Lewis T. Evans and
Graeme A. Guthrie
"Risk, price regulation, and irreversible investment"
regulation, cost of capital, rate base, sunk costs
Abstract: We show that regulators'
price-setting, rate base, and allowed rate of return decisions are inextricably
linked if prices are set so that regulated firms just break even whenever they
are forced to invest. Breaking even ex ante is a necessary condition for Ramsey
pricing to be sustainable over time. Unless regulators adopt traditional rate of
return regulation, the irreversibility of much infrastructure investment
significantly alters the results of the approach to price-setting described by
Marshall, Yawitz and
Greenberg (1981). In particular, the practice of `optimizing' inefficient assets
out of the regulated firm's rate base, as occurs in total element long-run
incremental cost calculations in telecommunications, exposes the firm to demand
risk. The firm requires an economically-significant premium for bearing this
risk, and this premium is a function of both the systematic and unsystematic
risk of demand shocks. In addition, we argue that if the firm is to break even
under incentive regulation then the level of the rate base will exceed the
optimized replacement cost by an amount which we interpret as the value of the
excess capacity of the firm's assets. If this component is excluded from the
rate base, incentive regulation will not be sustainable.
Pre-publication pdf copy.