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Capital Investment Strategies under Uncertain Regulation

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Author Info
Elizabeth Olmstead Teisberg
Abstract

This article presents a positive model of investment choices by regulated firms that offers rational explanations for electric utilities' recent behavior of delaying investment and choosing smaller, shorter-lead-time technologies. The model assumes that firms' capital investments require long lead times, during which the value of the completed project is uncertain. Firms anticipate regulatory profit and loss restrictions, but expectations about the value of a completed project change over time. Firms' decisions are modelled using an option pricing approach that incorporates the value of flexibility to delay or abandon projects. The article shows why rational firms invest in smaller, shorter-lead-time plants, or delay investment when faced with uncertain and asymmetric profit and loss restrictions. It also looks at decisions to abandon partially completed plants, and shows that the static result that a higher cost allowance on abandoned projects increases the incentive for investment is not generally true in a dynamic model.

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Publisher Info
Article provided by The RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 24 (1993)
Issue (Month): 4 (Winter)
Pages: 591-604
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Handle: RePEc:rje:randje:v:24:y:1993:i:winter:p:591-604

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  1. Michele Moretto & Paolo M. Panteghini & Carlo Scarpa, 2007. "Profit Sharing and Investment by Regulated Utilities: a Welfare Analysis," "Marco Fanno" Working Papers 0059, Dipartimento di Scienze Economiche "Marco Fanno". [Downloadable!]
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  2. Ulrich Blum & Christian Growitsch & Niels Krap, 2006. "Network investment and the threat of regulation – preventing monopoly exploitation or infrastructure construction?," IWH Discussion Papers 7-06, Halle Institute for Economic Research. [Downloadable!]
  3. Fernando Camacho & Flavio Menezes, 2009. "Access pricing and investment: a real options approach," Journal of Regulatory Economics, Springer, vol. 36(2), pages 107-126, October. [Downloadable!] (restricted)
  4. Fernando T. Camacho & Flavio M. Menezes, 2008. "Price Regulation and Investment: A Real Options Approach," Discussion Papers Series 373, School of Economics, University of Queensland, Australia. [Downloadable!]
  5. Michele Moretto & Paola Valbonesi, 2007. "Firm Regulation and Profit Sharing: A Real Option Approach," The B.E. Journal of Economic Analysis & Policy, Berkeley Electronic Press, vol. 7(1). [Downloadable!]
    Other versions:
  6. Michele Moretto & Chiara D’Alpaos, 2004. "The Value of Flexibility in the Italian Water Service Sector: A Real Option Analysis," Working Papers 2004.140, Fondazione Eni Enrico Mattei. [Downloadable!]
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