Investment and Capital Structure of Partially Private Regulated Firms

• Published date: 01 April 2016
• Author: Yossi Spiegel,Carlo Cambini
• Date: 01 April 2016
• DOI: http://doi.org/10.1111/jems.12153

Investment and Capital Structure of Partially

Private Regulated Firms

CARLO CAMBINI

Politecnico di Torino

DIGEP

Corso Duca degli Abruzzi

24, 10129, Torino Italy and IEFE-Bocconi University

carlo.cambini@polito.it

YOSSI SPIEGEL

Recanati Graduate School of Business Administration

TelAviv University

Ramat Aviv Tel Aviv, 69978, Israel and CEPR, and ZEW

spiegel@post.tau.ac.il

We develop a model that examines the capital structure and investment decisions of regulated

firms in a setting that incorporates two key institutional features of the public utilities sector

in many countries: firms are partially owned by the state and regulators are not necessarily

independent. Among other things, we show that regulated firms issue more debt, invest more, and

enjoy higher regulated prices when they face more independent regulators, are more privatized,

and when regulators are more pro-firm. Moreover, regulatory independence, higher degree of

privatization, and pro-firm regulatory climate are associated with higher social welfare.

1. Introduction

Since the early 1990s, many countries around the world have substantially reformedtheir

public utilities sector through large-scale privatization and by establishing Independent

Regulatory Agencies (IRAs) to regulate the newly privatized utilities.1IntheEUfor

example, the structural reforms were prompted by the European Commission through

a series of Directives, and were intended to enhance cost efficiency and service quality,

open the market to competition where technologically feasible, and boost investments

in infrastructure.2The decision whether to privatize state-owned monopolies was left

however entirely in the hands of national governments.3The implementation of mar-

ket reforms varies considerably across EU states and across sectors. Reforms are most

advanced in the telecommunications industry,where IRAs were established in virtually

all member states and most telecoms have been, at least partially, privatized. Reforms

Wethank seminar participants at the 2009 EARIE Conference in Ljubljana, the 2010 “International Conference

on Infrastructure Economics and Development” in Toulouse,the 2011 “Industrial Organization: Theory,Em-

pirics and Experiments” workshop in Otranto, the 2011 CRESSE Conference in Rhodes, the 2012 Conference

on the Economics of the Public-Private Partnerships in Barcelona, FEEM in Milano, IAE in Paris, LUISS in

Rome and University of Melbourne. Yossi Spiegel thanks the Henry Crown Institute of Business Research in

Israel for financial assistance and Carlo Cambini gratefully acknowledges financial support from the Italian

Ministry of Education (No. 20089PYFHY_004).

1. For a comprehensive review of the structural reforms, see Kessides (2004).

2. For more detail about the structural reforms in the EU, see Cambini et al. (2012).

3. Indeed, the establishment of IRA typically precedes privatization, see Bortolotti et al. (2011) and Zhang

et al. (2005).

C2015Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 2, Summer 2016, 487–515

488 Journal of Economics & Management Strategy

are also advanced in the energy sector, where the majority of electric and gas utilities

are now regulated by IRAs. However, many natural gas utilities, and to a lesser extent

electric utilities, are still controlled by the government, especially in France, Germany,

Italy,and Portugal. Structural reforms, however, are still lagging behind in water supply

and transportation infrastructure (docks and ports, airports, and freight motorways):

with the exception of the United Kingdom, France, Germany, and Italy, most water and

transportation utilities are still controlled by central and local governments and are still

subject to regulation by ministries or other branches of the government rather than by

IRAs.

Although for the most part, the structural reforms have significantly improved

infrastructure performance (see, e.g., Kessides, 2004, pp. 9–15), they were also accompa-

nied by a substantial increase in the financial leverage of regulated utilities.4This trend,

coined the “dash for debt,” is widespread across countries and across sectors and has

raised substantial concerns among policy markers. For instance, a joint study of the UK

Department of Trade and Industry (DTI) and the HM Treasury argues that the “dash

for debt” within the UK utilities sector from the mid-late 1990s “could imply greater

risks of financial distress, transferring risk to consumers and taxpayers and threaten-

ing the future financeability of investment requirements” (DTI and HM Treasury, 2004,

p. 6). Likewise, the Italian energy regulatory agency, AEEG, has recently expressed its

concern that excessive financial leverage could lead to financial distresses which in turn

could cause service interruptions (AEEG, 2008, paragraph 22.13). The AEEG has also

announced its intention to start monitoring the financial leverage of Italian energy util-

ities in order to discourage speculative behavior that might jeopardize their financial

stability (see AEEG, 2007, paragraph 17.40 and AEEG, 2009, paragraph 11.8).

To put the concerns about the dash for debt phenomenon in perspective, it is

worth noting that regulated network industries account for around 7.5% of the EU-15

states’ total value added, and 5.4% of the total workforce in the EU-25 states (European

Commission, 2007).5Moreover, the investment levels in these industries account for a

significant fraction of GDP: for example, TableAI in the Appendix shows that in the EU-

15 states’ the average rate of gross fixed capital formation in the energy sector (electricity

and gas), telecommunications, water supply, and transportation, ranges between 14.6%

and 15.9% of GDP in the period 2005–2009.6Given the sheer size of investments at

stake, their high market value, and the overall importance of the public utilities sector

(telecommunications, energy, transportation, and water) for the economy and consumers

at large, it is clearly important to understand the determinants of the investments and

financial decisions of regulated firms and study how these decisions affect social welfare.

Earlier literature on this topic (e.g., Taggart,1981, 1985; Dasgupta and Nanda, 1993;

Spiegel, 1994, 1996; Spiegel and Spulber, 1994, 1997) has shown that regulatedfirms may

have an incentive to strategically issue debt to induce regulators to set a relatively high

price in order to minimize the risk that the firm will become financially distressed.7

This literature however implicitly assumes that the regulated firm is privately owned

and regulators are independent.8Although these assumptions reflect the institutional

4. See Bortolotti et al. (2011) for evidence on the EU-15 states and Da Silva et al. (2006) for evidence on

Latin America and Asia.

5. Moreover,of the 30 companies with the largest market capitalization in the European Industrial Sector,

10 are telecoms or energy utilities (Bortolotti et al., 2013).

6. The table is based on OECD data. Currently,2009 is the most recent year for which the data is available.

7. Jamison et al. (2014) show that regulators can prevent firms from issuing excessive debt if they can

impose substantial penalties if the firm becomes financially distressed.

8. Moreover, with the exception of Spiegel (1994), this literature has only considered the interaction

between capital structure and regulated prices, holding the firm’s investment level constant.