Price Cap Regulation and Investment Incentives Under Demand Uncertainty
EPRG 0616 Non-Technical Summary | PDF
Abstract: We study the e¤ect of price cap regulation on investment in new capacity in an oligopolistic (Cournot) industry, using a continuous time model with stochastic demand. A price cap has two mutually competing e¤ects on investment under demand uncertainty: it makes the option of deferring investment very valuable, but it also reduces the interest of strategic underinvestment to raise prices. We show that there exists an optimal price cap that maximizes investment incentives. Just as in the case of deterministic demand, the optimal price cap is the clearing price of the competitive market. However, unlike the deterministic case, we show that such a price cap does not restore the competitive equilibrium; there is still under-investment. Sensitivity analyses and Monte Carlo simulations show that the e¢ ciency of price cap regulation depends critically on demand volatility and that errors in the choice of the price cap can have detrimental consequences on investment and average prices. The model insights are discussed in the light of the electricity industry.
Keywords: Real options, stochastic games, price cap regulation, electricity markets