Profit Sharing and Investment by Regulated Utilities: A Welfare Analysis

We analyse the effects of different regulatory schemes (price cap and profit sharing) on a firm's investment of endogenous size. Using a real option approach in continuous time, we show that profit sharing does not delay a firm's start-up investment relative to a pure price cap scheme. Profit sharing does not necessarily affect total investment either, if the threshold for profit sharing is high enough. Onlya profit sharing intervening for low profit levels may delay further investments. We also evaluate the effects of profit sharing on social welfare, determining the level of profit that should optimally trigger tighter regulation: profit sharing should be less stringent in sectors where investment opportunities are larger.