Abstract:
The irreversibility of much infrastructure investment means that some assets will stop earning revenue before the end of their physical lives; they will be stranded. Under traditional rate of return regulation firms are guaranteed the ability to recover the costs of investment insulating them from the consequences of asset stranding. Under modern incentive regulation firms are allowed to earn revenue just sufficient to cover the costs of a hypothetical efficient firm which provides services at minimum cost exposing them to the risk of asset stranding. By actively encouraging competition regulators increase this risk. We suggest two conditions applicable to both regimes which must be met if regulation is to be "reasonable": the regulated firm must not lose value from investment and it cannot collect more revenue than would the lowest cost alternative provider. This implies that regulated firms should be allowed to earn the riskless rate of return on the historical cost of their assets under rate of return regulation and a different (generally higher) rate of return on the replacement cost of their assets under incentive regulation. The risk premium depends on both the systematic and unsystematic risk of demand shocks. Since customers bear the risk of asset stranding under rate of return regulation and shareholders bear this risk under incentive regulation welfare is higher under incentive regulation as long as customers are more risk-averse than shareholders. We show that when there is a choice between reversible and irreversible technology there is no price specification under rate of return regulation that will induce the firm to choose the efficient bundle of technology while under incentive regulation the firm will choose the efficient mix of technologies. That is incentive regulation allocates the risk of asset stranding efficiently and also gives firms the incentive to reduce this risk to efficient levels. Finally incentive regulation has less demanding information requirements than traditional rate of return regulation.
