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Price Cap Regulation and Investment Incentives under Demand Uncertainty

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  • Roques, F.A.
  • Savva , N.S.

Abstract

We study the effect of price cap regulation on investment in new capacity in an oligopolistic (Cournot) industry, using a continuous time model with stochastic demand. A price cap has two mutually competing effects on investment under demand uncertainty: it makes the option of deferring investment very valuable, but it also reduces the interest of strategic underinvestment to raise prices. We show that there exists an optimal price cap that maximizes investment incentives. As with deterministic demand, the optimal price cap is the clearing price of the competitive market. However, unlike the deterministic case, we show that such a price cap does not restore the competitive equilibrium; there is still under-investment. Sensitivity analyses and Monte Carlo simulations show that the efficiency of price cap regulation depends critically on demand volatility and that errors in the choice of the price cap can have detrimental consequences on investment and average prices.

Suggested Citation

  • Roques, F.A. & Savva , N.S., 2006. "Price Cap Regulation and Investment Incentives under Demand Uncertainty," Cambridge Working Papers in Economics 0636, Faculty of Economics, University of Cambridge.
    • Handle: RePEc:cam:camdae:0636
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    File URL: http://www.electricitypolicy.org.uk/pubs/wp/eprg0616.pdf
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    References listed on IDEAS

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    Citations

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    Cited by:

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    2. Cullmann, Astrid & Nieswand, Maria, 2016. "Regulation and investment incentives in electricity distribution: An empirical assessment," Energy Economics, Elsevier, vol. 57(C), pages 192-203.
    3. Astrid Cullmann & Maria Nieswand, 2015. "Regulierung und Investitionen in der leitungsgebundenen Energieversorgung," DIW Roundup: Politik im Fokus 54, DIW Berlin, German Institute for Economic Research.
    4. Ingo Vogelsang, 2012. "Incentive Regulation, Investments and Technological Change," Chapters, in: Gerald R. Faulhaber & Gary Madden & Jeffrey Petchey (ed.), Regulation and the Performance of Communication and Information Networks, chapter 4, Edward Elgar Publishing.
    5. Jan Vlachý, 2009. "Strategie podniku a finanční teorie [Corporate strategy and financial theory]," Politická ekonomie, Prague University of Economics and Business, vol. 2009(2), pages 147-162.
    6. Cédric Clastres & Catherine Locatelli, 2012. "European Union energy security: the challenges of liberalisation in a risk-prone international environment Society," Post-Print halshs-00787123, HAL.
    7. Müller, Christine & Growitsch, Christian & Wissner, Matthias, 2010. "Regulierung und Investitionsanreize in der ökonomischen Theorie. IRIN Working Paper im Rahmen des Arbeitspakets: Smart Grid-gerechte Weiterentwicklung der Anreizregulierung," WIK Discussion Papers 349, WIK Wissenschaftliches Institut für Infrastruktur und Kommunikationsdienste GmbH.
    8. Dockner, Engelbert J. & Kucsera, Dénes & Rammerstorfer, Margarethe, 2013. "Investment, firm value, and risk for a system operator balancing energy grids," Energy Economics, Elsevier, vol. 37(C), pages 182-192.
    9. Debora Di Gioacchino, 2008. "Strategic technology choice in regulated markets with demand uncertainty," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 35(2), pages 145-164, April.
    10. Hardy, A. & Glew, D. & Gorse, C., 2019. "Assessing the equity and effectiveness of the GB energy price caps using smart meter data," Energy Policy, Elsevier, vol. 127(C), pages 179-185.
    11. Tishler, Asher & Milstein, Irena & Woo, Chi-Keung, 2008. "Capacity commitment and price volatility in a competitive electricity market," Energy Economics, Elsevier, vol. 30(4), pages 1625-1647, July.
    12. Gui, Benedetto & de Villemeur, Étienne, 2007. "Regulation of a Monopoly Generating Externalities," IDEI Working Papers 469, Institut d'Économie Industrielle (IDEI), Toulouse, revised Jan 2011.
    13. Cullmann, Astrid & Nieswand, Maria, 2015. "Regulation and Investment Incentives in Electricity Distribution," VfS Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 113090, Verein für Socialpolitik / German Economic Association.

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    More about this item

    Keywords

    real options; stochastic games; price cap regulation; electricity markets;
    All these keywords.

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
    • L94 - Industrial Organization - - Industry Studies: Transportation and Utilities - - - Electric Utilities

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