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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.

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Bibliographic Info

Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 0636.

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Length: 32
Date of creation: May 2006
Date of revision:
Handle: RePEc:cam:camdae:0636

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Web page: http://www.econ.cam.ac.uk/index.htm

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Keywords: real options; stochastic games; price cap regulation; electricity markets;

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References

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Citations

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Cited by:
  1. Ingo Vogelsang, 2010. "Incentive Regulation, Investments and Technological Change," CESifo Working Paper Series 2964, CESifo Group Munich.
  2. Gui, Benedetto & de Villemeur, Étienne, 2007. "Regulation of a Monopoly Generating Externalities," IDEI Working Papers, Institut d'Économie Industrielle (IDEI), Toulouse 469, Institut d'Économie Industrielle (IDEI), Toulouse, revised Jan 2011.
  3. 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.
  4. Westner, Günther & Madlener, Reinhard, 2010. "Investment in New Power Generation under Uncertainty: Benefits of CHP vs Condensing Plants in a Copula-Based Analysis," FCN Working Papers, E.ON Energy Research Center, Future Energy Consumer Needs and Behavior (FCN) 12/2010, E.ON Energy Research Center, Future Energy Consumer Needs and Behavior (FCN).
  5. Dockner, Engelbert J. & Kucsera, Dénes & Rammerstorfer, Margarethe, 2013. "Investment, firm value, and risk for a system operator balancing energy grids," Energy Economics, Elsevier, Elsevier, vol. 37(C), pages 182-192.
  6. Tishler, Asher & Milstein, Irena & Woo, Chi-Keung, 2008. "Capacity commitment and price volatility in a competitive electricity market," Energy Economics, Elsevier, Elsevier, vol. 30(4), pages 1625-1647, July.
  7. Debora Di Gioacchino, 2008. "Strategic technology choice in regulated markets with demand uncertainty," Empirica, Springer, Springer, vol. 35(2), pages 145-164, April.

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