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

Now let us suppose that the regulator decides to cap the company’s returns by imposing
a cap on the overall project rate of return from the expiry date onwards. This amounts to
prevent the company from earning the excessive payoffs, i.e. to truncate the right-hand tail
of the distribution at the expiry date. As Ofcom correctly points out, the expected return for
the company falls under regulation. Does this tilt the decision whether to invest in our
model or not? It does not. In fact, in real option models the company decision to invest is
exclusively affected by the shape of the distribution below the strike price and not by the
shape above the strike price.

Except in the (very unlikely) case that the regulator imposes a rate of returns cap
permanently below zero (i.e. cumulative net cash flow falls below the investment
disbursement) - that would cause the company to run consistent losses -, the portion of the
NPV distribution which lies below the strike price remains unchanged even after the
truncation imposed by the regulator: hence the incentives to invest are unaffected. Thus
over the long run, that is from the expiry date onwards, the investment decision by the
company is unaffected by a rate of return cap¹⁸, at least within this real option model.

This result holds true from t₃ onwards. In the initial period, from t₀ to t₃, when
uncertainty over the project outcome still exists, the intervention of the regulator does make
a difference, however. In fact, by lowering the payout, the regulator tilts the decision of the
company on whether to exercise the option or not by affecting the “lost payout”
component. Obligations from the regulator make it more likely that the company postpones
its investment decision until t₃. As we shall see, this finding supports the regulatory
prescription of relaxing regulation on NGN in the initial phase of the investment when
uncertainty is still high.

¹⁸ Again this is true only if the regulated price allows the company to recover its initial disbursement.

21

<<   19   20   21   22   23   24   25   >>

More intriguing information