Risk, Price Regulation, and Irreversible Investment

Abstract

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

Broadband investment and regulation: A literature review

“…Theoretical literature points out that the methodology of replacement cost, like the TELRIC, is not seemly for the reason that it exposes the firm to risk, but does not provide enough premiums for it. An early model by Evans and Guthrie (2003) addresses the issue of dynamic efficiency over time and suggests, instead of the replacement cost methodology, the so-called optimized deprival value approach which measures the reduction in the firm's value if the firm was deprived of ownership of the assets. Later, Guthrie (2005, 2006) extended the model to discuss the timing of the regulated firm's investment specifically under a revenue-sharing scheme.…”

Modeling welfare loss asymmetries arising from uncertainty in the regulatory cost of finance

“…This means that the firm, once it knows its cost of finance, can decide on whether to invest or not, and where investments are deferrable, it may choose to defer the decision to the next RRP. However, once a service is launched, a 'universal service obligation' applies, such that the firm is required to satisfy the demand for the service through all future time (see Evans and Guthrie 2005).…”

Risk Sharing, the Cost of Equity and the Optimal Capital Structure of the Regulated Firm

“…The firm is assumed, instead, to be risk averse with a utility function that is solely dependent on the firm's profits. Evans and Guthrie (2005), building on the work of Marshall et al (1981), examine the effect of demand (but not price) uncertainty on the firm's rate base and its allowed rate of return but do not consider consumers' preferences regarding risk. 2 The capital structure of the regulated firm has also received little attention in the literature.…”

“…Only the proposal by Glas Cymru to acquire Welsh Water received regulatory approval and could, therefore, be implemented. 2 Evans and Guthrie (2005) focus on the measurement of the rate base under incentive regulation; they conclude that a premium should be included in the allowed rate of return to compensate for both systematic and unsystematic demand risk when there are unanticipated changes in technology. 3 At the end of 1998/99 average leverage in the UK water industry was about 40%.…”