Incentive Regulation and Capital Structure in Digital Networks: Theory, Evidence and Implications

Abstract

Financing questions are important in assessing firms in regulated sectors, such as telecommunications, as they have high debt levels. Concomitantly, a regulatory innovation influencing firms behavior has seen ‘cost-plus’ rate of return regulation giving way to incentive-based ‘price-minus’ approaches, such as price caps where inflationary price increases may be awarded, subject to meeting a productivity target. The impacts of such regulatory transitions on firm leverage have not been conceptually or empirically evaluated. We analytically model whether the regulatory transition to a price caps regime, from a rate of return framework, would affect firms’ leverage. Thereafter, our proposition is evaluated with data for the United States telecommunications industry, the sector providing the digital carriage backbone for the American economy, to draw widely-applicable conclusions. Detailed granular time-series data allow assessment of the impact of regulatory change on incumbent local exchange companies’ leverage. This natural experiment format permits a salient issue examination, via generalizable evidence, given that communications technologies affect all aspects of our lives. We find that price cap regulated firms have had 39 percent lower leverage levels than firms regulated by the rate of return method. Hybrid or intermediate regulations have had no impact or positive impact on leverage. Leverage decline after price caps introduction would be motivated by efficiency considerations; nevertheless, after the introduction of competition, firms would not only need to cut costs to boost fiscal performance but also send entrants signals that low leverage levels would provide incumbents financial slack to tackle competition and protect markets.