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University of Colorado Copyright © 2005 James Alleman. All Rights Reserved. James Alleman Transatlantic Dialogue Montpellier, France 22 November 20055 Regulatory Failure Time for a New Policy Paradigm
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Incorrect Foundations Lack of Dynamic Efficiency Lessons Conclusion & Further Research
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview
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Transatlantic Dialogue Broadband Conference Agenda Cost of regulation > benefits Wrong models Economic dynamics
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Transatlantic Dialogue Broadband Conference Agenda Cost of regulation > benefits Administrative costs, Regulatory capture and Other effects
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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
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Incorrect Foundations Competition Faux Success Optimal Pricing
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Incorrect Foundations Lack of Dynamic Efficiency Lessons
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Incorrect Foundations Lack of Dynamic Efficiency Lessons Conclusion & Further Research
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Incorrect Foundations Lack of Dynamic Efficiency Lessons Conclusion & Further Research
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Overview/Literature Review Regulatory Models Dynamic Models Real Options Approach
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Objectives Uncertainty Modelled Dynamic Models Regulation Modelled Cost of Regulation Estimated
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Incorrect Foundations Lack of Dynamic Efficiency
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Overview/Literature Review Regulatory Models Dynamic Models Real Options Approach
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Growth Models Certainty ƒ Complete information ƒ Exogenous depreciation Dynamic Models
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Real Options ƒ What are they? ƒ Types of Options
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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)
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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
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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
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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
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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
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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
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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
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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
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview/Literature Review Real Options Regulatory Distortions
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Assumptions/Model q1q1 1 - q 1 go stop
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions q1q1 1 - q 1 stop
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Regulatory Distortions q1q1 1 - q 1 stop revenue constraint
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview/Literature Review Real Options Regulatory Distortions Investment Criterion
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University t=0t=1 S0S0 RS 0 S1S1 A Risk-Neutral Model
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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)
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University S0S0 V K Probability f(V) Call Option
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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)
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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)
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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 22
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Example
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University ƒ PV[Cash out] = PV[K T ] = 110/1.06 = 103.8 ƒ PV[Cash in] = S = E[ PV[S 1 ]] = 100 ƒ NPV = PV[cash in] – PV[cash out] = 100 – 103.8 = - 3.8 Net Present Value
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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)
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University 3.4 ExNPV Expanded NPV 10.2 M - 3.8 M 6.4 M NPV +ROV =ExNPV = Flexibility value to defer = Conventional Value of Project
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University When is ExNPV = 0, when NPV < 0? Methodology
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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
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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
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University : Normal distribution (0,1): f N (v) Solve
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University LHS ( left hand side ) Solve
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University LHS ( left hand side ) Solve
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University D* = 0.2773 Solve
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University ExNPV > 0ExNPV < 0 Criterion
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University ExNPV > 0ExNPV < 0 LHS > 0LHS < 0 Criterion
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Implications for Regulation Impact on "riskiness" Reduces
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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
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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
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Future Research Empirical Estimates Investment ƒ Endogenous ƒ Economic depreciation Ramsey Pricing
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Dr. James Alleman University Colorado CB 422 UBS Boulder, CO 80309-0422 phone: +1 303 443-4465 facsimile: +1 303 492-1112 mobile: +1 917 294-1688 e-mail: James.Alleman@Colorado.edu Dr. Paul Rappoport Temple University Broad Street Philadelphia, PA 19075 phone: +1 215 204 5025 e-mail: prapp4@comcast.net Contact Information
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Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University Agenda Overview Incorrect Foundations
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