Intertemporal Price Cap Regulation Under Uncertainty

Abstract

This paper examines the intertemporal price cap regulation of a firm that has market power. Under uncertainty, the unconstrained firm 'waits longer' before investing or adding to capacity and as a corollary, enjoys higher prices over time than would be observed in an equivalent competitive industry. In the certainty case, the imposition of an inter-temporal price cap can be used to realise the competitive market solution; by contrast, under uncertainty, it cannot. Even if the price cap is optimally chosen, under uncertainty, the monopoly firm will generally (a) under-invest and (b) impose quantity rationing on its customers.Price cap regulation has been extensively studied over recent years in both atemporal and inter-temporal contexts. In the atemporal context, the focus has often been on how to deal with multiple and new products, on efficiency and incentive issues, or on how to regulate complex tariffs (Hillman and Braeutigam, 1989; Laffont and Tirole, 1990a, b;Armstrong et al. 1995), whilst in the intertemporal context, the construction of price adjustment processes and their potential manipulation by regulated firms has been examined (Hagerman, 1990; Braeutigan and Panzar, 1993). This paper by contrast focuses on the impact of inter-temporal price cap regulation on the firm's choice of investment in capacity when such investment is largely irreversible and when evolution of key variables such as product demand, technology etc. are governed by stochastic processes.

Regulation and investment incentives in electricity distribution: An empirical assessment

“…Based on modeling tools of real option analysis, Dixit and Pindyck (1994) show that under uncertainty delaying investments may be beneficial, even though a project may recover its capital costs. Dobbs (2004) emphasizes that price cap regulation under uncertainty causes regulated firms to postpone investments. Guthrie et al (2006) show the effect of different asset valuation methods to determine the regulatory asset base on firms' investment behaviors.…”

Subsidized Capacity Investment Under Uncertainty

“…Several literatures have studied to use price regulation such as the price cap to regulate the delayed investment under uncertainty. For instance, Dobbs (2004) argues that the first-best outcome cannot be reached as price cap is used for two goals: optimal investment ex-ante and optimal post-investment pricing. Building on Dobbs (2004), Evans and Guthrie (2012) show that the price cap should be lowered under scale economics where grouping investments across time is cost efficient.…”

“…For instance, Dobbs (2004) argues that the first-best outcome cannot be reached as price cap is used for two goals: optimal investment ex-ante and optimal post-investment pricing. Building on Dobbs (2004), Evans and Guthrie (2012) show that the price cap should be lowered under scale economics where grouping investments across time is cost efficient. By contrast, Willems and Zwart (2017) consider constant returns to scale where it is not optimal to group investments.…”

“…In risky environments it has been argued that a firm tends to postpone investment (see e.g., McDonald and Siegel (1986)). According to Dobbs (2004), the level of investment in capacity might also be constrained by the firm. For example, an electricity producer might hesitate to invest in renewable technology due to high investment costs compared to the fossil fuels.…”

Integrating Renewables in Distribution Grids : Storage, regulation and the interaction of different stakeholders in future grids

“…Additionally, uncertainty, caused by unpredictable regulation, for example leads to underinvestment (cf. Dixit (1989), Dixit and Pindyck (1994), Dobbs (2004a) and Dobbs (2004b)). Guthrie (2006) argues that under incentive regulation (in contrast to rate-of-return regulation), shareholders bear more of the investment risk, which discourages investment.…”