Dealing with Technological Risk in a Regulatory Context: The Case of Smart Grids

This paper aims to analyze the implementation of innovations, featuring technological risk, in network industries through the development of a suitable regulatory scheme. In particular, Smart grid (SG) technologies which have the potential to save operational costs and reduce the need for further investments in the grid, but are still surrounded by many uncertainties which discourage the investment. Therefore, a suitable regulatory scheme should be developed in order to incentivize network operators to invest in SG technologies, besides of conventional investments that yield the regulatory and warranted revenue. Through a decision model, it is shown that incentive regulation encourages the adoption of innovations that enhance efficiency. Yet the consideration of technological risk into the analysis reduces the set of investment opportunities. In addition, the model assesses the impact on firm’s decision of different types of projects that can displace more or less conventional capital and reduce more or less operational costs. Therefore, this paper provides a new tool that can be used to evaluate the effect of different regulatory designs in a wide range of investments with the characteristics of SG.