Backward- Versus Forward-Looking Regulation: Consequences for Investment and Welfare
27 Pages Posted: 1 Jun 2005
Date Written: May 15, 2005
In infrastructure industries the permitted revenue of a regulated firm depends crucially on the choice of rate base and the allowed rate of return. In this paper we examine the impact of these two variables on the timing of the regulated firm's investment. Since the firm bears all the cost of investing, but shares the resulting flow of surplus with consumers, the unregulated monopolistic firm generally invests too late from a social planner's point of view. We find that setting the rate base equal to the replacement cost of the firm's assets leads to even later investment than the unregulated firm. In some circumstances, and for some allowed rates of return, setting a historical cost rate base can lead to earlier investment than the unregulated firm. This result derives from the irreversible nature of infrastructure investment and the uncertainty surrounding future costs and surplus flows. We find that welfare is enhanced by allowing a rate of return which differs according to the choice of rate base and the unsystematic, as well as systematic, risk of cash flows. Our model suggests that setting the allowed rate of return above the optimal level results in a smaller decline in welfare than setting it below the optimal level.
Keywords: Regulation, Rate Base, Investment Timing, Uncertainty, Sunk Costs
JEL Classification: G18, G31, L5
Suggested Citation: Suggested Citation