Investment in Next Generation Networks and the Role of Regulation: A Real Option Approach

would produce a positive discounted cash flow). Often investment opportunities are held
“on the shelf”.

It is generally agreed (Guthrie, 2006) that one of the main reason for this delay is the
nature of the regulatory framework. Accordingly, economic literature on the impact of
regulation on investments is divided into two areas of research: (i) standard investment
analysis where the impact of regulation (either rate-of-return or incentive regulation) is
usually evaluated in a static context, although occasionally dynamic models of investment
behaviour⁸ are applied; and (ii) real options approach.

Several authors have focused their attention on the realistic rate of return for a regulated
firm but none has been able to find a solution in the case of firms which undertake
irreversible investments while constrained by incentive regulation with periodic retunes⁹.

Other authors have integrated uncertainty and irreversibility in their models and have
considered the more general problem of setting regulated prices when faced with non-
constant demand and technology¹⁰. Beard et al. (2003) employ a two-period model in
which a regulator decides (i) the revenues which a firm is authorized to earn in the case that
its assets are not stuck, and (ii) the reward which the firm will obtain if its assets are
stranded. The less reward offered, the more profit must be allowed if the firm is to
voluntarily invest in the project. As a result, full compensation would not be given by a
welfare-maximizing regulator.

Conversely the real option approach captures the notion that, in the real world, demand,
technology, factor prices and other parameters affecting investment decisions are subject to
many uncertainties¹¹. As a consequence it may be in the company’s own interest to delay
the investment in order to acquire more information and ultimately to reduce risk. In

⁸ A survey of the static and dynamic models of investment under different forms of regulation and optimal
(Ramsey) pricing may be found in Biglaiser and Riordan (2000). Most of this literature assumes static models
of which the Averch-Johnson is the best known (1962). These models show that rate-of-return regulation does
not provide the incentive for the firm to minimize costs or capital investments.

⁹ Evans and Guthrie (2005) provide en exstensive review of the topic.

¹⁰ Dobbs (2004) estimates the firm’s choice of the level and timing of investment when constrained to a price
cap which is proportional to the established capital price; that is, the cap varies with the replacement cost of
the firm’s assets.

¹¹ The literature on real-options research from the financial perspective is reviewed and integrated in
Trigeorgis (1996); Hull (2000) has an extensive coverage of options, as does Luenberger (1998). See Smith
and Nau (1995) for the relationship between decision trees and real options.

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