University of Groningen
Optimal regulation of energy network expansion when costs are stochastic
Zwart, Gijsbert
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Journal of Economic Dynamics and Control
DOI:
10.1016/j.jedc.2020.103945
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Zwart, G. (2021). Optimal regulation of energy network expansion when costs are stochastic. Journal of
Economic Dynamics and Control, 126, [103945]. https://doi.org/10.1016/j.jedc.2020.103945
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ContentslistsavailableatScienceDirect
Journal
of
Economic
Dynamics
&
Control
journalhomepage:www.elsevier.com/locate/jedcOptimal
regulation
of
energy
network
expansion
when
costs
are
stochastic
R
Gijsbert
Zwart
∗University of Groningen, Netherlands
a
r
t
i
c
l
e
i
n
f
o
Article history:
Received 11 September 2019 Revised 29 May 2020 Accepted 12 June 2020 Available online 17 June 2020
JEL classification: D86 G31 L51 Keywords: Adverse Selection Dynamic contracting Real option Investment timing Principal-Agent model Regulation
a
b
s
t
r
a
c
t
Weanalyzeoptimalregulationofthegradual investmentsinenergynetworks necessary toaccommodatethe energytransition.We focusonarealoption problemwhere costs ofnew networktechnologyarestochasticand notobservabletothe regulator.Wesolve fortheregulatoryschemethatoptimallybalancestimelyinvestmentswithrentextraction inthisdynamicagency context.Wethenapplythismethodologytoasituationinwhich investmentcanbeeitherintraditionalnetworktechnology,withobservablecosts,orusing aninnovativenetworktechnologyforwhichthereisasymmetricinformationoncosts.The optimal choicetradesoff the potential benefitsofcheaper expansionwith thecosts of overcominginformationfrictions.
© 2020TheAuthor(s).PublishedbyElsevierB.V. ThisisanopenaccessarticleundertheCCBYlicense. (http://creativecommons.org/licenses/by/4.0/)
1. Introduction
The transitionto a more environmentally friendly energymarket requires large investments, not only by competitive energy producers, but also by monopolistic firms owning and operating power and gas grids. For example, to accom-modatelarge amounts ofsmall-scalerenewable electricity productionatconsumers’ homes(suchassolar panels, micro-CHPs), system balancing functions may have to be decentralized in smart grids, that require deployment of new tech-nologies.Bertoliniet al.(2018), forexample,studyhow smart grids facilitateinvestment indomestic solar panels,while
Sidhuetal.(2018)explorethecostsandbenefitsofintroducingenergystorageinthegrid,allowingbetteraccommodation ofdistributedgeneration.Likewise,achoiceforcarboncaptureandstoragewillrequireinvestmentsinpipeline infrastruc-turestotransportthegreenhousegasfromitsindustrialsourcestostoragelocations.Andlargescaledeploymentofelectric vehiclesnecessitatesmoreelaborateinfrastructureforroadsidecharging.
Acommoncharacteristicofthesenewinfrastructures isthatthey arestillunderdevelopment. Asinallnew technolo-gies,costs fordeploymentareexpectedtofall inthelongerrunasmoreexperienceisgained,buttheirevolutionwill be
R I have benefited from useful comments from seminar participants at the Brescia workshop on Investments, Energy, and Green Economy, in April 2019.
I also thank two anonymous referees for their insightful comments.
∗ Corresponding author. E-mail address: g.t.j.zwart@rug.nl https://doi.org/10.1016/j.jedc.2020.103945
0165-1889/© 2020 The Author(s). Published by Elsevier B.V. This is an open access article under the CC BY license. ( http://creativecommons.org/licenses/by/4.0/ )
uncertainintheshorterrun(EPRI,2011;Sidhuetal.,2018).Also,investmentsinthenewenergysystemswillbemade pro-gressively,startingatthoselocationswithhighbenefits,andexpandingascostsarereduced.Optimalinvestmentwilloccur gradually,takingintoaccounttheoptionvalueofwaitingforimprovedinformationoncosts.Suchinvestmentproblemsare welldescribedbyrealoptions,inparticularwithongoingexpansionopportunitiessuchaspioneeredine.g.Pindyck(1988). The speed atwhich network firms will adopt such new technologies will,however, not only be guided by changing costsandsocietalbenefits.Theenergyandnetworkownersarenaturalmonopolies,andtheyaretypicallyregulatedbythe government.The regulatoryframeworks that thesefirmsoperateinwill determinetheir allowed revenues, andtherefore willalsoaffecttheirinvestmentbehavior(Cambinietal.,2016).
Inthispaper,weanalyzetheproblemofoptimalregulationoflong-runinfrastructureinvestmentprocessesinthe pres-enceofasymmetricinformationoncosts.Todoso,weconsidera realoptionmodelwithcontinuousinvestmentina dy-namicprincipal-agentsetting.The networkfirm,who istheagent, privatelyobservesthe stochasticinvestmentcosts, and decides onitsinvestments.The governmentregulator,whoisthe principal,doesnot observethe stochasticcosts,butcan observecapacitybuiltby thenetwork. Theregulator will determinetheallowed revenues(consistingof asetof capacity dependent fees),whichwilldrivethenetwork’s investmentbehavior. Weaskwhat setoffeestheregulator shouldsetto elicitsocialsurplusmaximizinginvestmentbehaviorastheseunobservedcostsfallstochastically.1
Intheabsenceofinformationasymmetry,therealoptionproblemoffindingsurplusmaximizinginvestmentwasstudied byPindyck(1988)(seealsoDixitandPindyck,1994,chapter11),whoshowedthat capacityshouldbeexpandedwhenever costs dropbelowa capacitydependent threshold:thehighercapacity,the lowercosts needtofalltoincrease that capac-ityfurther. Dobbs(2004)considered the regulatoryproblemof incentivizinginvestment by amonopolist usingpricecap regulation,butdidnotspecifytheasymmetryofinformationthatnecessitatessuchregulation.Morettoetal.(2008) inves-tigatehowvariousregulatoryschemescompareinrealoptioninvestmenttiming.Guthrie(2006)providesasurveyofsuch applicationsofrealoptionsinvestmentinregulationcontexts.
Regulationofdiscrete,lumpyinvestmentwasstudiedfromamechanismdesignperspective inBroerandZwart(2013), whoassumedstaticasymmetricinformationonaconstant costlevel.There,thestochasticvariable,demand,wasassumed tobe observablebyboth regulatorandthemonopolist.Anextension tocontinuousinvestmentinnetworkexpansion was consideredinWillemsandZwart(2018),whoinadditionlookedatafinancingconstraintrequiringtheinvestmentstobe paidoutofusagefeesonanongoingbasis.
Our firstcontribution here isto address the regulatory problemwith dynamic asymmetric information: the regulator cannot observecosts whichare continuously evolving. Weusethe frameworkfordealingwithsuch dynamicadverse se-lectionincontinuous-time realoptionsmodels developedinArve andZwart (2016).Related techniqueswere exploredin
BergemannandStrack(2015);Maeland(2006).Inpreviousrealoptionsapplications,discreteinvestmentswereconsidered. Inthispaperwedemonstratehowthemethodologycanbeexpandedtodealwithcontinuousinvestmentmodels.
We then apply this methodology to studyhow optimal regulation should drive investment in a greenfield situation, wherethereisachoicebetweenatraditionaltechnology,withpubliclyobservablecosts,andaninnovativetechnologywith asymmetricinformationonstochasticcosts. Ineithercase,aninitial investmentwillbemade;afterthatthenetworkwill begraduallyexpandedascosts(whichfortheinnovativetechnologyareunobservabletotheregulator)declinefurther.
Thechoicebetweentraditionalandinnovativetechnologyisinpartdrivenby thepotential costandqualitybenefitsof theinnovative technology:both initialcosts andthereal-optionvalue ofexpansion mightbemorefavorableforthe new technology.Informationasymmetry,ontheotherhand,distortsdecisionsinthedirectionofthetraditionaltechnology,for whichtheregulatorcanincentivizeinvestmentwithouttheneedforpayingeconomicrentstothefirm.Wefindthatinthe optimalregulation,withasymmetricinformation,networkswithlowcostswillalwaysbeincentivizedtopursuethe innova-tivetechnology,providedthat thisalternativealsodominateswithoutinformationasymmetry.Forhighercostrealizations, ontheotherhand,theinformationasymmetrymakesithardertooutperformthetraditionaltechnology.Evenifthehighest possiblecost-levelwoulddominatethetraditionaltechnologyinasituationwithoutinformationasymmetry,optimal regu-lationmaycallforresortingtoinvestmentintraditionaltechnologyinthosecasesinstead,toenabletheregulatortolimit theallowedrevenuestothenetwork.
Inthe following,we willfirst introduce themodel.In section 3we solvethe modelinthe first-bestreal option situ-ation, along the linesof Pindyck (1988).Then we turn to theeffects of informationasymmetry. Ifthe regulator (whois theprincipal)cannotobservecosts, butthenetwork (theagent)can,we firstshowthat still,theregulatorcould designa setof feesthatinduces the agentto followthesame,first-bestreal-optioninvestment rule.Thisiscostly, though,asthe agentreceivesinformationrentsfromitsadvantagedposition.Theprincipalcandoabetterbalancingactbetweenefficient investmentandrent extractionbysetting feesthat delayinvestment, comparedto thereal-optionbenchmark.This delay isgreater foran agenthavinghigherex-antecost levels.In section5, weturnto theapplication. Fora specific,constant elasticitywelfare function,we explore thetrade-offsin termsofoptionvalues andinformationrentsbetweentraditional andinnovativetechnologies.Weconcludewithadiscussionoftheresultsandtheassumptionofregulatorycommitment.
1 We assume commitment on fees for the regulator. If the regulator could not commit, additional distortions would be introduced. The agent would have
incentives not to respond truthfully to protect future rents, resulting in a ratchet effect ( Laffont and Tirole, 1988 ). We also assume that there is no danger of renegotiation. Renegotiation typically increases agency costs ( Battaglini, 20 07; Bester and Strausz, 20 01; Hart and Tirole, 1988; Laffont and Tirole, 1990 ).
2. Model
Letusconsideracontinuoustime investmentmodelfora firmwithinitialcapacityQ0 andtheopportunity to contin-uouslyincreasethiscapacityby makingirreversibleinvestments.ThemarginalinvestmentcostsCt arestochastic,evolving accordingtoageometricBrownianmotion,
dCt=
μ
Ctdt+σ
Ctdz.Wehaveinmindthecaseinwhichthedrift
μ
<0,sothatcostsareexpectedtofall,butfluctuatearoundthatexpectedpath withvolatilityσ
.Thesocial benefitsofhavingcapacityQare measuredbyaflowofsurplus,w(Q)dt,withw(Q) increasing butconcave.Marginalbenefitsdecreasetozero,reachedatsomelevelQ∗whichmaybeinfinite.Irreversibleinvestmentwill becarried out,on behalf ofa principal(whois theregulator),by an agent(theregulated network)who has private information on the stochastic costs Ct.The principal will contract withthe agent att=0 on capacityinvestments,capacityQiscontractable.2Theprincipal’sprioroncostsC
0attime0isthatthesearedistributedon [CL,CH]accordingtocumulativedistributionF(C0),withdensity f=F.AsinArveandZwart(2016),weadoptthetechnical assumptionthat thedistributionof thelogarithmofC0 hasamonotone hazard rate.3 The principaldoesnot observethe evolutionofCt, buttheparameters ofthestochastic process,
μ
andσ
,are assumedtobe commonknowledge, asisthe discountrater.The principalcan use a setof capacity-dependentfees toencourage optimalbehavior. In generality, thesefees might consistofp(Q),acapacity-dependentflowfee,
φ
(Q) acontributiontowardsinvestmentcosts wheneverQisincreased,and anupfrontlumpsumcontractfeeφ
0.4Theprincipalisassumedtomaximizethepresentvalueofsurplusw(Q),minusthe paymentsmadetotheagent:foragivenchoiceoffees(p,φ
,φ
0),theprincipal’sexpectedsurplusisgivenbyW=E
∞t=0e
−rt
(
w(
Qt)
− p(
Qt))
dt− e−rtφ
(
Qt)
dQt−φ
0. (1)Thefirsttermencapsulatestheexpectedbenefitsofnetworkcapacity,anditsexpansionovertime ascosts fall.Theother partsarethepresentvalueoftheexpectedfees:thecontinuousflowp(Q),theadditionalfeespaidoutwhenQisincreased bytheagent, andtheupfrontlumpsum
φ
0.Theexpectation hereisnot onlyontheevolution ofcosts Ct overtime,but alsoovertheinitialvalueofcostsC0,thelatterknowntotheagentbutunknowntotheprincipal.Here,dQtistheprocess ofinvestmentsincapacityexpansion.Thisprocessofcapacityexpansionischosenbytheagent,whodeterminesaprivatelyoptimalthresholdcostlevelC¯
(
Q)
. Theagentwillexpandcapacitywhenevercosts dropbelowthiscapacity-dependentthresholdlevel.Theoptimalthreshold fortheagentdependsonthestructureoftheexpostfees,p(Q)andφ
(Q).Theagentchooses investmentsoastooptimize hisexpectedutilityU(Q0,C0),i.e.thesumoftheexantefeeφ
0,andthecontinuationutilityV(Q0,C0),U
(
Q0,C0)
=φ
0+V(
Q0,C0)
=φ
0+EC0 ∞ t=0e −rtp(
Q t)
dt+e−rt(
φ
(
Qt)
− Ct)
dQt , (2)withdQt governedbytheagent’soptimalchoiceofinvestmentthresholdC¯
(
Q)
.Theexpectationishereconditionalonthe stochasticprocessstartingatC0.Theagent’sparticipationconstraintisU(Q0,C0)≥ 0foranyC0∈[CL,CH].3. Firstbest
Asabenchmark,wefirst analyzethecasewithoutasymmetricinformation.Theprincipalwillinthatcaseinstructthe agenttoadoptthefirst-bestinvestmentrule,andremunerate theinvestmentcosts,leavingtheagentzerorents.The prin-cipal’sobjectivethenistoprescribeaninvestmentrulemaximizingexpectedtotalsurplus,
W
(
Q0,C0)
=EC0 ∞ t=0e −rtw(
Q t)
dt− e−rtCtdQt , (3)withthefirsttermrepresentingtheflowofgrosssurplus,andthesecond termthecapitaloutlaysascapacityisexpanded byanincrementdQt.Theoptimalruleis(Pindyck,1988)toinvestwhenevercostsCdroptoacapacity-dependentthreshold levelC¯
(
Q)
.Theoptimizationconsistsoffindingthatoptimalthreshold.2 There is no loss in generality in assuming all contracting to take place at t = 0 . Since the only verifiable information to the principal will be the capacity
additions by the agent, there is no benefit in postponing part of contracting to later stages, as any future contracting contingent on such capacity additions can already be specified at t = 0 . There could be a downside to later contracting, if this also means respecting the agent’s participation constraints at those later dates. This would impose additional constraints on the principal’s maximization problem.
3 Commonly, the monotone hazard rate assumption is made on the type itself, to avoid solutions involving bunching. In our case, due to the multiplicative
nature of the stochastic process, we need to make that assumption on the log of C 0 .
4 There is some redundancy in this formulation: both the investment contribution φ( Q ) and the lump sum φ
0 may be subsumed, by suitable shifts, into
the flow fee p ( Q ), keeping the present value of the fees the same. Such a regulation with only a flow fee is more likely to be observed in practical cases, as we will explain in section 5 . We keep the general fee structure here for clarity of the theoretical exposition.
To maximize W(Q0, C0), we first evaluate the right-hand side using standard real optionmethods (see e.g. Dixit and
Pindyck, 1994).In theregion inwhich noinvestment occurs,C>C¯
(
Q)
,total welfareW(Q,C) satisfiesa Hamilton-Jacobi-Bellmanequation, rW(
Q,C)
=w(
Q)
+μ
CWC+ 1 2σ
2C2W CC,wheresubscriptsdenotepartialderivatives.Thisequationissolvedby5
W
(
Q,C)
=w(
rQ)
+g(
Q)
Cλ−.forsomefunction g(Q),and
λ
− thenegativerootofthecharacteristicequation r=μλ
+12
σ
2λ
(
λ
− 1)
.Thefirsttermhere equalsthepresentvalueoffuturesurplusfromcurrentcapacity,whereasthesecondtermrepresentstherealoptionvalue ofexpandingcapacityfurtherwhenCtdrops.Tofindg(Q),weusetheboundaryconditionattheinvestmentthresholdC¯.At thethreshold,wehaveavalue-matching(continuity)condition,WQ
(
Q,C¯)
=C¯, orwQ
r +gQ
(
Q)
C¯λ−=C¯.
stating that investment occurswhen marginal costs of addingcapacity, C¯, equal themarginal benefits, consisting ofthe presentvalueoftheadditionalsurplusflows,andthechangeinthevalueoftheoptiontoexpandcapacityevenfurtherin thefuture.
To determine g(Q), we use the boundary condition at large capacity, where there is no value to further investment,
g
(
Q∗)
=0,sothat g(
Q)
= Q∗ Q wQ(
q)
r − ¯C(
q)
¯ C(
q)
−λ−dq.Now,optimizingWoverthethresholdC¯
(
Q)
isachievedbyoptimizingg(Q).Usingpointwisemaximizationoftheintegrand, wefindthefirst-ordercondition−
λ
−wQr(
Q)
−(
1−λ
−)
C¯(
Q)
=0, or6 ¯ C(
Q)
=λ
λ
− −− 1 wQ(
Q)
r . (4)Since the factor
λ
−/(
λ
−− 1)
<1, investment is delayed beyond the moment at which marginal investment costs equal marginalincrease inpresentvalueofthesurplusflow.Thedifferenceisaccountedforby theoptionvalue ofdelayingthe investment(McDonaldandSiegel,1986).4. Agencyproblem
Now consider the case where the principal needs to delegate the capacityexpansion to an agent who has superior knowledgeabouttheevolvingcosts Ct.Theprincipalneedstoremuneratetheagentfortheinvestmentcostsincurred,but alsotoincentivizetheagenttoinvestatthecorrectcostthresholdsC¯
(
Q)
.Asoutlinedabove,weassumethattheprincipalcanuseasetofcapacity-dependentfeestoencourageoptimalbehavior:
p(Q), a capacity-dependentflow fee,
φ
(Q) a contribution towards investment costs, and an upfront contract feeφ
0. The principal’sexpectedsurplusforagivenstructureofthosefees,W(Q),isgivenby(1).The principal’sproblem,therefore,is to choosea menu offees(p,φ
,φ
0), so astooptimize hisexpected surplus, subjectto aparticipation constraintforthe agent,andsubjecttotheagentchoosinghisprivatelyoptimalinvestmentthresholdC¯(
Q)
giventhosefees.4.1. Incentivizingfirst-bestinvestment
As a preliminarystep,let usconsider ascheme that succeedsin incentivizinginvestment atthe first-bestinvestment thresholdC¯
(
Q)
.Supposefirsttheprincipaloffersonlyasinglestreamoffeesp(Q),tobepaidtotheagent.Theagent,after havingacceptedthiscontract,willchoosetoinvestinawaythatmaximizesitsutility,V
(
Q0,C0)
=EC0 ∞ t=0e−rtp
(
Qt)
dt− e−rtCtdQt.5 Using the boundary condition that as C → ∞ , W should not diverge. 6 The same result can also be found using a smooth pasting condition on W
Thisproblemisthesameastheoneencounteredinthesolutionofthefirst-bestproblem(4),exceptforthesubstitutionof
p(Q)insteadofw(Q).Wethereforehavethattheagent’sprivatelyoptimalthresholdinthiscasewillbegivenby ¯
C
(
Q)
=λ
λ
−−− 1 pQ
(
Q)
r . (5)
Comparison withthe first-best investment threshold (4)shows that we need that the marginal benefit for the agentof increasingcapacityQcoincideswiththemarginalwelfare,orinother wordspQ=wQ.
Clearly,oneexampleofsuchaschemeincentivizingfirst-bestinvestmentwouldbeallocatingtheentirebenefitsofthe networktothe agent, p
(
Q)
=w(
Q)
.Inthat casetheagentisresidualclaimantto allsocial benefitsandcosts,andhence chooses the totalwelfare maximizing investment strategy. Such a schemeon its own doesnot, of course, maximize the principal’sutility, asitleaves all surplustothe agent. Totransfer partof thatutility to the principal,the schemewould needtobecomplemented withafixed fee,eitherintheformofanexantefeeφ
0,ora fixedcash flowtobe subtracted fromthefee p(Q).This constructionamounts toa sell-outcontract,wheretheprincipal transfersthe entireprojecttothe agentinreturnforafixedpayment.Thissell-out contractcan, however,not transfer all ofthesurplus tothe principal.The obstacle tothat is theagent’s participationconstraint.Totalsurplusinthefirst bestdependsontheinitialcost levelC0: thelowerthisinitialcostlevel, thefaster theagentwill investandbenefit fromlarger flows.Hence, low-cost agents earnhighersurplusthan high-cost agents.Sinceinitialcostsarenotobservabletotheprincipal,however,theonlywaytomakethesell-outcontractacceptable toanyagenttype,istochargeanupfrontfee
φ
0(ortheequivalentconstantshiftinfeesp(Q))thatleavesthehighest-cost agent,whostartsatCH,withzerorents:φ
0=−W(
Q0,CH)
,sincewiththesell-outcontract,p
(
Q)
=w(
Q)
,totalrentsfromtheflowfeealoneareequaltototalwelfareforthis highest-costtype.Withthisupfrontpayment,lower-costagentsearnarentW(
Q0,C0)
− W(
Q0,CH)
≥ 0.Addingapayment
φ
(Q),afeepaidperunitofnewinvestment,doesnotalterthisanalysismaterially.Itisstraightforward tocheckthatthesameconclusionsfollow,butnowwithpQ(
Q)
+rφ
(
Q)
substitutedforpQ.Theprincipalcandobetterbydroppingtherequirementthatinvestmentisatthefirst-besttiming.Theoptimalscheme consistsofamenuthatdifferentiates amonginitialagenttypesC0.Itdelaysinvestmentthresholdsforhigh-costagents,to reducetheinformationalrentsenjoyedbylower-costagents.Wenextturntotheanalysisofthatoptimalscheme.
4.2.Theoptimalscheme
The optimal scheme can be expressed in terms of a menu of fees, {p(Q; C0),
φ
0(C0)|C0 ∈[CL, CH]}, that is incentive compatible:anagentofinitialcostsC0 willmaximize itsprivateutilityU(Q0,C0)bychoosing,att=0,thecombinationof feesp(Q; C0)andφ
0(C0)intended forthat initialcost levelC0.Forsimplicity,andwithout lossofgenerality, let usagain assumetheremunerationforcapacityinvestmentφ
(Q)iszeroforallcontractsinthemenu.It isstraightforwardto check thatasintheprevioussubsection,anynon-zeroφ
(Q)isequivalenttoachangeinpQ.Theprincipal’sproblemisthentomaximize itsownutility,theexpectedvalueofflowofwelfarew(Q)minus the pay-mentsmadetotheagent,takingintoaccountthattheagentchoosestheinvestmentthresholdC¯
(
Q)
inresponsetothefees itisoffered, maximizingits utility U(Q0,C0).The principal’soptimizationover menusissubjectto theincentive compat-ibility (i.e.out of themenu ofsets offees onoffer, agents preferto opt forthe setof feesintended fortheir individual initialcostlevelC0)andtotheagent’sparticipationconstraint,U(Q0,C0)≥ 0foranyinitialcostlevelC0.Bysubstitutingthe expressionfortheagent’scontinuationutility,(2),intheprincipal’ssurplus,equation(1),wehaveW= max {p(Q;C0),φ0(C0)} CH CL
EC0 ∞ t=0e −rtw(
Q)
dt− e−rtC tdQt − U(
Q0,C0)
dF(
C0)
, (6)s.t.incentivecompatibilityandparticipationconstraints.
Notethat,again,expectationisnotonlytakenoverthefuturepathofcostsCt(capturedbytheexpectationoperatorE),but alsoexplicitlyoveritsinitialvalueC0,distributedaccordingtoF(C0).
Toanalyzethisproblem,wefirstrephrasethequestionintermsoffindingtheoptimalthresholdC¯
(
Q;C0)
foreachinitial costlevel.Wealreadyknow,fromequation(5),thatthechoiceofathresholdisequivalenttothechoiceofafeep(Q)upto anintegrationconstant.Inaddition,weneedtoexpresstheagent’scontinuationutility,V(Q,C0),intermsofthatthreshold. Todoso,wenotethat,foranyC,theagent’scontinuationutilityV(Q,C)satisfiesanHJBequation,withvaluematchingand smooth-pastingdeterminingtheboundaryconditionsatC¯(
Q)
,analogoustotheequationssolvedbytotalwelfareWinthe first-bestanalysisinsection3(smooth-pastingholdsbecausetheagentchoosesthethresholdC¯(
Q)
tooptimizeitsvalue):rV
(
Q,C)
=p(
Q)
+μ
CVC+ 1 2σ
2C2V CC (7) VQ(
Q,C¯(
Q))
=C¯(
Q)
(8) VQC(
Q,C¯(
Q))
=1 (9)FromthisHJBequation,wecanderivethefollowingrelationlinkingvalueV(Q,C)andthethreshold:7
Lemma1. PrivatelyoptimalinvestmentfortheagentmakessurethatitscontinuationutilityV(Q,C)satisfiesthecondition
VQC
(
Q,C)
= C ¯ C(
Q)
λ−−1 (10) forallC<C¯(
Q)
.We can nowturnto the principal’sex anteproblemof specifyinga thresholddesignedforeach agenttype, C¯
(
Q;C0)
. Onceweknowthatthreshold,wecanchooseaflowoffeesp(Q;C0)implementingthatthresholdaccordingtoequation(5).φ
0(C0) isgoingtodothejobofextractingtherentsgeneratedfromtheexpostfees,upto aninformationrentnecessary toinducetheagenttorevealhisinitialcostlevelC0(i.e.,incentivecompatibility).Restricting to direct incentive compatible mechanisms, we can rewrite the principal’s optimization (6) as choosing a menuofexantefeesandinvestmentthresholds
φ
0(
C0)
,C¯(
Q;C0)
,ratherthanthefeesp(Q;C0).
Tosolvetheconstrainedoptimization,we usethestandard(Mirrlees)observationthatoptimalityoftruthfullyrevealing
C0impliesthat dU dC0
(
Q,C0)
=∂
V∂
C0(
Q,C0)
. (11)Moreover, the resulting optimalinvestment thresholdshould be decreasing in the ex ante type C0. We will ignore this monotonicityconditionfornow,andcheckthat itholdsexpost, dueto ourmonotonicityassumptiononthehazard rate. We proceed by using(11),in conjunctionwitha binding participation constraintforthe highestcost type, to writeU= −CH
C0 VCdC.Pluggingthisintotheprincipal’sobjectivefunction(6)anddoingapartialintegrationthenyields
W = CH CL
EC0 ∞ t=0e −rtw(
Q)
dt− e−rtC¯(
Q;C0)
dQt+F f(
C0)
VC(
Q,C0)
dF(
C0)
. (12)WeneedtooptimizethisexpressionbychoosinganappropriateinvestmentthresholdC¯
(
Q;C0)
foreachvalueofinitialcost levelC0.Todoso,firstweevaluatetheexpectedcontinuationutility,thefirstexpectedvaluetermundertheintegral,fora giveninitialcostlevelC0andagivenchoiceofthresholdC¯(
Q)
.(Thisisthesamecomputationasinsolvingthefirstbestinsection3.) EC0
∞ t=0e −rtw(
Q)
dt− e−rt(
C¯(
Q))
dQt= w(
Q)
r + Q∗ Q C0 ¯ C(
q)
λ− wQ r − ¯C(
q)
dq. Forthesecondtermintheintegrandin(12)wecanuselemma1towriteVC0
(
Q,C0)
=− Q∗ Q VQC0dq=− Q∗ Q C0 ¯ C(
q)
λ−−1 dq.Combiningthesetwoexpressions,itisstraightforwardtocomputetheoptimalthresholdC¯
(
Q;C0)
foreachvalueofC0∈[CL,CH],8
Proposition1. Theoptimalmenuresults inadifferentinvestmentthresholddependingontheagent’sinitialcostlevelC0,given
by ¯ C
(
Q;C0)
1+ 1 C0 F f(
C0)
=λ
−λ
−− 1 wQ r . (13)Comparingwiththefirst-bestthreshold(4),weseeasimilarexpressionexceptfortheappearanceofthefactorinvolving thedistributionoftheinitialcostsF(C0).Forthelowesttype,C0=CL,F
(
CL)
=0sowegetnodistortionthere,¯
C
(
Q;CL)
=λ
−λ
−− 1 wQr .
Higher cost types,in contrast,get a distortion,leadingto lower thresholds thanthe first-best ones. Thismeans that the optimalregulatory schemeinduces theagentto delayinvestment comparedto the first-bestreal-optionbenchmark. The reason is that lower cost typeshave to be awarded an information rent to reveal their true exante type; the delay in investmentreducestherentsobtainedby claiminghigherthanactualcosts initially.Thisinturnreducestherequiredrent toinduceagentstoreporttheirinitialcoststruthfully.
7 proof in the appendix
8 and verify that it satisfies the required monotonicity in C 0
Itremains tocompute theactualmenuofcontracts,includingtheupfrontfee
φ
0 andtheex-postfeep(Q).Thisfeecan simplybechosenaccordingtoequation(5),leadingto 1+ 1 C0 F f(
C0)
pQ=wQ, (14)makingtheagentresidualclaimanttothetotalutilitygeneratedmoduloacorrectionfactor.Thecorrespondingupfrontfee
φ
0isthensetsoastomakesurethattotalutilityequalstherequiredinformationrentU=−CH
C0 VCdC.
5. Application:traditionalorinnovativeinfrastructure?
Letusnowapply theseresultstoanswerthefollowingquestion. Considera greenfieldsituationinwhichthe network firmhastobuildanewnetworkinfrastructure,say,connectinganewly builtneighborhoodtothegrid.Suppose thereare twoalternativetechnologiestodoso.
Thefirst involveschoosing atraditional,well-understood, technology,forwhich thereisno asymmetry ofinformation betweenthe networkfirmandtheregulator.The secondalternativeis anewtechnology,forwhichthenetworkfirm has superiorinformation,andwhichthereforesuffersfromagencyfrictions.
Bothtechnologieshavestochasticallyfallingcosts,Cold
t andCtnew,respectively.Theseevolveaccordingtogeometric Brow-nianmotions,with
μ
old,μ
new≤ 0,andlikewisevolatilitiesthatmaybetechnology-specific.9Attime zero,thetechnologyischosen.Foreithertechnology,dependingontheinitialvalueC0old,new,thefirmwillfirstbuildaninitialcapacityQ0old,new,
andwillsubsequentlykeeponexpandingcapacity,usingthatsametechnology,ascostsfall.
Thequestionfacingtheregulatoris,whenitshouldaskthefirmtobuildinfrastructureusingthetraditional,wellknown technology;andwhen itshould insteadencourage thefirm to startbuildingthe newgrid technology,which mighthave lower cost, or higherlikelihood of future cost declines, butwhich may necessitaterents left to the firm in view of the informationasymmetrythatneedstobeovercome.
Weanalyzetheregulator’schoiceinthespecificcasewhenthesocialsurplusfloww(Q)isofconstant-elasticitytype, w
(
Q)
=w· Q1−γ1−
γ
with0<
γ
< 1 theinverseelasticity(asin Dobbs,2004; WillemsandZwart, 2018). Thefactor wmeasuresquality,and couldbe differentforthetwo technologies,wold versuswnew.Forinstance,thenewtechnologymightbemoreconducive toaccommodatingenvironmentallyfriendlygenerationinsidethenetwork,makingwnew>wold.Foranalyzing theoptimalinvestmentstrategylet usfirst,asabenchmark, establishtheoptimalinvestmentrules,and totalwelfare,inthefirst-bestcaseswithoutinformationasymmetry,foreithertechnology.
Lemma2. Inthegreenfieldinvestmentprojectwithconstantelasticitysocialsurplus,optimalinvestmentintherealoptioncase withcurrentcostlevelC0involvesbuildinginitialcapacityQ0,
w· Q0−γ =rC0
λ
−− 1λ
− ,andexpandingcapacitywhenthethresholdC¯
(
Q)
= λ−λ−−1
w·Q−γ
r iscrossed. Total(expected)surplus (includingthecostsC0Q0 of
theinitialinvestment)is
W
(
C0)
=1−γ
γ
·γ
(
γ
λ
(
λ
−− 1)
−− 1
)
+1· C0Q0.Inthesymmetricinformationsetting,theregulator’soptimalchoicebetweentraditionalornewtechnologyisthenclear: pickthealternativeyieldingthelargestexpectedsurplus.Inthespecialcasewhenbothtechnologies’costsfollowthesame stochasticprocesses,sothat
λ
old− =
λ
new− ,wehavethat Wnew≥ Wold isequivalentto wnewwold
Cold 0 Cnew 01
−γ ≥ 1.Clearly,intheabsenceofdifferencesinquality,wnew=wold,itisoptimaltochoosethelowestcosttechnology,forwhich initialinvestmentishigher.Modificationsfordifferencesinthestochasticparametersarestraightforward,andreflect poten-tialdifferencesintheexpansionoptionvalueofeithertechnology.
Letusnow add asymmetryofinformation onthecostsCnew
t forthenewtechnology,where theregulator onlyknows thedistributionofinitialcosts,F
(
Cnew0
)
,boundedbetweenlowestandhighestlevelsCLandCH,respectively.Thetraditional technologyiswellknown,anddoesnotsufferfrominformationalasymmetry.Wecanuseourresultsfromproposition1forcomputingtheoptimalregulationifweonlyfocusonthenewtechnology:afirmofinitialcostsCnew
0 isincentivizedtoinvest asifitscostswerelargerbyafactor
α
(
Cnew0)
≡ 1+ 1 Cnew 0 F f(
C new 0)
.In our setting withconstant elasticity surplus, this means that initial capacity is distorted downwards compared to its symmetricinformationcounterpartinlemma2,to
wnewQ˜−γ
0 =r
α
(
C0new)
C0newλ
−− 1λ
− ,andtheregulator’sexpectedsurplus,whichisnowreducedbecauseoftheinformationrentslefttothefirm,becomes,using theanalogouscalculationasinlemma2
¯ Wnew=
γ
1−γ
·γ λ
γ
(
−λ
+−− 11−)
γ
CH CLα
(
Cnew 0)
C0newQ˜0dF(
C0new)
.ComparedtoasymmetricinformationaverageoverthedifferentinitialcostslevelsCnew
0 ,theintegrandhereisreducedby afactor
α
(
Cnew0
)
1−1
γ <1(notetheextrafactorof
α
comingfromthedistortedcapacitychoice,Q˜0).A simple first attempt to making the trade off betweenusing the traditional established technology versus the new technology withitsinformation rents,isto comparethe two expectedsurpluses,Wold andW¯new,anddirect thefirm to choosewhichevertechnologygiveshighestsurplus.
Theregulatorcandobetter,however,byallowingthefirmtomakethattechnologychoiceitself,usingitssuperior infor-mationontheactual valueofCnew
0 .Providedthat thelowest costlevelforthenewtechnology,CL,givesabetteroutcome thanusingthetraditionaltechnology,orWnew
(
CL
)
>Wold,theoptimalregulationwillinvolveatleastsomeprobability of deploymentofthenewtechnology.Proposition2. Inthegreenfieldinvestmentprojectwithconstantelasticitysocialsurplus,optimalregulationinvolvesinvestment inthenewtechnologyforlow-costtypes,andtraditionalinvestmentforhighercostslevelsofthenewtechnology.Thetransition occursataninitialcostlevelC˜forthenewtechnologyforwhich
Wnew
(
α
(
C˜)
C˜)
=Wold(
Cold 0)
.Comparedtothefirst-besttrade-off,inthepresenceofinformationasymmetry,weneedtoswitch betweentraditional andnew technologiesguided by the virtual costs of the newtechnology, which are inflated by the factor
α
(
Cnew0
)
. This means thatthetraditional technologywillbe selectedmorefrequentlythan withsymmetric information.The intuitionis thatoptingforthetraditionaltechnologyisoptimalnotonlyifitallowsbuildingmorecapacityatlowercosts (efficiency); havingthetraditionaltechnologyasan outsideoptionalsoallowstheregulator tocutdownontheinformationrentsthat needtobepaidtothefirmincaseswherenewtechnologycostsarelow,andthenewtechnologyisselected.Sincethemark-upfactor
α
isequaltooneforthelowestcosttype,Cnew0 =CL,andincreasesforhighercostrealizations, wehavethefollowingcorollary.
Corollary 1. IfforCnew
0 =CL,thenew technologydominatesthetraditionaltechnology,thenalsowithinformationasymmetry,
optimalregulationwillimplementthattechnologyforlowcostrealizations.Incontrast,evenifforhighinitialcostsCH thenew
technologyismoreefficientthantheoldone,optimalregulationmaycallfortraditionaltechnologyinthatsituation.
Lowcostsdonotleadtodistortionsintheoptimalscheme,andwehavetheefficientoutcome.Decisionsforhighcosts aredistorted,ontheotherhand,andaretakenasifcostsareevenhigherbyafactor
α
(CH)>1.Whatmattersforchoiceof oldversusnewtechnologyisnotCH,butα
(CH)CH ascomparedtotheoldtechnology’scostlevelC0old.10Howcouldtheoptimalregulationschemebeimplementedinpractice?Inmanycountries,regulationinvolvessettingan allowed levelofrevenuesforthefirmtocollectfromitsconsumersthroughitscumulative tariffsforallservicesitoffers. Thislevelmaybecomputedbymultiplyingaregulatoryrateofreturnwiththefirm’sregulatoryassetbase.11Inthecontext
of the currentapplication, we may envisagean existing network firm that is allowed regulated revenues fromcharging tariffsforallitsservicestoallitscustomers.Wecanthenincorporatetheoptimalschemeforthecurrentgreenfieldproject intosuchacountry’sregulatoryschemebydeterminingthecontributiontothefirm’sallowedrevenuesfromthisparticular greenfieldproject.
If the firm chooses investing in traditional technology, accordingto the optimal investment trajectory Qold
t , it should receiveadditionalallowed revenuesequalto rtimesitsinvestmentoutlays,making goodits capitalcosts,butearningno rentsontop.If,ontheotherhand,itoptsforthenewtechnology,theproject’scontributiontoallowedrevenueswilldepend
10 Of course, taking into account potential differences in stochastic process for either technology (embodied in λ
−), as well as quality differences, the w -factor.
onthecapacityinvestmentQnew
0 .DependingonthechoiceofQ0new,contributionstothefirm’sallowedfuturerevenueswill besettothesumofaQ-dependentcontribution
p
(
Q)
=α
(
wnew· Q1−γ Qnew0
)(
1−γ
)
, andafixed contribution, φ0(Qnew0 )r .Here,
α
(
Q0new)
isdetermined tobe themark-up factorforinitial costsC0new consistent withtheoptimalchoiceofinitialcapacityQnew0 ,i.e.solving Cnew 0 =
λ
λ
− −− 1 wnew·(
Qnew 0)
−γα
(
Cnew 0)
r .Theallowed revenuescomponentequalto p(Q) determines howallowed revenuesincrease asthe assetbaseQincreases, givingtherightincentivesforoptimalinvestmentincapacityexpansionasfuturecostsdecrease.Thefirm receivespositive expectedrents from thisQ-dependent component. These rents can be computed analogously to the computationof the first-bestsocialsurplus,andareequalto
V=
γ
γ
− 1(
γ λ
−γ λ
−γ
−+1)
wnew·(
Qnew 0)
1−γα
(
Qnew 0)
r .The
φ
0/rcomponentto theallowedrevenuesdoesnot changeascapacityislaterincreased:itisacomponenttototal allowedrevenuesthatstaysfixed overtime.Itisusedtoshifttotalrentsforthefirm suchthatthey becomeequaltothe requiredinformation rents. In particular, forCnew0 =C˜– the maximal level of costs above which thefirm should refrain frominvestinginthe newtechnology,butshould adoptthe traditionaltechnologyinstead – totalinformationrents need tobe zero.For thatcost-level, therefore,thiscomponentis negative,
φ
0=−V.Forlower C0new, there needto be positive informationrents,toensureincentivecompatibility,andφ
0willbelargerthan−V.6. Discussion:commitmentversuslearning
Thesolutiontotheoptimalregulationproblemmakesclearthatonlytheinitialcostlevel,C0,playsaroleinthesetting oftheinvestmentthresholdsC¯
(
Q)
;subsequent updatesofthesecosts,asaresultofthestochasticprocess thatCfollows, donotaltertheoptimalpolicy.Indeed,wereC0commonknowledgeexante,aswesawinsection4.1,theregulator could achieve thefirst-best resultbyusing thesell-out contractwith pQ=wQ, andextractingallrents through anappropriate ex-antefixedfee(or,alternatively,afixedshiftinthestreamoffeesp).Incontrast,theinformationadvantagethattheagentobtainsatlaterdates,asaresultofstochasticmovementsofCtafter
t=0,doesnotresultinanyadditionalrentstotheagent,andasaconsequencedoesnotnecessitatefurtherdistortionsin thethreshold.Theintuition forthis(see Baron andBesanko, 1984;Es˝o andSzentes,2017) isthat thoselater updatesare ex-antesymmetricinformation:the expectation value ofanyinformationrentsthat the agentmight obtaininthe future canalreadybeextractedinitiallywhensigningthecontract.
Acrucialassumptioninthecurrentmodelisthat theregulator isabletocommit,ex-ante, totheregulatoryschedule. Asiswell knownfromtheliteratureondynamicmechanismdesignandtheratcheteffectinregulationtheory(Baronand Besanko,1984;LaffontandTirole,1988),itiscrucialthat theregulatorcanalsocommitnotto usetheinformationlearnt fromthe agent’schoice ofcontract (the choice ofthreshold) to later adjustthresholds to some value closerto the first-best.12 Ofcourse,ex-post suchan adjustmentwouldbe optimal:once informationalasymmetry hasbeenresolved, there
isnolonger anyneedfordistortedinvestment.From an ex-antepoint ofview,however,suchlearning, andupdating the incentiveschemeon the basis ofthat learning, would be detrimentalto the regulator’sobjective.The reasonis that the agentwillanticipatesuch regulatorybehavior,and, knowingthatfuturerentswillbe extractedbytheregulator basedon theagent’s earlierrevelation of private information, theagent willin response requirehigher exante transfers in order to truthfullyreveal its initial cost level. Byspreading distortions across periods andignoring potential updatesbased on informationrevealedthroughtheagent’schoices,totalwelfarecostsareminimized.
Regulatorycommitmenthasbeenwellappreciatedasbeingofhighimportanceintheenergysector. Intheabsenceof such commitment,firms wouldrefrain fromsinking investments,for fear ofex postregulatory expropriation. Inthe US, firmsareprotectedfromsuch‘regulatorytakings’throughlegalmeasuresfollowingtheSupremeCourt’sHopeGasruling.In Europe,CERRE(2013)arguesthatthesettingoftheregulatoryassetbasecanprovidesuchregulatorycommitment.13Since,
aswesaw,ourschemeofregulatoryfeescan beimplementedintermsofcontributions tothisregulatoryassetbase,this providessomecomfortthatcommitmentcanbefeasibleinpractice.
12 Even aside from private information, the exogenous changes of the stochastic process could also give rise to commitment problems for the regulator.
See for instance Di Corato (2013) who in a real option setting studies the risk of expropriation of a company’s assets by a foreign host country, and the resulting distortions in profit sharing contracts this engenders.
13 In particular, “There is general agreement that RABs are an effective commitment device for natural monopoly elements of infrastructure companies –
ProofofLemma1.. WehavethatV(Q,C)satisfiestheHJBequation rV
(
Q,C)
=p(
Q)
+μ
CVC+ 1 2σ
2C2V CC.WecantakeQ-andC-derivativesfromthisequationandrewritetoobtain rCVQC
(
Q,C)
=μ
C∂
∂
C(
CVQC)
+ 1 2σ
2C2∂
2∂
C2(
CVQC)
,sothefunctionCVQC itselfalsosatisfiesanHJBequationwithoutasourceterm. Furthermore,wehavethesmooth-pastingconditiononC¯
(
Q)
,VQC
(
Q,C¯(
Q))
=1whichequivalentlycanbewrittenas ¯
C
(
Q)
VQC(
Q,C¯(
Q))
=C¯(
Q)
.From thesetwo equations,we learn that, given Q, above the boundary, C>C¯
(
Q)
, the function CVQC satisfies an HJB equation andon thatboundary,we knowitsvalue. Fromthat information,we canfindan explicitexpressionforCVQC:it shouldbeequalto CVQC(
Q,C)
=E¯ C
(
Q)
e−rT=C¯(
Q)
C ¯ C(
Q)
λ− fromwhichfollowstheexpressioninthelemma,VQC
(
Q,C)
= C ¯ C(
Q)
λ−−1 .ProofofProposition1.. Theprincipaloptimizesitsobjectivefunctionwhichiswrittenasequation(12),
W = CH CL
EC0 ∞ t=0 e−rtw(
Q)
dt− e−rtC¯(
Q;C0)
dQt +F f(
C0)
VC0(
Q,C0)
dF(
C0)
. Inthemaintext,wehaveexpressionsforthetwopartsinthisintegral,EC0
∞ t=0e −rtw(
Q)
dt− e−rt(
C¯(
Q))
dQt = w(
Q)
r + Q∗ Q C0 ¯ C(
q)
λ− wQ r − ¯C(
q)
dq. and VC0(
Q,C0)
=− Q∗ Q VQC0dq=− Q∗ Q C0 ¯ C(
q)
λ−−1 dq. ThecombinationofthesetwopartsleadstoW = CH CL
w(
Q)
r + Q∗ Q C0 ¯ C(
q)
λ− wQ r − ¯C(
q)
− ¯ C(
q)
C0 F f(
C0)
dqdF
(
C0)
. ThiswecanoptimizepointwiseforeachpossibleC0,leadingto¯ C
(
Q;C0)
1+ 1 C0 F f(
C0)
=λ
λ
− −− 1 wQ r .Moreover,fromtheassumedmonotonicityofthelogofthehazardrate,thisthresholdisdecreasinginC0.
Proof of Lemma 2.. With w
(
Q)
=w·Q1−γ1−γ , we have wQ=w· Q−γ. Plugging this into the first-best cost-threshold from
section3,wehaveinvestmentthreshold(equation4) ¯
C
(
Q)
=λ
λ
−−− 1 w· Q−γ
r .
Totalwelfareattheinvestmentthresholdis W
(
Q,C¯(
Q))
= w· Q1−γ(
1−γ
)
r+g(
Q)
C¯ λ−, with g(
Q)
= ∞ Q ¯ C(
q)
−λ− wq−γ r − ¯C(
q)
dq=
wλ
− r(
λ
−− 1)
−
λ− w r(
λ
−− 1)
Qγ (λ−−1)+1γ
(
λ
−− 1)
+1.We get total welfare for the greenfield project by subtracting construction costs to bring initial capacity to threshold, ¯
C
(
Q)
Q= λ−λ−−1
w·Q1−γ
r .
ProofofProposition2.. TheprincipalnowhastheoutsideoptionofobtainingWold,thesocialwelfareforthetraditional technology,andhastodeterminetheoptimalcostlevelC˜abovewhichshutdownofthenewtechnologywillbepreferred; thismeansoptimizing
C˜ CL ECnew 0
∞ t=0e −rtwnew(
Q)
dt− e−rtα
(
Cnew 0)
C¯(
Q;C0new)
dQt dF(
Cnew 0)
+(
1− F(
C˜))
Wold overC¯aswellasC˜.Here,α
(
Cnew0
)
isthemark-up,1+ 1 Cnew0
F
f
(
C0new)
.Clearly,themaximumobtainsforC˜suchthatthevirtual welfare(i.e.,welfareasifcostlevelisinflatedbyα
(
Cnew0
)
)isequaltoWold,or,fromlemma2γ
1−γ
·γ
(
γ
λ
(
−λ
− 1−− 1)
+)
1α
(
˜ C)
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