A real options-based model to supporting risk allocation in price cap regulation approach for public utilities

Abstract

Price cap regulation of public utilities is based on an incentive mechanism to prevent monopolistic infrastructure firms from charging excessive prices. The challenge of this regulation mechanism is to define incentives able to avoid abnormal profits of firms and simultaneously increase quality of service and promote investment projects. A new risk-based approach to support the definition of the fair incentive mechanism as between the regulator, the community and the firm is proposed. The methodology is based on the combined use of real options theory and Monte Carlo simulation. The methodology is then applied to the Italian water market where the regulator adopts a ‘hybrid’ price cap mechanism that gives monopolistic firms the incentive to implement investment projects for reducing the actual infrastructural gap in the water supply system. The results reveal the capability of the proposed model to support public decision makers at the negotiation stage to define the incentive scheme and investment plan able to increase the quality of service allowing a fair risk allocation among parties.