Price cap regulation and investment behavior: how real options can explain underinvestment

Thomas Nagel, Margarethe Rammerstorfer

Abstract

ABSTRACT

In this paper we analyze the timing and extent of investment by a firm acting in a regulated transmission market. When capping prices, the regulatory authority limits possible higher future levels of market prices. In order to derive an optimal pricing rule for regulators, we use a real option approach, where the price cap enters a dynamic investment decision model in the form of a set of short call options. Furthermore, we calibrate our model with respect to European electricity transmission markets and show how deviations from this optimum affect investment behavior.