Risk, price regulation, and irreversible investment

We show that regulators' price-setting, rate base, and allowed rate of return decisions are inextricably linked if prices are set so that regulated firms just break even whenever they are forced to invest. Breaking even ex ante is a necessary condition for Ramsey pricing to be sustainable over time. Unless regulators adopt traditional rate of return regulation, the irreversibility of much infrastructure investment significantly alters the results of the approach to price-setting described by Marshall et al. (1981) [Marshall, William J., Yawitz, Jess B., Greenberg, Edward, 1981. Optimal regulation under uncertainty. Journal of Finance 36 (4), 909-921]. In particular, the practice of 'optimizing' inefficient assets out of the regulated firm's rate base, as occurs in total element long-run incremental cost calculations in telecommunications, exposes the firm to demand risk. The firm requires an economically significant premium for bearing this risk, and this premium is a function of both the systematic and unsystematic risk of demand shocks. In addition, we argue that if the firm is to break even under incentive regulation then the level of the rate base will exceed the optimized replacement cost by an amount which we interpret as the value of the excess capacity of the firm's assets. If this component is excluded from the rate base, incentive regulation will not be sustainable.