Indexation, investment, and utility prices
This paper explores how different risk-sharing arrangements between utility companies and consumers can contribute to better investment decisions and reduce utility prices. The main idea is that utility prices should be largely indexed to changes in the company's cost of capital. The rationale is that companies have little influence over the cost of capital and, because of the uncertainty about future capital costs, regulators use crude upward adjustments to the cost of capital, often termed headroom, to mitigate any under-investment problems. Indexation would largely or even completely avoid the need for headroom and, we believe, lead to lower prices. Indexation would also result in more efficient investment and consumption decisions since headroom can only be a crude and inefficient method of dealing with the uncertainty around the cost of capital. Copyright 2009, Oxford University Press.
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