This paper analyses the incentives for collusion among firms when an industry is regulated by means of yardstick competition. The central assumption is that firms must write collusive side contracts before the revelation of private, correlated information and are unable to communicate later. The analysis shows that collusion is costly to society only if firms can commit to side payments. Third-best, collusion-proof yardstick competition entails more (less) distortion of efficiency for low-productivity (high-productivity) firms than second-best yardstick competition. The benefit of yardstick competition vanishes in the limit as correlation of private information becomes near perfect.