3.2 - Impact of regulation on investment: the issue of truncation
The example of the previous section allows us to highlight one important result of the
real option model as far as the impact of regulation on investment is concerned: the fact that
the expectation of future regulatory remedies does not tilt the investment decision by the
company. This is known as the ‘truncation’ issue.
As we stressed earlier, the central theme of the regulatory debate is whether existing
obligations, which basically consists of granting access to the established operator’s
network at prices equal to costs, can be extended onto future networks without causing the
investment in NGNs to be reduced or even cancelled. The leading view by large operators -
which has been represented by LECG (2007) in a paper made for the organisation of
incumbent operators - is that an extension of current obligations would lead both
incumbents and alternative operators to reduce the amount of investment in NGNs.
Established operators would cut back on investment because regulation will make
perspective quasi-rents to disappear; on the other hand, alternative operators would rather
buy the services from incumbents at regulated prices than make their own infrastructures.
Such a view is echoed by Ofcom, the UK regulator, in a recent document on NGNs:
“The imposition of regulatory remedies that mandate access at a specific price may result in
asymmetric risk borne by investors and a change to the prospective returns available for an
investing firm......However a straight-forward application of the standard cost plus pricing
approach may result in lower incentives to invest. This approach would cap the total returns
that the firm could make if demand turned out to be high but force the firm to bear all of the
losses in the event that there was virtually no demand” (Ofcom, 2007).
Whereas the reasoning by Ofcom is well grounded in traditional finance models, such as
the capital asset pricing model, in a real option context this view needs to be qualified.
Regulatory intervention that caps the total returns affects investments in NGN negatively
only in the initial period; in the long run, according to the real option model, investments
are not affected.
In order to understand this point, we have to go back to the illustrative binomial example
of Section 3.1. As we saw, at all times between t0 and t3 the company faces a distribution of
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