Regulation, Welfare, and the Risk of Asset Stranding

Abstract

Regulated firms are exposed to asset-stranding risk whenever allowed revenue depends on past capital expenditure: if demand falls far enough, past expenditure is unrecoverable. I show that such regulation induces firms to invest in more capital, but distorts the trade-off between investment scale and timing flexibility. Lower allowed rates of return induce firms to invest earlier. Slower regulatory depreciation induces them to invest in larger steps. In order to maximize welfare the allowed rate of return should be set significantly above the cost of capital and the rate of regulatory depreciation significantly above any plausible measure of actual depreciation.

Keywords: regulation, investment, real options, increasing returns, Averch-Johnson effect

JEL Classification: D21, D25, D42, D92, G31, L51, L98