Profit sharing and Investment by Regulated Utilities: A Welfare Analysis

We analyse the effects of different regulatory schemes (price cap and profit sharing) on the endogenous size of a firm's investment. Using a real option approach in continuous time, we show that profit sharing does not delay a firm's start-up investment compared to a pure price cap scheme. Profit sharing does not necessarily affect total investment either, if the threshold for profit sharing is high enough. Only a profit sharing intervening for low profit levels could delay further investments. We also evaluate the effects of profit sharing on social welfare, determining profit level that should optimally trigger tighter regulation: profit sharing should be less stringent in sectors where there is more opportunity for larger investment.