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Capital Investment Strategies under Uncertain Regulation

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  • Elizabeth Olmstead Teisberg
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    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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    Bibliographic 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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    Cited by:
    1. Mario Ekboir, Javier, 1997. "Technical change and irreversible investment under risk," Agricultural Economics, Blackwell, vol. 16(1), pages 55-65, March.
    2. Marc Gürtler & Gernot Sieg, 2010. "Crunch Time: A Policy to Avoid the 'Announcement Effect' when Terminating a Subsidy," German Economic Review, Verein für Socialpolitik, vol. 11, pages 25-36, 02.
    3. Martzoukos, Spiros H. & Trigeorgis, Lenos, 2002. "Real (investment) options with multiple sources of rare events," European Journal of Operational Research, Elsevier, vol. 136(3), pages 696-706, February.
    4. Michele Moretto & Paolo M. Panteghini & Carlo Scarpa, 2006. "Profit Sharing and Investment by Regulated Utilities: A Welfare Analysis," Working Papers ubs0611, University of Brescia, Department of Economics.
    5. Ulrich Blum & Christian Growitsch & Niels Krap, 2006. "Network Investment and the Threat of Regulation – Preventing Monopoly Exploitation or Infrastructure Construction?," IWH Discussion Papers 7, Halle Institute for Economic Research.
    6. Nick Wills-Johnson, 2010. "Response to Peter Monkhouse," Economic Analysis and Policy (EAP), Queensland University of Technology (QUT), School of Economics and Finance, vol. 40(1), pages 112-123, March.
    7. Graeme Guthrie, 2006. "Regulating Infrastructure: The Impact on Risk and Investment," Journal of Economic Literature, American Economic Association, vol. 44(4), pages 925-972, December.
    8. Sumit Agarwal & David Lucca & Amit Seru & Francesco Trebbi, 2012. "Inconsistent Regulators: Evidence From Banking," NBER Working Papers 17736, National Bureau of Economic Research, Inc.
    9. Lander, Diane M. & Pinches, George E., 1998. "Challenges to the Practical Implementation of Modeling and Valuing Real Options," The Quarterly Review of Economics and Finance, Elsevier, vol. 38(3, Part 2), pages 537-567.
    10. repec:cam:camdae:1324 is not listed on IDEAS
    11. Bar-Ilan, Avner & Strange, William C., 1998. "A model of sequential investment," Journal of Economic Dynamics and Control, Elsevier, vol. 22(3), pages 437-463, March.
    12. Stratford Douglas & Thomas A. Garrett & Russell M. Rhine, 2009. "Disallowances and overcapitalization in the U.S. electric utility industry," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 23-32.

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