University of Colorado Copyright © 2005 James Alleman. All Rights Reserved. James Alleman Transatlantic Dialogue Montpellier, France 22 November 20055

University of Colorado

Copyright © 2005 James Alleman. All Rights Reserved.

James Alleman

Transatlantic DialogueMontpellier, France 22 November 20055

Regulatory Failure

Time for a New Policy Paradigm

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University

Agenda

OverviewIncorrect FoundationsLack of Dynamic EfficiencyLessonsConclusion & Further Research


Agenda

Overview

Transatlantic Dialogue Broadband Conference

Agenda

Cost of regulation > benefits

Wrong modelsEconomic dynamics


Agenda

Cost of regulation > benefitsAdministrative costs, Regulatory capture and Other effects


Agenda

Cost of regulation > benefitsAdministrative costs, Regulatory capture and Other effects

Wrong models Misallocation of resourcesA lowering of social welfare


Agenda

OverviewIncorrect FoundationsLack of Dynamic Efficiency

Unrecognized Opportunity CostsSunk Costs


Agenda

OverviewIncorrect Foundations

CompetitionFaux Success Optimal Pricing


Agenda

OverviewIncorrect FoundationsLack of Dynamic EfficiencyLessons


Agenda



Agenda



Overview/Literature Review

Regulatory ModelsDynamic ModelsReal Options Approach


Investments DistortionsƒWrong incentivesƒAverch-Johnson

Static/Comparative StaticCertainty

Regulatory Models


Objectives

Uncertainty ModelledDynamic ModelsRegulation ModelledCost of Regulation Estimated


Agenda

OverviewIncorrect FoundationsLack of Dynamic Efficiency


Agenda

Overview/Literature ReviewReal OptionsRegulatory DistortionsInvestment CriterionImplications for RegulationFuture Research


Overview/Literature Review

Regulatory ModelsDynamic ModelsReal Options Approach


Investments DistortionsƒWrong incentivesƒAverch-Johnson

Static/Comparative StaticCertainty

Regulatory Models


Growth ModelsCertainty

ƒComplete informationƒExogenous depreciation

Dynamic Models


Valuation ModelsƒProject valuationsƒNo retail pricing

No Regulatory Models

Real Options


Agenda

OverviewReal Options

ƒWhat are they?ƒTypes of Options


What Are Real Options?

Financial Option AnalogyƒRight ƒNot obligationƒUpside potential (profit)ƒLimit downside risk (loss)


DeferƒTo wait to determine if a "good" state-of-nature obtains

Types of Options


DeferAbandon

ƒTo obtain salvage value or opportunity cost of the asset

Types of Options


DeferAbandon Shutdown & Restart

ƒTo wait for a "good" state-of-nature and re-enter

Types of Options


DeferAbandon Shutdown & RestartTime-to-build

ƒTo delay or default on project - a

compound option

Types of Options


DeferAbandon Shutdown & RestartTime-to-buildContract

ƒTo reduce operations if state is worse than expected

Types of Options


DeferAbandon ...ContractSwitch

ƒTo use alternative technologies depending on input prices

Types of Options


Defer...ContractSwitchExpand/Growth/Learn

ƒTo expand if state-of-nature is better than expected

Types of Options


DeferAbandon Shutdown & RestartTime-to-buildContractSwitchExpand/Growth/Learn

Types of Options


Agenda

Overview/Literature ReviewReal OptionsRegulatory Distortions


Assumptions/Model

q1

1 - q1

go

stop


Regulatory Distortions

Revenue ConstraintƒRate-based, rate-of-returnƒPrice Capsƒ Interconnection pricesƒUNEs price ceilingƒModelled as "Good" Ceiling



q1

1 - q1

stop



q1

1 - q1

stop

revenue constraint



Revenue ConstraintƒRate-based, rate-of-returnƒPrice CapsƒUNEs price ceilingƒModelled as "Good" Ceiling

Defer


Defer: To wait to determine if a "good" state-of-nature obtains



Value in Waiting Like Call OptionInfluences:

ƒuncertaintyƒ foregone profits

Choice: Max [immediate investment, waiting, 0]

Delay: Waiting to Invest


Revenue ConstraintDefer: To wait to determine if a "good" state-of-nature obtains

Abandon: To obtain salvage value or opportunity cost of the asset

Description of Options



Price CeilingsƒRevenue constraintsƒPrice setting (UNEs/Interconnection)

Obligation to ServeƒUniversal service



Price CeilingsƒRevenue constraintsƒPrice setting (UNEs)


Lack of delay





Lack of delayLack of abandonment




Obligation to ServeƒUniversal serviceƒPay telephones




Obligation to ServeƒUniversal serviceƒPay telephones

Lack of abandonment





Lack of delayLack of abandonment

ƒPay telephonesLack of abandonment


Regulation Distortions

CostlyƒCash flow constrainedƒDelay-cash flow constrainedƒAbandon-cash flow constraint

Unrecognized Cost


Agenda

Overview/Literature ReviewReal OptionsRegulatory DistortionsInvestment Criterion


t=0 t=1

S0RS0

S1

A Risk-Neutral Model


t=0 t=1

S0RS0

S1

A Risk-Neutral Model (Continuous Additive)


A Risk-Neutral Model (Continuous Additive)

t=0 t=1

S0RS0

V S1


S0

VK

Probability

f(V)

Call Option


Call Option

S0

VK

V-K

Probability

f(V)

Payoff : P(V)


Call Option Price

S0

VK

V-K

Probability

f(V)

Payoff : P(V)


3.2 Defer Option

Present value of a project’s future cash flow

Investment toacquire the project assets

Length of time the decision may be deferred

Time value of money

Riskiness of the project assets

Stock price

Exercise price

Time to expiration

Risk-free rate of return

Variance of returnson stock

Defer Option Call Option

S

K

T

rf

2


Example


ƒ PV[Cash out] = PV[KT]

= 110/1.06 = 103.8ƒ PV[Cash in] = S = E[ PV[S1]]

= 100ƒ NPV = PV[cash in] – PV[cash out] = 100 – 103.8 = - 3.8

Net Present Value


S=100

V

K=110/1.06=103.8

V-K

ROV (Real Option Value)


3.4 ExNPV

Expanded NPV10.2 M

- 3.8 M

6.4 M

NPV + ROV = ExNPV

= Flexibility value

to defer

= Conventional

Value of Project


When is ExNPV = 0, when NPV < 0?

Methodology


When is ExNPV = 0, when NPV < 0 ?

Wait and watch the market!

Do not invest

ExNPV > 0 ExNPV < 0

ExNPV = 0

Methodology


If NPV < 0, when is ExNPV = 0? i.e.

ExNPV = ROV + NPV = 0

Methodology


SV

K

V-K

Methodology

ƒ When is ExNPV = 0, give NPV < 0?ƒ ExNPV = ROV + NPV = 0


: Normal distribution (0,1): fN(v)

Solve


LHS ( left hand side )

Solve


LHS ( left hand side )

Solve


D* = 0.2773

Solve


ExNPV > 0 ExNPV < 0

Criterion


ExNPV > 0 ExNPV < 0

LHS > 0 LHS < 0

Criterion


Implications for Regulation

Impact on "riskiness" Reduces


Agenda

Overview/Literature ReviewReal OptionsRegulatory DistortionsInvestment CriterionImplications for Regulation


Agenda

Overview/Literature ReviewReal OptionsRegulatory DistortionsInvestment CriterionImplications for RegulationFuture Research


Future Research

Empirical EstimatesInvestment

ƒEndogenous ƒEconomic depreciation

Ramsey Pricing


Dr. James AllemanUniversity ColoradoCB 422 UBSBoulder, CO 80309-0422

phone: +1 303 443-4465facsimile: +1 303 492-1112mobile: +1 917 294-1688e-mail: [email protected] Dr. Paul RappoportTemple UniversityBroad StreetPhiladelphia, PA 19075

phone: +1 215 204 5025e-mail: [email protected]

Contact Information


Agenda

OverviewIncorrect Foundations

Documents

University of Colorado Copyright © 2005 James Alleman. All Rights Reserved. James Alleman Transatlantic Dialogue Montpellier, France 22 November 20055