Incentive Regulation of Prices when Costs are Sunk

Abstract

We present a model featuring irreversible investment uncertain future demand and capital prices and a regulator who sets the firm's output price at discrete intervals. Using this model we derive a closed-form solution for the firm's output price which ensures that whenever the regulator resets the price the present value of the firm's future net revenue stream equals the present value of the investment expenditure incurred by a hypothetical efficient firm which replaced the regulated firm. We calculate the rate of return which shareholders should receive to compensate them for the exposure to demand risk and capital price risk induced by modern incentive regulation. In contrast to rate of return regulation we find that resetting the regulated price more frequently increases the risk faced by the firm's owners and that this is reflected in a higher output price and a higher weighted-average cost of capital. We show that the market value of the regulated firm will generally exceed the replacement cost of its existing assets by an amount that we interpret as the value of the firm's excess capacity. The higher valuation is required in order for the firm to prospectively manage fixed costs that are implied by irreversibility. We suggest it is indicative of the efficient treatment of investment in advance. This contrasts with much of the existing literature which argues that the market value of a regulated firm should equal the cost of its existing assets.