Regulated Prices and Real Options

23 Pages Posted: 30 Apr 2011 Last revised: 23 Nov 2011

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: November 23, 2011

Abstract

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

Guthrie, Graeme, Regulated Prices and Real Options (November 23, 2011). Available at SSRN: https://ssrn.com/abstract=1825109 or http://dx.doi.org/10.2139/ssrn.1825109

Graeme Guthrie (Contact Author)

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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