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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

Regulation ofNetwork Infrastructure Investments -An Experimental Evaluation

Bastian Henze, Charles Noussair & Bert Willems

Stockholm, 21 June 2011

DOWNLOADABLE FROM

http://ssrn.com/abstract=1791568

overview
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
1 incentive regulation price cap
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
2 regulatory holiday
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
3 forward auctioning
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.)
general features
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
1 price cap
1. Price Cap
  • Shippers bid into uniform sealed bit auction
    • Price for shippers = lowest accepted bid
    • Price for network operator = price cap
2 regulatory holiday1
2. Regulatory Holiday
  • Network operator receives unregulated price cap for new capacity
3 forward auctioning1
3: Forward Auctioning
  • Network operator sells capacity in forward auction at regulated price
  • Spot market functions as a secondary market for shippers
efficiency
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?
aggregate bidding behavior
Aggregate Bidding Behavior
  • Revealed aggregate demand function, normalized on demand level
  • 1 standard deviation error boundaries
aggregate bidding behavior1
Aggregate Bidding Behavior

Revealed demand is more elastic than underlying demand

Network users underbid for capacity

aggregate bidding behavior2
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

conclusion1
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