Graeme Guthrie

Regulating Infrastructure: The Impact on Risk and Investment

The last thirty years have witnessed a fundamental change in the regulation of infrastructure industries. Whereas firms were subject to rate of return regulation and protected from entry in the past, they now face various forms of incentive regulation, competition is actively promoted by many regulators, and both regulators and the firms they regulate must often confront rapid technological progress. This paper surveys the literature on the investment implications of different regulatory schemes, highlighting the relevance of modern investment theory, which puts risk and intertemporal issues, such as the irreversibility of much infrastructure investment, center stage. It discusses the impact on regulated monopolists? investment behavior of key regulatory characteristics, namely the price flexibility allowed by the regulator, the length of the regulatory cycle, and the costs the regulator will allow the firm to recover at future regulatory hearings. It also considers the impact of competition, especially the situation where a vertically integrated firm has its operation of a bottleneck asset regulated, on investment by regulated firms and their competitors.

Open mouth operations

This paper explains how central bank statements, rather than open market operations, can be used to implement monetary policy. In the extreme, policy instruments can be held constant, and yet interest rates will evolve along the path desired by the central bank. We show how the recent implementation of monetary policy in New Zealand works in this way. Using announcement data from New Zealand, we find that open mouth operations lead to large changes in interest rates across all maturities, and these changes cannot be explained by open market operations. Implications are drawn for monetary policy in other jurisdictions.

Recursion operators and non-local symmetries

A new formulation of recursion operators is presented which eliminates difficulties associated with integro-differential operators. This interpretation treats recursion operators and their inverses on an equal footing. Efficient techniques for constructing non-local symmetries of differential equations result.

Incentive Regulation of Prices when Costs are Sunk

We present a model featuring irreversible investment uncertain future demand and capital prices and a regulator who sets the firms output price at discrete intervals. Using this model we derive a closed-form solution for the firms output price which ensures that whenever the regulator resets the price the present value of the firms future net revenue stream equals the present value of the investment expenditure incurred by a hypothetical efficient firm which replaced the regulated firm. We calculate the rate of return which shareholders should receive to compensate them for the exposure to demand risk and capital price risk induced by modern incentive regulation. In contrast to rate of return regulation we find that resetting the regulated price more frequently increases the risk faced by the firms owners and that this is reflected in a higher output price and a higher weighted-average cost of capital. We show that the market value of the regulated firm will generally exceed the replacement cost of its existing assets by an amount that we interpret as the value of the firms excess capacity. The higher valuation is required in order for the firm to prospectively manage fixed costs that are implied by irreversibility. We suggest it is indicative of the efficient treatment of investment in advance. This contrasts with much of the existing literature which argues that the market value of a regulated firm should equal the cost of its existing assets.

Nonlocal symmetries of the KdV equation

A loop algebra of nonlocal isovectors of the Korteweg–de Vries (KdV) equation is introduced which is derived from the bi‐Hamiltonian structure of that equation by inverting the usual recursion operator. These symmetries are lifted to the modified KdV (mKdV) equation and two related evolution equations via coordinate transformations. The effect on the algebraic structure of the isovector algebra is considered. Possible applications of these symmetries include recovering Miura‐type transformations.

Cricket interruptus: fairness and incentive in limited overs cricket matches

We present an adjustment rule for interrupted cricket matches that equalizes the probability of winning before and after the interruption, which we claim is both fair and free of incentive effects. We give several examples of how our rule could have been applied in past matches, including some in which the ultimate result might have been different.

House Prices, Development Costs, and the Value of Waiting

This paper demonstrates that new house prices can exceed direct development costs by considerable margins in competitive housing markets with finite price-elasticities of demand and no restrictive land-use regulation. The premium reflects the value of the option to delay developing the marginal piece of undeveloped land. Competition amongst landowners reduces the option value relative to the standard open-city framework, but--as long as undeveloped land is heterogeneous--does not reduce it to zero. Calibrating a special case of the model to US data suggests that the premium is economically significant. In addition to proving that prices can exceed costs without regulation, this paper shows that the relationship between volatility and the rate of investment is more complicated than previously thought.

Price-Cap Regulation and the Scale and Timing of Investment

This paper shows how scale economies affect welfare-maximizing regulation and regulated firms’ investment behavior. Price-regulated firms take less advantage of scale economies than social planners, with greater investment distortions for greater economies of scale. Price caps should be below the caps implied by planners’ investment programs for moderate economies of scale, and above them otherwise. Despite quantity regulation raising the average cost of building capacity, price caps should be lower when quantity is regulated. Immediately after firms make their initial investment, regulators want to transfer surplus from customers to shareholders by raising the price cap in order to fund service improvements.

Uncertainty, and the Trade-Off Between Scale and Flexibility in Investment

This paper analyzes the behavior of a firm that chooses both the scale and timing of its investment. Sensitivity analysis shows that greater demand volatility is associated with the firm investing in larger increments, less frequently. This is in contrast to the conventional wisdom, which is that greater volatility leads to investment in smaller increments, more frequently. Overall, the reduced frequency dominates the greater scale, so that the long-run average rate of investment is a decreasing function of demand volatility. The timing and scale of investment are most sensitive to volatility when there are substantial investment economies of scale.

Assessing the Integration of Electricity Markets Using Principal Component Analysis: Network and Market Structure Effects

The major difficulties in assessing market power in electricity wholesale spot markets mean that great weight should be placed upon assessing market outcomes against the fundamental determinants of supply demand and competition. In this spirit we study whether the New Zealand market has been a national market or a set of local markets since its inception in 1996. Electricity markets generally have loop flows that require simultaneous assessment of prices at all nodes thereby limiting the informativeness of pair-wise nodal comparisons. We introduce principal component analysis to this application and show that it is a natural tool for the qualitative and quantitative assessment of the presence of local markets. We find that increased competition induced some separation into local markets that was eliminated by transmission enhancement and the introduction of generation downstream from the constrained circuits. For most of the period New Zealand has had one national market.