Investment and Capital Structure of Partially Private Regulated Firms

Abstract

We develop a model that examines the capital structure and investment decisions of regulated firms in a setting that incorporates two key institutional features of the public utilities sector in many countries: firms are partially owned by the state and regulators are not necessarily independent. Among other things, we show that regulated firms issue more debt, invest more, and enjoy higher regulated prices when they face more independent regulators, are more privatized, and when regulators are more pro‐firm. Moreover, regulatory independence, higher degree of privatization, and pro‐firm regulatory climate are associated with higher social welfare.

Consumer welfare and the strategic choice of price cap and leverage ratio

“…A few papers have examined the interaction of regulator's pricecap decision and firm's leverage decision (Bortolotti et al, 2007;Cambini & Spiegel, 2011;Dasgupta & Nanda, 1993). However, there is not much work on the joint effect of corporate investment and leverage decisions and their interaction with the regulator's price-cap decision, and how this interaction affects consumer welfare in equilibrium.…”

“…4 The increased leverage ratios under regulation have also caused concern to policymakers. For instance, a report by the UK Department of Trade and Industry and the Treasury Department mentions that the higher leverage ratios could imply greater risks of financial distress; also, the Italian energy regulation agency expressed concern that excessive financial leverage could lead to financial distress causing service interruptions (Cambini & Spiegel, 2011).…”

“…But these studies are limited to unlevered firms, hence they ignore the important role played by firm leverage in the regulatory process. The process of regulation is often viewed as a bargaining game between regulator and firm, where the former uses price cap and the latter uses leverage ratio to bargain (Cambini & Spiegel, 2011;Dasgupta & Nanda, 1993).…”

“…The combined effect is therefore not clear; if the "investment" effect is quantitatively more (less) important than the "consumer surplus" effect, then regulation will reduce (increase) consumer welfare. Further complicating the issue are a couple of points: (i) companies behave strategically in their capital structure decisions, by increasing leverage ratio in order to pressurize regulators to set higher price limit (Bortolotti, Cambini, Rondi, & Spiegel, 2007;Cambini & Spiegel, 2011;Dasgupta & Nanda, 1993), which regulation. An important determinant of the above effect is how strongly pro-consumer the regulator is.…”

Paying Returns to Shareholders of Water Utilities: Evidence from Italy

“…Wansley [18] showed that unregulated firms pay out a smaller portion of their earnings than do firms in most regulated industries. Cambini and Spiegel [19] showed in their model that regulated firms issue more debt, invest more, and enjoy higher regulated prices when they face more independent regulators; they are more privatized when regulators are more pro-firm. Cambini and Spiegel [19] also showed that regulatory independence, higher degree of privatization, and pro-firm regulatory climate are associated with higher social welfare.…”