security for the nation, instead of providing a lower level of security than is warranted. Given the significance of the private sector in homeland security settings, structuring incentives properly is critical.

To be sure, private firms currently have some incentive to avoid the direct financial losses associated with a terrorist attack on their facilities or operations. In general, however, that incentive is not compelling enough to encourage the appropriate level of security—and should therefore be supplemented with stronger market-based incentives in several sectors.

Private markets, by themselves, do not provide adequate incentives to invest in homeland security, and

A mixed system of minimum regulatory standards, insurance, and third-party inspections would better harness the power of private markets to invest in homeland security in a cost-effective manner.