Optimal regulation of network expansion

• Date: 01 March 2018
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/1756-2171.12217
• Author: Gijsbert Zwart,Bert Willems

RAND Journal of Economics

Vol.49, No. 1, Spring 2018

pp. 23–42

Optimal regulation of network expansion

Bert Willems∗

and

Gijsbert Zwart ∗∗

We model the regulation of irreversible capacity expansion by a firm with private information

about capacity costs, where investments are financed from the firm’s cash flows and demand is

stochastic. The optimal mechanism is implemented by a revenue tax that increases with the price

cap. If the asymmetric information has large support, then the optimal mechanism consists of

a laissez-faire regime for low-cost firms. That is, the firm’s price cap corresponds to that of an

unregulated monopolist, and it is not taxed. This “maximal distortion at the top” is necessary to

provide information rents, as direct subsidies are not feasible.

1. Introduction

Since the nineties, many regulated network industries switched from cost-plus (or rate-

of-return) to incentive regulation, often under some form of price cap regulation. This switch

was motivated by the fear that cost-plus regulated firms would “gold-plate” their networks and

overinvestin capital (Averchand Johnson, 1962) and the realization that a price cap provides high-

powered incentives for cost-efficiency (Cabral and Riordan, 1989).1However, in recent years,

stakeholders have argued that with high-powered incentive regulation, firms postpone socially

efficient investments in durable assets, especiallyin risky environments, and that a different form

of regulation is necessary. For instance, in response to large investment needs, the UK Office of

Gas and Electricity Markets, Ofgem, modernized its price cap mechanism by explicitlytaking into

account these investmentneeds.2European energy directives allow specific networkinvestments to

∗Tilburg Universityand Toulouse School of Economics; bwillems@tilburguniversity.edu.

∗∗University of Groningen and Tilburg University, Tilec; g.t.j.zwart@r ug.nl.

We have benefited from useful comments from seminar participants at Chulalongkorn University, June 2017, Ecoles

de Mines de Paris, March 2013, Norwegian University of Science and Technology,June 2016, Thammassat University,

June 2017, Tilburg University, April 2014, ToulouseUniversity, January 2017, UCL Louvain La Neuve, December 2016,

University of Basel, February 2017, the Symposium in Honour of Jean Tirole, The Hague, December 2014, the IFN

Conference on the Performance of Electricity Markets, Stockholm, July 2014, the IAEE conference, Singapore, June

2017, and from discussions with Peter Broer, Claude Crampes, SteffenHoer nig, Bruno Julien, Thomas-Olivier L´

eautier,

and Thomas Tanger˚

as. We also thank two anonymous referees and Mark Armstrong, the Editor, for their insightful

comments.

1See, for instance, Sappington (2002) for an overview of the perceiveddrawbacks of rate-of-return regulation.

2The United Kingdom was one of the first countries to introduce the RPI-X price cap model where the caps grows

with the Retail Price Index (RPI) minus expected efficiency savingsX. (Beesley and Littlechild, 1989). After a review, a

C2018 The Authors The RAND Journal of Economics published by Wiley Periodicals, Inc. on behalf of The RAND

Corporation. This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-

NoDerivs License, which permits use and distribution in any medium, provided the original work is properlycited, the

use is non-commercial and no modifications or adaptations are made. 23

24 / THE RAND JOURNAL OF ECONOMICS

be exempted from regulation in order to foster investmentsif uncertainty is large.3For the telecom

sector, the European Telecommunications Network Operators’ Association, ETNO, recommends

relaxing access regulation, as it sees it as the main reason for European infrastructure investments

lagging those in the United States (Williamson,Lewin, and Wood,2016).4Also, academic scholars

recognize that implementing price cap regulation is challenging for durableinvestments and when

uncertainty is important (Guthrie, 2006; Armstrong and Sappington, 2007).

In this article, we contribute to this debate by studying the optimal regulation of capacity

investments in a dynamic setting in which investment prospects are uncertain. For this, we

consider a regulated private firm that has to gradually expand its networkto cope with a growth in

demand for network access, needs to fund its investmentsfrom operating profits, and has superior

information on investments costs. The regulator contracts with the firm about when it should

expand capacity (and when it would be better to delay), at which price the capacity should be

sold, and which fraction of its revenues it may keep. The regulator acts as a social planner and

maximizes the expected discounted sum of consumers’ surplus and the firm’s profit.

In the optimal regulatory mechanism, existing capacity is always used efficiently: prices

for network access are equal to the short-run marginal cost of transportation as long as there is

spare capacity,and prices are above marginal cost when there is congestion. Capacity is expanded

whenever the price for capacity reaches a threshold value. This price threshold increases with

investment costs and is always higher than under the first-best symmetric information optimum

with demand uncertainty. Hence, investments are delayed.5

As we assume that the firm does not receive subsidies, investmentcosts need to be paid from

market revenues. However, any operating profits that remain after those costs have been paid for

could be taxed by the regulator. Under optimal regulation, the regulator does not tax the firms

that reveal to be relatively efficient, whereas the tax rate for the less efficient firms increases with

their levels of inefficiency. Those low tax rates are necessary to provide the efficient firms with

information rents.

If the information asymmetry between the regulator and the firm has large support, then

the relatively efficient firms will be allowed to invest as if they were unregulated monopolists, as

this provides the largest possible information rents. Hence, a laissez-faire regime is optimal for

those firms. In the case with small support, the regulator will bunch the more efficient firms and

require identical investment levels for these. Hence, optimal regulation no longer results in an

equilibrium with full separation of types.

In our model, demand growth is not fully predictable(i.e., stochastic) and network investmentsare

sunk. Hence, the firm is continuously forecasting demand and balancing the benefits of expanding

capacity now (and obtaining additional revenue)and delaying investments (and obtaining superior

information about future demand). In other words, it needs to take into account the real-option

value of investments (Dixit and Pindyck, 1994). McDonald and Siegel (1986) show that an

unregulated monopolist delays investments under uncertainty, and Pindyck (1988) extends this

result to a continuous investment model. Although first-best investment also involves a delay,

under monopoly,this delay is longer. If a regulator would try to correct this situation with only the

price cap instrument at its disposal, then the first-best outcome cannot be reached (Dobbs, 2004),

as one instrument is used for two goals: efficient investments ex ante and optimal consumption

new set of regulatory principles was introduced,the RIIO (Revenue =Incentives + Innovation + Outputs) model. This is

still a form of price regulation, but includes output obligations and additional funds for experimentation (Ofgem, 2010b).

3Exemptions can be granted if among others “the level of risk attached to the investmentis such that the investment

would not take place unless an exemption was granted” (Regulation EC 714/2009, Art.17, and Directive 2009/73/EC,

Art. 36). Until 2015, there were 35 exemption requests, most of which were(partially) granted.

4In contrast to the energy sector, the European Commission does not allowregulatory exemptions for the telecom-

munication sector and successfully appealed the decision of the German government to grant Deutsche Telekom an

exemption (Commission v.Germany 2009, case number C-424/07, the European Court of Justice).

5Note that the first-best investment expansion plan already delaysinvestments to take into account the real-option

value of network expansion.

C

The RAND Corporation 2018.