Infrastructure Price Regulation and Investment

The objective of this thesis is to investigate the relationship between price regulation and investment. More specifically, this thesis aims to answer the following two questions: (i) Does price regulation distort the firm’s decisions of when and whether to invest? and (ii) Does price regulation impact the firm’s cost of capital? This thesis is divided into two parts. The first part examines a discrete model of an investment decision in a network industry characterized by demand uncertainty, economies of scale and sunk costs. In the absence of regulation, the market conditions under which a monopolist decides to invest early as well as the underlying overall welfare output are identified. In a regulated environment, I first consider a monopolist facing no downstream competition but subject to Cost of Service (COS) or Price Cap (PC) on the downstream retail (final good) market. I identify the welfare-maximising regulated prices using the unregulated market output as a benchmark. In particular, I show that optimal regulation depends on market conditions (that is, the nature of demand) and that there are three possible outcomes: (i) price regulation does not improve welfare; (ii) regulated prices include an option to delay value and provide a positive payoff to the firm; and (iii) regulated prices yield a zero payoff to the firm. Second, I consider a vertically integrated network provider that is required to provide access to downstream competitors. I show that when the regulator has only one instrument, namely the access price, an option-to-delay pricing rule generates (weakly) higher welfare than the Efficient Component Pricing Rule (ECPR), except under very specific conditions. The second part of the thesis investigates how price regulation under moral hazard can affect the firm’s financing decision and its cost of capital. I consider a monopolist facing no downstream competition but subject to COS or PC on the downstream retail (final good) market. I show that there is a trade-off between lower operational costs and a higher cost of capital under PC regulation, and higher operational costs and lower cost of capital under COS regulation. As a result, when moral hazard is not significant, PC regulation may generate lower welfare than COS regulation.