Risk, price regulation, and irreversible investment

We show that regulators’ price-setting, rate base, and allowed rate of return decisions are inextricably linked. Once regulators switch from traditional rate of return regulation, the irreversibility of much infrastructure investment significantly alters the results of the usual approach to price-setting, as exemplified by Marshall, Yawitz and Greenberg (1981). In particular, the practice of ‘optimizing’ inefficient assets out of the regulated firm’s rate base, as in total element long-run incremental cost (TELRIC) calculations in telecommunications, exposes the firm to demand risk. The firm requires an economically-significant premium for bearing this risk, and this premium is an increasing function of the unsystematic risk of demand shocks. In addition, we argue that if the firm is to break even under incentive regulation then the level of the rate base will not generally equal the optimized replacement cost. JEL Classification code: G31, L5