Irreversible Investments and Regulatory Risk

This paper addresses the issue of how regulatory constraints affect firm’s investment choices when the firm has an option to delay investment. The RPI-x rule is compared to a profit sharing rule, which increases the x factor in case profits go beyond a given level. It is shown that a pure price cap and profit sharing are identical in their impact on investment choices: the change in the option value that we have with a profit sharing regime exactly compensates the change in the “direct“ profitability of investment. Regulatory risk – breaching of the regulatory contract – may or may not affect negatively investment decisions. Even if a distortion exists, we show that this distortion is the same, even if a pure price cap could be considered riskier than a profit sharing rule.