Investment In Flexibility Under Rate Regulation

This paper considers the effects of a regulated firm's capital structure on the firm's choice of technology. In models of rate regulation, the firm has an incentive to adopt a technology that is too inflexible, relative to the social optimum, in the sense that it would like to choose a cost function with higher than optimal variable costs and lower than optimal fixed costs. This effect arises because regulators wish to maximize welfare, and therefore have an incentive to require that the regulated price will be set as close as possible to marginal cost. Hence, a technology with a low marginal cost is associated with a low regulated price, and is not attractive to the firm. Performance under rate regulation can be improved, however, if the firm is leveraged, because debt induces regulators to increase the regulated price to prevent the firm from becoming financially distressed. Consequently the cost of flexibility to the firm is lowered, leading it to choose a more flexible technology, closer to the socially optimal level. In the context of this model, the firm may have an incentive to gold plate (i.e., waste resources) if regulators restrict its ability to issue debt. This incentive disappears, however, when the firm is allowed to issue its most preferred capital structure.