Risk, Price Regulation, and Irreversible Investment

20 Pages Posted: 1 Jan 2004

See all articles by Lewis T. Evans

Lewis T. Evans

Victoria University of Wellington - New Zealand Institute for Study of Competition and Regulation Inc. (ISCR)

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: December 22, 2003

Abstract

We show that regulators' price-setting, rate base, and allowed rate of return decisions are inextricably linked. Once regulators switch from traditional rate of return regulation, the irreversibility of much infrastructure investment significantly alters the results of the usual approach to price-setting, as exemplified by Marshall, Yawitz and Greenberg (1981). In particular, the practice of 'optimizing' inefficient assets out of the regulated firm's rate base, as in total element long-run incremental cost (TELRIC) calculations in telecommunications, exposes the firm to demand risk. The firm requires an economically-significant premium for bearing this risk, and this premium is an increasing function of the 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 not generally equal the optimized replacement cost.

Keywords: Regulation, Cost of capital, Rate base, Sunk costs

JEL Classification: G31, L5

Suggested Citation

Evans, Lewis T. and Guthrie, Graeme, Risk, Price Regulation, and Irreversible Investment (December 22, 2003). Available at SSRN: https://ssrn.com/abstract=482647 or http://dx.doi.org/10.2139/ssrn.482647

Lewis T. Evans

Victoria University of Wellington - New Zealand Institute for Study of Competition and Regulation Inc. (ISCR) ( email )

Wellington 6001
New Zealand
64 4 4635562 (Phone)
64 4 4635566 (Fax)

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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