Infrastructure Investment in Network Industries: The Role of Incentive Regulation and Regulatory Independence



A regulated firm that faces possible cost disallowance because the regulator relies on ex post
information will be more prudent and will pick only those investment projects that are subject to
low future shocks. In particular, a long time lag between the decision and the completion of an
investment project makes investment vulnerable to future shocks. Hence, investors will act with
caution in selecting projects with long lead time and smaller projects involving less sunk costs
will be chosen over large projects that offer economies of scale. Industries with fast technological
progress are also more likely to be hit by demand shocks and by a fall in capital costs. Therefore,
an
ex post evaluation of investment by the regulator would make incumbents in these sectors
overly cautious.

Timing of the regulatory review

When the regulatory cycle is sufficiently long relative to investment, firms will invest to benefit
from cost-reducing investments in the case of incentive price regulation and because all costs are
passed onto consumers under rate-of-return regulation. If the firm can choose the timing of the
investment and if the timing of the regulatory reviews is exogenous, the firm will invest after the
regulatory review to maximise payoff. The closer to the next review, the more likely that
investment will be delayed until after the beginning of the next regulatory period and only then
will the firm seek to lower costs. If prices are reviewed in reaction to the profitability of the firm
operating under rate-of-return regulation, the firm will refrain from implementing investments as
the firm’s rate of return approaches the upper bound. Instead, it will invest right after the review
when the rate of return is reset.8 When the regulatory cycle is too short, firms operating under a
price cap regime will not be able to benefit from improved efficiency and will have less incentive
to invest. Under price caps, regulatory reviews are often scheduled every 4 to 5 years. Industries
subject to comparatively slow technological progress and a low-volatility environment such as the
water industry can have longer review periods of eight years with an option to request an early
review (Guthrie, 2006).

8.        Rate-of-return regulation could be viewed as a system where the rate of return of the regulated

firm fluctuates in a range. If the actual rate of return drops below the “fair” rate of return, the
firm will request a review for an upward price adjustment, whereas if the firm’s profitability
increases beyond the “fair” rate of return, well-organised consumers may request a review to
decrease prices or the regulated firm itself can ask for lower prices in anticipation to the
consumers’ reaction. As a result, the realised dates of reviews are determined endogenously as a
function of the firm’s profitability (Joskow, 1974). Endogenous timing has the advantage for the
firm that it can shift some of the risks onto consumers by requesting an early review if cost
shocks arise.



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