Backward- Versus Forward-Looking Regulation: Consequences for Investment and Welfare

27 Pages Posted: 1 Jun 2005

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: May 15, 2005

Abstract

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

Evans, Lewis T. and Guthrie, Graeme, Backward- Versus Forward-Looking Regulation: Consequences for Investment and Welfare (May 15, 2005). Available at SSRN: https://ssrn.com/abstract=731443 or http://dx.doi.org/10.2139/ssrn.731443

Lewis T. Evans (Contact Author)

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

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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