Optimal Regulation Under Uncertainty

Marshall, William J.; Yawitz, Jess B.; Greenberg, Edward

doi:10.2307/2327555

Cited by 9 publications

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“…Llewellyn and Mauer argue that stabilization mechanisms in incentive regulation (rules which allocate unexpected returns between utilities' shareholders and customers) will have similar impact on measured riskiness (Llewellyn and Mauer, 1993: 264). Structural linkage of risk and return in US rate regulation is also discussed by Marshall et al (1981), Chen (1982), Prager (1989), Gombola and Kahl (1990) and Teisberg (1993).…”

Section: Background and Related Literaturementioning

confidence: 99%

Risk and regulation in water utilities: a cross-country comparison of evidence from the CAPM

2014

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The full-text may be used and/or reproduced, and given to third parties in any format or medium, without prior permission or charge, for personal research or study, educational, or not-for-pro t purposes provided that:• a full bibliographic reference is made to the original source • a link is made to the metadata record in DRO • the full-text is not changed in any way The full-text must not be sold in any format or medium without the formal permission of the copyright holders.Please consult the full DRO policy for further details. AbstractThis paper addresses a core issue for the regulated utility: what are the risks taken by investors in organizations that supply a product whose supply is regulated? Prior research on returns of regulated water supply and distribution companies in the United Kingdom concluded that regulation interacts significantly with equity returns and that the systematic risk and hence required returns of water utilities equity were low and decreasing over time (Buckland and Fraser, 2001). The current research analyses the returns on securities issued by regulated water companies in the differently-regulated economies of the UK and the USA, using data from 1980 to 2010. Mirroring the results from the 1990s, the evidence suggests that UK regulators have chronically overestimated the systematic risks borne by investors in water utilities, resulting in lax pressure on permitted returns and higher prices than are needed to provoke efficient supply. The analysis also confirms that there are striking differences between the regulatory risks and patterns of returns for private sector water utilities in the USA and the UK.

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Section: Background and Related Literaturementioning

confidence: 99%

Risk and regulation in water utilities: a cross-country comparison of evidence from the CAPM

2014

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“…(3) What prices is the firm allowed to charge? Marshall et al (1981) point out that the prices set by a regulator affect the risk borne by the firm, and therefore the rate of return which the firm should be allowed to 16 Regulation of electricity transmission in New Zealand uses such a rate base (Ministry of Economic Development, 2000). Although considered favorably by regulators in Australia, ODV was rejected in favor of an ORC regime (Clarke, 1998;Johnstone, 2003, p. 3).…”

Section: Replacement Cost (Rc)mentioning

confidence: 99%

“…It needs to choose the appropriate cost of the firm's assets (the rate base), the rate of return the firm is allowed to earn on this rate base, and the prices the firm is allowed to charge. Marshall, Yawitz and Greenberg (1981) show how the last two decisions are inter-related.…”

Section: Introductionmentioning

confidence: 99%

“…The analysis of Marshall et al (1981) is adapted for irreversibility and applied to the different regulatory regimes in Section 4. We examine the dependence of demand risk allocation on regulatory policy in Section 5, where we present some numerical measures of the implications of our analysis.…”

Section: Introductionmentioning

confidence: 99%

“…Breaking even ex ante is a necessary condition for Ramsey pricing to be sustainable over time. Unless regulators adopt traditional rate of return regulation, the irreversibility of much infrastructure investment significantly alters the results of the approach to price-setting described by Marshall, Yawitz and Greenberg (1981). In particular, the practice of 'optimizing' inefficient assets out of the regulated firm's rate base, as occurs in total element long-run incremental cost calculations in telecommunications, exposes the firm to demand risk.…”

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confidence: 99%

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Risk, Price Regulation, and Irreversible Investment

Evans

Guthrie

2003

SSRN Journal

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We show that regulators' price-setting, rate base, and allowed rate of return decisions are inextricably linked if prices are set so that regulated firms just break even whenever they are forced to invest. Breaking even ex ante is a necessary condition for Ramsey pricing to be sustainable over time. Unless regulators adopt traditional rate of return regulation, the irreversibility of much infrastructure investment significantly alters the results of the approach to price-setting described by Marshall, Yawitz and Greenberg (1981). In particular, the practice of 'optimizing' inefficient assets out of the regulated firm's rate base, as occurs in total element long-run incremental cost calculations in telecommunications, exposes the firm to demand risk. The firm requires an economically-significant premium for bearing this risk, and this premium is a function of both the systematic and unsystematic risk of demand shocks. In addition, we argue that if the firm is to break even under incentive regulation then the level of the rate base will exceed the optimized replacement cost by an amount which we interpret as the value of the excess capacity of the firm's assets. If this component is excluded from the rate base, incentive regulation will not be sustainable. JEL Classification code: G31, L5

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Incentive Regulation of Prices When Costs are Sunk

Evans

Guthrie

2006

J Regul Econ

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We present a model featuring irreversible investment, economies of scale, uncertain future demand and capital prices, and a regulator who sets the firm’s output price according to the cost structure of a hypothetical replacement firm. We show that a replacement firm has a fundamental cost advantage over the regulated firm: it can better exploit the economies of scale because it has not had to confront the historical uncertainties faced by the regulated firm. We show that setting prices so low that a replacement firm is just willing to participate is insufficient to allow the regulated firm to expect to break even whenever it has to invest. Thus, unless the regulator is willing to incur costly monitoring to ensure the firm invests, revenue must be allowed in excess of that required for a replacement firm to participate. This contrasts with much of the existing literature, which argues that the market value of a regulated firm should equal the cost of replacing its existing assets. We also obtain a closed-form solution for the regulated firm’s output price when this price is set at discrete intervals. In contrast to rate of return regulation, we find that resetting the regulated price more frequently can increase the risk faced by the firm’s owners, and that this is reflected in a higher output price and a higher weighted-average cost of capital. Copyright Springer Science+Business Media, Inc. 2006Incentive regulation, Uncertainty, Sunk costs, Economies of scale, G31, L5,

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Optimal Regulation Under Uncertainty

Cited by 9 publications

References 0 publications

Risk and regulation in water utilities: a cross-country comparison of evidence from the CAPM

Risk and regulation in water utilities: a cross-country comparison of evidence from the CAPM

Risk, Price Regulation, and Irreversible Investment

Incentive Regulation of Prices When Costs are Sunk

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