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Regulation of Network Infrastructure Investments - An Experimental Evaluation

Regulation of Network Infrastructure Investments - An Experimental Evaluation. Bastian Henze , Charles Noussair & Bert Willems Stockholm, 21 June 2011 DOWNLOADABLE FROM http://ssrn.com/abstract=1791568. Overview. Large need for additional investments in gas transportation capacities

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Regulation of Network Infrastructure Investments - An Experimental Evaluation

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  1. Regulation ofNetwork Infrastructure Investments -An Experimental Evaluation Bastian Henze, Charles Noussair & Bert Willems Stockholm, 21 June 2011 DOWNLOADABLE FROM http://ssrn.com/abstract=1791568

  2. Overview • Large need for additional investments in gas transportation capacities • We compare the performance of 3 regulatory schemes for investments in network infrastructure • We use economic lab experiments • Students are put into a controlled laboratory environment • They interact according to a set of rules (“institutions”) specified by the experimenter • They are paid in real currency (EUR), their payment is performance-dependent

  3. 1. Incentive regulation - price cap • Often introduced to replace cost-plus regulation • To prevent over-investments (Averch & Johnson. 1962) and X-inefficiencies • Possibly underinvestment in durable capacity • Price cap does not account for real option value of investments [Guthrie 2006, Armstrong and Sappington 2007] • Hold-up vis-a-vis regulator

  4. 2. Regulatory Holiday • Network operator is temporarily exempted from regulation of the profits that new investments yield • Why? • Additional revenue is intended to compensate the Network operator[Gans and King 2004, Spanjer 2008, Nagel and Rammerstorfer 2008, Vogelsang 2010] • Easy to administrate, regulator can easily commit to it • Used? • EU energy regulation has provisions for such exemptions • Of 11 current gas projects, 8 investors received exemptions under this provision

  5. 3. Forward Auctioning • Forward auctions for long term network capacity sold by the network operator to network users • Why? • Forward price gives information about future demand. It reduces risk for network operator • Hedges income of the network operator of uncertain spot prices • Secondary market for capacity becomes more competitive (more traders on both sides of the market) • Used? • “Open-season” system for network capacity is often implemented in gas markets (E.U. and U.S.)

  6. Set up

  7. General Features • 4 sessions / treatment • in each session: 1 Network operator, 4 shippers • Demand: private information for each shipper, • On aggregate linear demand function, random, but growing on average •  We want to test how information on future demand is transmitted •  Random demand creates uncertainty for network investor • Supply: Network operator builds network capacity • Investment is irreversible, each installed capacity has a per period cost •  Irreversibility and lumpiness of investments to take into account real option value

  8. 1. Price Cap • Shippers bid into uniform sealed bit auction • Price for shippers = lowest accepted bid • Price for network operator = price cap

  9. 2. Regulatory Holiday • Network operator receives unregulated price cap for new capacity

  10. 3: Forward Auctioning • Network operator sells capacity in forward auction at regulated price • Spot market functions as a secondary market for shippers

  11. Results

  12. Spot Price Installed Capacity

  13. Efficiency • Overall efficiency: Comparison with first best • Static efficiency: Is the good allocated to the right shippers? • Dynamic efficiency: Is the right amount of goods invested?

  14. Aggregate Bidding Behavior • Revealed aggregate demand function, normalized on demand level • 1 standard deviation error boundaries

  15. Aggregate Bidding Behavior Revealed demand is more elastic than underlying demand Network users underbid for capacity

  16. Aggregate Bidding Behavior • Forward demand function is more elastic, closer to valuation • Forward demand function is more uncertain • Signs of arbitrage: • Users bidding above valuation (resell later) • Users bidding below valuation (buy later, keep price low) Revealed demand is more elastic than underlying demand Network users underbid for capacity

  17. Conclusion

  18. Conclusion • Regulatory holidays underperforms • Network operator has incentive to keep prices high in subsequent periods (as simulated) • However: demand side participation can reduce market power somewhat • Forward auctioning has benefits • Higher demand elasticity • Prices or on average closer to valuation (arbitrage helps) • Investors can hedge • However, forward auctioning underperforms • Arbitrage requires bidders to “speculate” on the future spot price. This reduces allocativeefficiency, as bids are less related to the bidders’ own valuation • Arbitrage increases the uncertainty of forward prices, lowering investment levels

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