Investment under Regulatory Uncertainty : U . S . Electricity Generation Investment Since 1996

We investigate how uncertainty surrounding possible comprehensive regulatory restructuring affect the investment behavior of firms operating in the industry. We argue that such regulatory uncertainty can create a substantial option value that leads to firms delaying their investment decision in order to gather more information and assurances regarding future regulatory changes. We empirically examine this claim using data on U.S. electricity generation investment from 1996 to 2000. Using state-level, aggregate investment data, we find evidence that is consistent with the presence of substantial option value: a strong link between lesser aggregate generation investment and greater restructuring enactment uncertainty. Using data on firm-level generation investment decisions for a sample of major U.S. independent power producers (IPPs) from 1996 to 2000, we estimate a more structural model of generation investment that incorporates the option value effect. Comparing estimates from this “real options” based model with the corresponding estimates from two alternative models, expected Net Present Value (NPV) and Forward-Looking (FWL), we show that accounting for the option value can lead to different inferences regarding the impact of regulatory restructuring on IPP generation investment. 3151 Social Science Plaza, Irvine, CA 92697-5100, E-mail: [email protected]; 1000 El Camino Real, Menlo Park, CA 94025, E-mail: [email protected]. We are grateful for comments (on this and earlier drafts) from seminar participants at Berkeley, Davis, and the IDEI/CEPR Conference on “Competition and Coordination in the Electricity Industry,” especially Farid Gasmi. Part of this draft was written while Jun Ishii was a visiting researcher at the U.C. Energy Institute (UCEI) Center for the Study of Energy Markets (CSEM). The paper borrows from two earlier drafts by the authors, Ishii (2001) and Yan (2001).