University of Colorado Copyright © 2005 James Alleman. All Rights Reserved. James Alleman Transatlantic Dialogue Montpellier, France 22 November Regulatory Failure Time for a New Policy Paradigm

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations  Lack of Dynamic Efficiency  Lessons  Conclusion & Further Research

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview

Transatlantic Dialogue Broadband Conference Agenda  Cost of regulation > benefits  Wrong models  Economic dynamics

Transatlantic Dialogue Broadband Conference Agenda  Cost of regulation > benefits  Administrative costs,  Regulatory capture and  Other effects

Transatlantic Dialogue Broadband Conference Agenda  Cost of regulation > benefits  Administrative costs,  Regulatory capture and  Other effects  Wrong models  Misallocation of resources  A lowering of social welfare

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations  Lack of Dynamic Efficiency  Unrecognized Opportunity Costs  Sunk Costs

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations  Competition  Faux Success  Optimal Pricing

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations  Lack of Dynamic Efficiency  Lessons

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations  Lack of Dynamic Efficiency  Lessons  Conclusion & Further Research

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations  Lack of Dynamic Efficiency  Lessons  Conclusion & Further Research

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Overview/Literature Review  Regulatory Models  Dynamic Models  Real Options Approach

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Investments Distortions ƒ Wrong incentives ƒ Averch-Johnson  Static/Comparative Static  Certainty Regulatory Models

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Objectives  Uncertainty Modelled  Dynamic Models  Regulation Modelled  Cost of Regulation Estimated

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations  Lack of Dynamic Efficiency

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview/Literature Review  Real Options  Regulatory Distortions  Investment Criterion  Implications for Regulation  Future Research

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Overview/Literature Review  Regulatory Models  Dynamic Models  Real Options Approach

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Investments Distortions ƒ Wrong incentives ƒ Averch-Johnson  Static/Comparative Static  Certainty Regulatory Models

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Growth Models  Certainty ƒ Complete information ƒ Exogenous depreciation Dynamic Models

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Valuation Models ƒ Project valuations ƒ No retail pricing  No Regulatory Models Real Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Real Options ƒ What are they? ƒ Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University What Are Real Options?  Financial Option Analogy ƒ Right ƒ Not obligation ƒ Upside potential (profit) ƒ Limit downside risk (loss)

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer ƒ To wait to determine if a "good" state-of-nature obtains Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer  Abandon ƒ To obtain salvage value or opportunity cost of the asset Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer  Abandon  Shutdown & Restart ƒ To wait for a "good" state-of-nature and re-enter Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer  Abandon  Shutdown & Restart  Time-to-build ƒ To delay or default on project - a compound option Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer  Abandon  Shutdown & Restart  Time-to-build  Contract ƒ To reduce operations if state is worse than expected Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer  Abandon ...  Contract  Switch ƒ To use alternative technologies depending on input prices Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer ...  Contract  Switch  Expand/Growth/Learn ƒ To expand if state-of-nature is better than expected Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer  Abandon  Shutdown & Restart  Time-to-build  Contract  Switch  Expand/Growth/Learn Types of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview/Literature Review  Real Options  Regulatory Distortions

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Assumptions/Model q1q1 1 - q 1 go stop

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Revenue Constraint ƒ Rate-based, rate-of-return ƒ Price Caps ƒ Interconnection prices ƒ UNEs price ceiling ƒ Modelled as "Good" Ceiling

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions q1q1 1 - q 1 stop

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions q1q1 1 - q 1 stop revenue constraint

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Revenue Constraint ƒ Rate-based, rate-of-return ƒ Price Caps ƒ UNEs price ceiling ƒ Modelled as "Good" Ceiling  Defer

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Defer: To wait to determine if a "good" state-of-nature obtains Regulatory Distortions

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Value in Waiting  Like Call Option  Influences: ƒ uncertainty ƒ foregone profits  Choice:  Max [immediate investment, waiting, 0] Delay: Waiting to Invest

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  Revenue Constraint  Defer: To wait to determine if a "good" state-of-nature obtains  Abandon: To obtain salvage value or opportunity cost of the asset Description of Options

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Price Ceilings ƒ Revenue constraints ƒ Price setting (UNEs/Interconnection)  Obligation to Serve ƒ Universal service

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Price Ceilings ƒ Revenue constraints ƒ Price setting (UNEs)  Obligation to Serve ƒ Universal service  Lack of delay

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Price Ceilings ƒ Revenue constraints ƒ Price setting (UNEs)  Obligation to Serve ƒ Universal service  Lack of delay  Lack of abandonment

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Price Ceilings ƒ Revenue constraints ƒ Price setting (UNEs)  Obligation to Serve ƒ Universal service ƒ Pay telephones

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Price Ceilings ƒ Revenue constraints ƒ Price setting (UNEs)  Obligation to Serve ƒ Universal service ƒ Pay telephones  Lack of abandonment

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions  Price Ceilings ƒ Revenue constraints ƒ Price setting (UNEs)  Obligation to Serve ƒ Universal service  Lack of delay  Lack of abandonment ƒ Pay telephones  Lack of abandonment

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulation Distortions  Costly ƒ Cash flow constrained ƒ Delay-cash flow constrained ƒ Abandon-cash flow constraint  Unrecognized Cost

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview/Literature Review  Real Options  Regulatory Distortions  Investment Criterion

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University t=0t=1 S0S0 RS 0 S1S1 A Risk-Neutral Model

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University t=0t=1 S0S0 RS 0 S1S1 A Risk-Neutral Model (Continuous Additive)

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University A Risk-Neutral Model (Continuous Additive) t=0t=1 S0S0 RS 0 V S1S1

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University S0S0 V K Probability f(V) Call Option

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Call Option S0S0 V K V-K Probability f(V) Payoff : P(V)

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Call Option Price S0S0 V K V-K Probability f(V) Payoff : P(V)

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University 3.2 Defer Option Present value of a project’s future cash flow Investment to acquire the project assets Length of time the decision may be deferred Time value of money Riskiness of the project assets Stock price Exercise price Time to expiration Risk-free rate of return Variance of returns on stock Defer OptionCall Option S K T rfrf 22

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Example

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University ƒ PV[Cash out] = PV[K T ] = 110/1.06 = ƒ PV[Cash in] = S = E[ PV[S 1 ]] = 100 ƒ NPV = PV[cash in] – PV[cash out] = 100 – = Net Present Value

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University S=100 V K=110/1.06=103.8 V-K  ROV (Real Option Value)

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University 3.4 ExNPV  Expanded NPV 10.2 M M 6.4 M NPV +ROV =ExNPV = Flexibility value to defer = Conventional Value of Project

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  When is ExNPV = 0, when NPV < 0? Methodology

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  When is ExNPV = 0, when NPV < 0 ? Wait and watch the market! Do not invest ExNPV > 0ExNPV < 0 ExNPV = 0 Methodology

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University  If NPV < 0, when is ExNPV = 0? i.e.  ExNPV= ROV + NPV = 0 Methodology

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University S V K V-K  Methodology ƒ When is ExNPV = 0, give NPV < 0? ƒ ExNPV = ROV + NPV = 0

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University : Normal distribution (0,1): f N (v) Solve

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University LHS ( left hand side ) Solve

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University LHS ( left hand side ) Solve

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University D* = Solve

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University ExNPV > 0ExNPV < 0 Criterion

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University ExNPV > 0ExNPV < 0 LHS > 0LHS < 0 Criterion

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Implications for Regulation  Impact on "riskiness"  Reduces 

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview/Literature Review  Real Options  Regulatory Distortions  Investment Criterion  Implications for Regulation

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview/Literature Review  Real Options  Regulatory Distortions  Investment Criterion  Implications for Regulation  Future Research

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Future Research  Empirical Estimates  Investment ƒ Endogenous ƒ Economic depreciation  Ramsey Pricing

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Dr. James Alleman University Colorado CB 422 UBS Boulder, CO phone: facsimile: mobile: Dr. Paul Rappoport Temple University Broad Street Philadelphia, PA phone: Contact Information

Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda  Overview  Incorrect Foundations