1. 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

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

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

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

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

6. 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

7. 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

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

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

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

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

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

13. 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

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

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

16. 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

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

18. 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

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

20. 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

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

22. 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)

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

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

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

33. 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

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

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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

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

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

49. 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)

50. 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

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

52. 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)

53. 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)

54. 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

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

56. 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

57. 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)

58. 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

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

60. 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

61. 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

62. 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

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

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

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

66. Transatlantic Dialogue Broadband Conference James Alleman & Paul Rappoport Colorado University & Temple University D* = 0.2773 Solve

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

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

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

70. 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

71. 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

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

73. 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

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