An Examination of Frank Wolak’s Model of Market Power and its Application to the New Zealand Electricity Market

This paper is the second in a symposium of papers that examine the 2009 report by Frank Wolak into the New Zealand electricity market. In this paper, we discuss the Report’s measures of the ability and incentives of generators to exercise unilateral market power. We show that the construction and interpretation of these measures are highly sensitive to some key assumptions, particularly those concerning the elasticity of demand for electricity in the wholesale market and the amount of transmission loss on the national grid.Electricity markets; market power

Competing Payment Schemes

This paper presents a model of competing payment schemes. Unlike previous work on generic twosided markets, the model allows for the fact that in a payment system users on one side of the market (merchants) compete to attract users on the other side (consumers who may use cards for purchases). It analyzes how competition between card associations and between merchants affects the choice of interchange fees, and thus the structure of fees charged to cardholders and merchants. Implications for other two-sided markets are discussed.

Cricket interruptus: Fairness and incentive in interruped cricket matches

We present a new adjustment rule for interrupted cricket matches that equalizes the probability of winning before and after the interruption. Our proposal differs from existing rules in the quantity preserved (the probability of winning), and also in the point at which it is measured (the time of interruption). We claim this 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.

Missed Opportunities: Optimal Investment Timing when Information is Costly

Real options analysis typically assumes that projects are continuously evaluated and launched at precisely the time determined to be optimal. However real world projects cannot be managed in this way because of the costs of formally evaluating an investment opportunity. This paper analyzes how projects should be managed in such a world. Information about a project comes in two flavors: project-specific information which can only be observed if a fixed evaluation cost is incurred; and generic information which can be observed without cost. If sufficiently good generic information is observed during the period immediately after a project evaluation the firm will invest without any further evaluation. Beyond this period the firm will always reevaluate the project before investment. The availability of information and project evaluation costs affect the firm's optimal behavior in different ways: a higher evaluation cost means that the firm evaluates the project later (that is sets a higher evaluation threshold) but invests sooner (that is sets a lower investment threshold); a bigger role for project-specific information also induces the firm to set a lower investment threshold but it actually encourages the firm to evaluate the project sooner. The value of waiting is lower when more information is project-specific and when project evaluations are more costly. Standard real option models may therefore overestimate the value of investment timing flexibility. This misvaluation is especially severe when the value of the completed project is strongly mean reverting because then precision in investment timing is particularly important

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 now they 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

Risk, Price Regulation, and Irreversible Investment

We show that regulators' price-setting rate base and allowed rate of return decisions are inextricably linked. Once regulators switch from traditional rate of return regulation the irreversibility of much infrastructure investment significantly alters the results of the usual approach to price-setting as exemplified by Marshall Yawitz and Greenberg (1981). In particular the practice of 'optimizing' inefficient assets out of the regulated firm's rate base as in total element long-run incremental cost (TELRIC) calculations in telecommunications exposes the firm to demand risk. The firm requires an economically-significant premium for bearing this risk and this premium is an increasing function of the unsystematic risk of demand shocks. In addition we argue that if the firm is to break even under incentive regulation then the level of the rate base will not generally equal the optimized replacement cost

Can Ex Post Rates of Return Detect Monopoly Profits?

We review the ability of the ex post internal rate of return (IRR) to detect monopoly profits. When market values are used as entry and exit values the ex post IRR simply reveals whether the firm did better or worse than the market expected at the entry date. It says nothing about monopoly profits. When replacement costs are used as entry and exit values the ex post IRR can in principle reveal something about monopoly profits. However since the ex post IRR is a noisy measure of ex ante monopoly profits it will be very difficult to reject the hypothesis given the sample periods typically available. The benchmarks typically used are market-determined and therefore only comparable to IRRs calculated using market values - a situation when the ex post IRR reveals nothing about monopoly profits anyway. Furthermore there is ample empirical and theoretical evidence that these benchmarks do not even represent fair rates of return

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 firm's output price at discrete intervals. Using this model we derive a closed-form solution for the firm's output price which ensures that whenever the regulator resets the price the present value of the firm's 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 firm's 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 firm's 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

Payback Without Apology

When interest rates are uncertain the net-present-value threshold required to justify an irreversible investment is increasing in the length of a project's payback period. Thus slowpayback projects should face a higher hurdle than fast-payback projects just as investment folklore suggests. This result suggests that the widely disparaged use of payback for capital budgeting purposes can be an intuitive response to correctly perceived costs and benefits

Cricket Interruptus: Fairness and Incentive in Interrupted Cricket Matches

We present a new adjustment rule for interrupted cricket matches that equalizes the probability of winning before and after the interruption. Our proposal differs from existing rules in the quantity preserved (the probability of winning) and also in the point at which it is measured (the time of interruption). We claim this 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