Modelling Regulatory Distortions with Real Options: An Extension

The introduction of uncertainty can make a significant difference in the valuation of a project. In a regulatory environment, this manifests itself, inter alia, in situations where regulatory constraints can affect the valuations of a firm’s investment which, in turn, has an adverse impact on consumers’ welfare. In particular, the inability of a regulated firm to exercise any or all of the delay, abandon, start/stop, and time-to-build options has an economic and social cost. With this view in mind, we specify a model using real options methodology where regulatory delay constraints impact the firm’s cash flow and its investment valuation. The use of real options analysis can address issues of regulation that have not been adequately quantified. We show that regulatory constraints on cash flow have an impact on investment valuations. Specifically, a model is developed to estimate the cost of regulation by constraining the delay option. We show that the cash flow constraints and the inability to delay has significant costs. Since some costs are not recognised in a static view of the world, this failure to recognise the operation and implications of non-flexibility by regulators (which can be modelled by real options methods) will lead to a reduction in company valuations which in turn will lead to a reduction in economics welfare. The impact of regulation changes the magnitude of uncertainty as measured by the variance used in the real options model. For example, price caps, access charges, or other regulatory devices dampen the possibility of a high return, thus reducing the variance of returns. We model the regulatory constraint by constraining variance, σ2 in the option model. As intuition would suggest, as the constraint becomes tighter, the probability that the deferred option will pay off is diminished.