Regulated Prices and Real Options
23 Pages Posted: 30 Apr 2011 Last revised: 23 Nov 2011
Date Written: November 23, 2011
This paper shows how the cash flows received by an unregulated firm operating in a workably competitive market can be replicated for a regulated firm. The only change to standard regulatory practice is that each time the regulated firm invests, the amount added to its rate base is the product of its capital expenditure and a multiplier, greater than one, that captures the reduction in value of the unregulated firm’s growth options that occurs whenever the firm invests. The regulated firm is allowed to earn a rate of return equal to its weighted-average cost of capital, applied to this rate base. Four possible approaches to estimating the size of the multiplier are presented, each based on an established real-options investment model.
Keywords: regulation, workable competition, real options, rate base
JEL Classification: D42, G31, L51, L98
Suggested Citation: Suggested Citation