Investment and apital struture of partially private regulated rms Carlo Cambini y and Yossi Spiegel z January 28, 2015 Abstrat We develop a model that examines the apital struture and investment deisions of regulated rms in a setting that inorporates two key institutional features of the publi utilities setor in many ountries: rms are partially owned by the state and regulators are not neessarily independent. Among other things, we show that regulated rms issue more debt, invest more, and enjoy higher regulated pries when they fae more independent regulators, are more privatized, and when regulators are more pro- rm. Moreover, regulatory independene, higher degree of privatization, and pro- rm regulatory limate are assoiated with higher soial welfare. We thank seminar partiipants at the 2009 EARIE Conferene in Ljubljana, the 2010 International Conferene on Infrastruture Eonomis and Development in Toulouse, the 2011 Industrial Organization: Theory, Empiris and Experiments workshop in Otranto, the 2011 CRESSE Conferene in Rhodes, the 2012 Conferene on the Eonomis of the Publi-Private Partnerships in Barelona, FEEM in Milano, IAE in Paris, LUISS in Rome and University of Melbourne. Yossi Spiegel thanks the Henry Crown Institute of Business Researh in Israel for nanial assistane and Carlo Cambini gratefully aknowledges nanial support from the Italian Ministry of Eduation (No. 20089PYFHY_004). y Politenio di Torino and IEFE-Booni University. Address: Politenio di Torino, DI- GEP, Corso Dua degli Abruzzi, 24, 10129 Torino, Italy. email: arlo.ambinipolito.it. http://works.bepress.om/arlo_ambini/ z Tel Aviv University, CEPR, and ZEW. Address: Reanati Graduate Shool of Business Administration, Tel Aviv University, Ramat Aviv, Tel Aviv, 69978, Israel. email: spiegelpost.tau.a.il, http://www.tau.a.il/~spiegel 1
JEL Classi ation: G32, L33, L51 Keywords: regulation, debt, investment, government ownership, regulatory independene, regulatory limate 2
1 Introdution Sine the early 1990 s, many ountries around the world have substantially reformed their publi utilities setor through large sale privatization and by establishing Independent Regulatory Agenies (IRAs) to regulate the newly privatized utilities. 1 In the EU for example, the strutural reforms were prompted by the European Commission through a series of Diretives, and were intended to enhane ost e ieny and servie quality, open the market to ompetition where tehnologially feasible, and boost investments in infrastruture. 2 The deision whether to privatize state-owned monopolies was left however entirely in the hands of national governments. 3 The implementation of market reforms varies onsiderably aross EU states and aross setors. Reforms are most advaned in the teleommuniations industry, where IRAs were established in virtually all member states and most teleoms have been, at least partially, privatized. Reforms are also advaned in the energy setor, where the majority of eletri and gas utilities are now regulated by IRAs. However, many natural gas utilities, and to a lesser extent eletri utilities, are still ontrolled by the government, espeially in Frane, Germany, Italy and Portugal. Strutural reforms, however, are still lagging behind in water supply and transportation infrastruture (doks and ports, airports and freight motorways): with the exeption of the UK, Frane, Germany, and Italy, most water and transportation utilities are still ontrolled by entral and loal governments and are still subjet to regulation by ministries or other branhes of the government rather than by independent regulatory agenies. While for the most part, the strutural reforms have signi antly improved infrastruture performane (see e.g., Kessides, 2004, p. 9-15), they were also aompanied by a substantial inrease in the nanial leverage of regulated utilities. 4 This trend, oined the dash for debt, is widespread aross ountries and aross setors and has raised substantial onerns among poliy markers. For instane, a joint study of the UK Department of 1 For a omprehensive review of the strutural reforms, see Kessides (2004). 2 For more detail about the strutural reforms in the EU, see Cambini, Rondi, and Spiegel (2012). 3 Indeed, the establishment of IRA typially preedes privatization, see Bortolotti et al. (2011) and Zhang, Parker, Kirkpatrik (2005). 4 See Bortolotti et al. (2011) for evidene on the EU-15 states and Da Silva, Estahe, and Järvelä (2006) for evidene on Latin Ameria and Asia. 3
Trade and Industry (DTI) and the HM Treasury argues that the dash for debt within the UK utilities setor from the mid-late 1990 s ould imply greater risks of nanial distress, transferring risk to onsumers and taxpayers and threatening the future naneability of investment requirements (DTI and HM Treasury, 2004, p. 6). Likewise, the Italian energy regulatory ageny, AEEG, has reently expressed its onern that exessive nanial leverage ould lead to nanial distresses whih in turn ould ause servie interruptions (AEEG 2008, paragraph 22.13). The AEEG has also announed its intention to start monitoring the nanial leverage of Italian energy utilities in order to disourage speulative behavior that might jeopardize their nanial stability (see AEEG, 2007, paragraph 17.40 and AEEG, 2009, paragraph 11.8). To put the onerns about the dash for debt phenomenon in perspetive, it is worth noting that regulated network industries aount for around 7:5% of the EU-15 s total value added, and 5:4% of the total workfore in the EU-25 states.(european Commission, 2007). 5 Moreover, the investment levels in these industries aount for a signi ant fration of GDP: for example, Table 1 in the Appendix shows that in the EU-15 states, the average rate of gross xed apital formation in the energy setor (eletriity and gas), teleommuniations, water supply, and transportation, ranges between 14:6% and 15:9% of GDP in the period 2005-2009. 6 Given the sheer size of investments at stake, their high market value, and the overall importane of the publi utilities setor (teleommuniations, energy, transportation, and water) for the eonomy and onsumers at large, it is learly important to understand the determinants of the investments and nanial deisions of regulated rms and study how these deisions a et soial welfare. Earlier literature on this topi (e.g., Taggart 1981 and 1985; Dasgupta and Nanda, 1993; Spiegel and Spulber, 1994 and 1997; and Spiegel, 1994 and 1996) has shown that regulated rms may have an inentive to strategially issue debt to indue regulators to set a relatively high prie in order to minimize the risk that the rm will beome nanially distressed. 7 This literature however impliitly assumed that the regulated rm is privately 5 Moreover, of the 30 ompanies with the largest market apitalization in the European Industrial Setor, 10 are teleoms or energy utilities (Bortolotti, Cambini and Rondi, 2013). 6 The table is based on OECD data. Currently, 2009 is the most reent year for whih the data is available. 7 Jamison, Mandy, and Sappington (2014) show that regulators an prevent rms from issuing exessive 4
owned and regulators are independent. 8 While these assumptions re et the institutional setting in the U.S. and more reently in the UK, in many other ountries around the world, inluding the EU, Latin Ameria, and Asia, entral or loal governments still hold signi ant ownership stakes (often ontrolling stakes) in many publi utilities (see e.g., Bortolotti and Faio, 2008; Boubakri and Cosset, 1998; and Boubakri, Cosset, and Guedhami, 2004), and IRAs do not exist in all setors. 9 Indeed, the large sale privatization proess that started in the 1990 s seems to have led to a new form of state apitalism, whereby governments hoose to remain partial owners of large rms (The Eonomist, 2012). 10 The purpose of this paper is to develop a tratable model that will allow us to study how (partial) state ownership and regulatory independene a et the apital struture and investments of the regulated rm, regulated pries, and welfare. To this end, we onsider the strategi interation between the managers of a regulated rm, who need to deide how muh to invest and how to nane this investment, and a regulator, who needs to set the regulated prie. A main assumption in our model is that the rm s ost is subjet to random shoks (e.g., an unexpeted surge of energy pries, or extra osts due to natural disasters). Hene, when the rm is leveraged, a su iently negative ost shok may result in a ostly debt if they an impose substantial penalties if the rm beomes nanially distressed. 8 Moreover, with the exeption of Spiegel (1994), this literature has only onsidered the interation between apital struture and regulated pries, holding the rm s investment level onstant. 9 For instane, fully or partially state-owned enterprises in the OECD area are valued at over 2 trillion USD and employ over 6 million people. About 50% of these rms by value and over 60% by employment operate in network industries, inluding teleommuniations, eletriity and gas, transportation, and postal servies (OECD, 2014, p. 10-11). And, as we mentioned above, in the EU, IRAs were established and are fully operational only in the teleommuniations and energy setors, but in other setors, like transportation and water, most utilities are still regulated diretly by ministries, governmental ommittees, or loal governments. 10 Aording to the Eonomist, the share of national/state-ontrolled ompanies in the MSCI emergingmarket index is over 65% in energy, and around 55% in utilities and 35% in teleommuniation servies. This phenomenon is also widespread in Europe. For example, as of the end of 2013, Frane Teleom-Orange is 23:2% held by the Frenh Government, Deutshe Telekom is 31:9% held by the German Government, TeliaSonera is 37% held by the Swedish Government and 13:2% by the Finnish Government, and Telekom Austria is 28% held by the Austrian Government. Likewise, in the energy setor, the Frenh Government holds a 84:5% stake in EDF, the Italian Government holds a 32% stake in Enel and 30% stake in Eni, and the Austrian Government holds a 70% stake in Verbund. 5
nanial distress. The regulator therefore faes a trade o between setting a low prie, whih bene ts onsumers, and a high prie, whih minimizes the probability of nanial distress. There is no general agreement in the literature on how to model the objetive of the management of a partially state-owned rm. We follow two main strands in the literature. Aording to the managerially-oriented publi enterprise (MPE) approah, due to Sappington and Sidak (2003, 2004), the managers of partially state-owned rms are onerned not only with pro t, but also with revenue, and the weight assigned to revenue inreases with the state s stake in the rm. As a result, the rm s managers e etively disount the rm s ost, and more so when the state s stake in the rm is large. 11 Aording to the soft budget onstraint (SBC) approah introdued by Kornai (1986), partially state-owned rms are more likely to be bailed out by the state in ase of nanial distress, espeially when the state s stake in the rm is large. Hene, under both approahes, the ost of nanial distress from the rm s perspetive is dereasing with the state s stake in the rm. Sine the regulator sets a regulated prie that takes the rm s objetive into aount, he sets a higher prie when the rm is more privatized and internalizes a larger fration of its ost. A higher regulated prie, in turn, allows the rm to issue more debt and indues it to inrease its investment. To model regulatory independene, we follow the literature on entral bank independene (see e.g., Cukierman, 1992) and assume that more independent regulators are more ommitted to the regulatory rule used to determine the regulated prie, while less independent regulators are more likely to behave opportunistially and deviate from their preannouned regulatory rule. Consequently, more regulatory independene leads to a higher regulated prie and hene indues the rm to inrease its debt and to invest more. Altogether then, our model implies that regulated rms that fae more independent regulators and are more privatized will be more leveraged, will invest more, and will enjoy higher regulated pries. In addition, our results show that higher degrees of regulatory independene and privatization, as well as more pro- rm regulatory limate (the regulator 11 If managers maximize a weighted average of revenue and pro t, then they maximize the expression R + (1 ) (R C), where R is revenue, C is ost, and is the state s stake in the rm. This expression is equivalent to R (1 ) C, so the managers disount the rm s ost more when the rm is less privatized (i.e., is high). 6
assigns more weight to the rm s payo in setting the regulated prie), are all welfare enhaning. These results suggest that the dash for debt phenomenon mentioned above is a natural outome of the privatization proess and the establishment of IRAs, and moreover, may be assoiated with higher soial welfare. The rest of the paper is organized as follows. Setion 2 presents the model. Setion 3 haraterizes the equilibrium regulated prie for given ombinations of debt and investment. In Setions 4 and 5, we solve for the equilibrium hoie of apital struture and investment and study how these hoies are a eted by the main exogenous parameters of the model, namely the degree of regulatory independene, the extent of privatization (i.e., the state s stake in the regulated rm), and the regulatory limate. In Setion 5, we onsider the rm s investment deision and study how it is a eted by the main exogenous parameters of the model. In Setion 6, we examine the impliations of our model for soial welfare. Conluding remarks are in Setion 7. All proofs are in the Appendix. 2 The model Consider a regulated rm, whih is partially owned by the state (at the national or the loal level). For simpliity (but without a serious loss of insights), we assume that the rm faes a unit demand funtion. The willingness of onsumers to pay depends on the rm s investment, k, and is given by a twie di erentiable, inreasing, and onave funtion V (k). That is, k an be interpreted as investment in the quality of the rm s servies. Using p to denote the regulated prie, onsumers surplus is given by V (k) p. 2.1 The apital struture of the rm and its expeted ost The rm s ost of prodution is subjet to random ost shoks and is given by a random variable,, distributed uniformly over the interval [0; ], where < V (0). The random ost shok ould represent an unexpeted surge of energy pries, 12 or extra osts due to natural 12 For example, the sharp inrease in eletriity wholesale pries in California from April 2000 to Deember 2000 due to drought, delays in approval of new power plants, and market manipulation, eventually fored Pai Gas and Eletri Company into bankrupty and fored Southern California Edison into near bankrupty. 7
disasters like earthquakes, oods, and tsunamis, or terrorism and wars. 13 Sine osts are random, the rm may be unable to pay its debt in full when is high. Using D to denote the fae value of the rm s debt, the rm an fully pay its debt only if D p. If D > p, the rm inurs a xed ost T due to nanial distress. 14 Hene, the total expeted ost of the rm is C + (p; D) T; 2 where (p; D) is the probability of nanial distress given by 8 0 D + p; >< (p; D) p D 1 D p < + D; >: 1 p < D: (1) Intuitively, when D + p, the rm an always pay D in full so (p; D) 0. On the other hand, when p < D, the rm annot pay D in full even when 0, so (p; D) 1. For intermediate ases, (p; D) 1 p D. Obviously, (p; D) is (weakly) inreasing with D and (weakly) dereasing with p: the rm is more likely to beome nanially distressed when its debt is high and the regulated prie is low. Likewise, an expeted surge in energy pries an hurt transportation ompanies: for instane, following the Italian government s deision to raised the prie of eletriity paid by railways in July 2014, the ost per km has unexpetedly inreased by 10%.and raised the ost of the inumbent Trenitalia by 120 million Euros and the ost of the new entrant NTV by 20 million Euros. NTV laims that the ost inrease fores it to re 30% of its employees (see e.g., http://www.repubblia.it/eonomia/2014/09/02/news/ntv_a_rishio-94850698/) 13 For instane, Tokyo Eletri Power Co. s sustained a 1.25 trillion yen ($15 billion) loss due to the Fukushima nulear risis (see e.g., http://www.bloomberg.om/news/2011-05-20/tepo-presidentresigns-after-utility-reports-reord-15-billion-loss.html) while the Thai teleommuniations setor sustained losses and damages of almost 3.85 billion Bhat following the 2012 oods in Thailand (see e.g., https://www.itu.int/itu-d/asp/cms/events/2012/emergenyworkshop/nokeo_ratanavong.pdf 14 Finanial distress does not neessarily mean formal bankrupty: it ould refer to any nanial problem that the rm may fae when it annot pay its debt in full and needs to reorganize it. For instane, nanial distress may make it harder for the rm to deal with ustomers and suppliers and raise apital for investment, and it also diverts managerial attention away from normal operations. 8
2.2 The regulated rm s objetive Let denote the state s stake in the rm s equity. As mentioned in the Introdution, there is no generally agreed upon way to model the e et of on the objetive of the rm s management. Our modeling approah follows two main strands in the literature: the manageriallyoriented publi enterprise (MPE) approah, due to Sappington and Sidak (2003, 2004), and the soft-budget onstraint (SBC) approah introdued by Kornai (1986). Aording to the MPE approah, the managers of the (partially) state-owned rm are onerned not only with pro t, R C, where R is revenue and C is ost, but also with revenue, R, and their objetive funtion, after investment is already sunk, is given by 15 R + (1 ) (R C). This objetive funtion re ets the idea that the managers of state-owned enterprises often have onsiderable interest in expanding the sale or sope of their ativities and expand the rm s budget for politial reasons. 16 about the extra ost it inurs when expanding its output. This implies that a state-owned rm is less onerned The greater the rm s fous on revenues rather than pro ts, the more the rm disounts its osts. Alternatively, the managers of partially state-owned rms are less exposed to the disiplining fores of the apital market and to takeover threats, and hene may nd it easier to expand the rm s budget in order to pursue their own private agenda. 17 Another possibility is that state-owned rms, whih are shielded from ompetitive pressures, are more prone to X-ine ienies, so their managers e etively disount, to some extent, the rm s ost. 18 At any rate, noting 15 For related papers whih model the e et of state ownership by modifying the rm s objetive funtion, see for example, Bös and Peters (1988), De Fraja and Delbono (1989), Fershtman (1990), Cremer, Marhand and Thisse (1989, 1991), and Lee and Hwang (2003). 16 For example, teleoms, Cable TV operators, and postal servies in the U.S. and in Europe are required to the provide a universal servie even in areas where the ost of servie exeeds the assoiated revenue. Likewise, state-owned rms may expand their labor fore to avoid an inrease in unemployment. 17 The MPE approah then is in the spirit of the managerial disretion hypothesis, due to Baumol (1959) and Williamson (1964), whih states that managers may pursue goals other than pro t maximization (see Marris and Mueller, 1980, for a survey). The MPE approah essentially says that in state-owned rms managers have even more disretion than in private rms. 18 Indeed, a series of empirial papers, summarized in Meggison and Netter (2001), shows that state-owned 9
that C + (p; D) T and realling that sine we have a unit demand funtion, R p, the 2 ex post payo of the rm s managers under the MPE approah an be written as R + (1 ) (R C) R (1 ) C p (1 ) 2 (1 ) (p; D) T: (2) As for the SBC approah, some authors (e.g., Shmidt, 1996; Maskin and Xu, 2001; and Kornai, Maskin, and Roland 2003) argue that publi ownership is a major ause of SBC. Aording to this view, state-owned rms are more likely to be bailed-out by the state in ase they beome nanially distressed. Using b to denote the probability of a bailout, and assuming for simpliity that the rm does not bear any ost of distress if it is bailed out (this assumption an be easily relaxed so long as the ost of distress is smaller under a bailout), the ex post payo of the rm s managers under the SBC approah is given by R 2 (1 b) (p; D) T p 2 (1 b) (p; D) T: (3) There is evidene that suggests that the probability of a bailout, b, inreases with the state s stake in the rm. For instane, Glowika (2006) nds that distressed publi rms are more likely to reeive long-term government assistane ( restruturing aid ), while distressed private rms are more likely to reeive only short-term resue aid, whih is intended to keep them in operation until a restruturing plan is in plae. Borisova et al. (2011) examine stok purhases in publily traded ompanies by governments or state-owned investors and nd strong support for the notion that debtholders view government ownership as an impliit assurane of repayment and protetion against bankrupty. Similarly, Borisova and Megginson (2011) examine orporate bonds of fully and partially privatized rms and show that on average, a one-perentage-point inrease in government ownership is assoiated with a derease in the redit spread of roughly three-quarters of a basis point. If we take b to be linear in, the payo of the rm s managers under the SBC approah oinides with their payo under the MPE approah, exept for the oe ient of, whih is 2 equal to 1 under the MPE approah, and is equal to 1 under the SBC approah. Hene, rms are generally less e ient than private ones, and that following privatization, rms beome more e ient, partiularly in the presene of substantial industry ompetition and independent regulators. See also Armstrong and Sappington (2006; p. 337). 10
we an apture both approahes with the following (ex post) payo funtion: p 2 (1 ) (p; D) T; (4) where 1 under the MPE approah and 1 under the SBC approah. Importantly, under both approahes, the managers of a partially state-owned regulated rm e etively behave as if they ignore a fration of the rm s expeted ost of nanial distress. Ex ante, before k is sunk, the managers objetive is given by the same expression minus k. 2.3 The rate setting proess, regulatory independene, and regulatory limate Following Besanko and Spulber (1992), Dasgupta and Nanda (1993), and Spiegel and Spulber (1997), we assume that the regulator sets the regulated prie, p, to maximize a welfare funtion de ned over onsumers surplus, V (k) p, and the rm s objetive funtion: (V (k) p) (p 2 (1 ) (p; D) T k) 1 : (5) The parameter 2 (0; 1) aptures the regulatory limate: the higher, the more proonsumer the regulator is. The resulting regulated prie alloates the expeted surplus aording to the asymmetri Nash bargaining solution for the regulatory proess. Under this interpretation, the parameters and 1 re et the bargaining powers of onsumers and the rm. Our approah is therefore onsistent with models that view the regulatory proess as a bargaining problem between onsumers and investors (Spulber, 1988 and 1989). Alternatively, (5) ould represent a redued form for the regulator s own payo from being involved in some politial eonomy game. Under both interpretations, the regulated prie is set to balane the interests of onsumers and rms, whih is onsistent with how regulated 11
pries are set in pratie. 19;20 It is often argued that a greater degree of regulatory independene improves the regulators ability to make long-term ommitments to regulatory poliies (see e.g., Levy and Spiller, 1994, Gilardi 2002 and 2005, Edwards and Waverman, 2006). 21 The reason is that independent regulators are more insulated from short-run politial pressures, whih may indue the government to deviate from past promises, espeially when a new government is eleted (Spiller, 2004, Hanretty, Larouhe, and Reindl, 2012). 22 Gilardi and Maggetti (2011) argue that regulatory independene has both formal determinants suh as the length of the term of o e, whether o ials an be dismissed, whether their appointment is renewable, whether independene is formally stated, the onditions under whih deisions an be over- 19 For example, aording to the U.S. Supreme Court, prie regulation involves a balaning of the investor s and the onsumers interests that should result in rates within a range of reasonableness (see Federal Power Comm. v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944)). Similarly, the water and sewerage regulatory ageny in England and Wales states that...it is our role to protet the interests of onsumers while enabling e ient ompanies to arry out and nane their funtions. This is a deliate balaning at. On the one hand, we must be sure that ustomers ontinue to reeive the servies that they expet at a prie they are willing to pay now and over the long term. On the other, we must ensure that the ompanies have su ient resoures to deliver servies e iently and remain attrative to investors... (see Ofwat, 2010, p. 3). 20 In priniple, the regulator might also give the rm a subsidy S if this is legally possible (in the EU for example, subsidies are generally prohibited by Artile 107(1) of the EU Treaty on the Funtioning of the European Union, with exeptions only in very speial irumstanes). The subsidy however would lower onsumer surplus by S and would raise the rm s pro t by S and hene (5) would now depend on p + S, meaning that setting S 0 entails no loss of generality. In fat, if raising publi funds is ostly, then subsidies would lower onsumer surplus by (1 + ) S, where > 0 is the shadow ost of publi funds. In this ase, the regulator is better o setting S 0 and relying only on the regulated prie to ompensate the rm. 21 Guash, La ont, and Straub (2008) provide empirial support for this argument by showing that the presene of an IRA lowered the probability of renegotiation of ontrats for the provision of utilities servies by 5% 7:3%. This e et is signi ant given that the average probability of renegotiation of any individual ontrat at any point in time is around 1%. The better ability of IRAs to make long-term ommitments suggests that IRAs are less opportunisti than non-independent regulators. 22 Of ourse, it is also possible that even independent regulators may be aptured by rms (see e.g., Stigler, 1971) and may fail to mazimize soial welfare. However, it is plausible that regulatory apture is an even bigger problem when the regulator is part of the government. In any event, our model abstrats from the possibility of regulatory apture. 12
turned, and the nanial and organizational independene of the ageny, as well as informal determinants suh as the frequeny of revolving doors, politial in uene on budget and on internal organization, and partisanship of nominations. In line with this argument, we follow the literature on entral bank independene (see e.g., Cukierman, 1992), and assume that the regulator is ommitted to the regulatory rule given by (5) only with probability. With probability 1, the regulator happens to be opportunisti, and after k is sunk, he sets a lower regulated prie. The parameter 2 (0; 1) then re ets the regulator s ability to make long-term ommitments to the regulatory rule and therefore serves as our measure of regulatory independene, with higher values of indiating a greater degree of independene. 23 Spei ally, we will assume that while a ommitted regulator always sets the prie p to maximize (5), an opportunisti regulator takes advantage of the fat that p is set after k is already sunk, and hene sets p to maximize an ex post objetive funtion that ignores k: (V (k) p) (p 2 (1 ) (p; D) T ) 1 : (6) Again, the probability that the regulator is ommitted is while the probability that the regulator is opportunisti is 1. 24 In a tehnial Appendix, we show that the main results of the paper remain virtually the same if we adopt an alternative approah and assume that an opportunisti regulator uses a more pro-onsumer rule when setting p (i.e., uses a higher for setting p) rather than ignore k when setting the regulated prie. 25 Although the parameters,, and might be orrelated (e.g., a more pro- rm regulator may be more ommitted or a larger stake in the rm may indue the state to lean on the regulator to pursue more pro- rm poliies), a-priori we will not impose any restritions on their relative sizes. 23 A ommon way to model the degree of entral bank independene is to assume that the publi assigns a larger probability to the event that the entral banker is ommitted to his preannouned level of in ation. By ontrast, an opportunisti entral banker hooses ex post an atual level of in ation whih may di er from the one that he has announed. See Cukierman (1992). 24 It is plausible that in developed ountries regulatory agenies would be more independent and would therefore have higher values of than agenies in developing ountries. 25 For details, see http://www.tau.a.il/~spiegel/papers/cs-appendix-july-4-2012-gamma.pdf 13
2.4 The sequene of events The strategi interation between the rm s managers and the regulator evolves in two stages. In stage 1, the rm s managers hoose k and issues debt with fae value D in a ompetitive apital market. 26 If the funds raised by issuing D exeed k, the rm pays the exess funds as a dividend. If the funds raised by issuing D fall short of k, the rm raises additional funds by issuing equity; to simplify matters, we assume that in this ase the state partiipates in the equity issue to maintain its original stake. 27 In stage 2, given k and D, the regulator sets the regulated prie p. As mentioned earlier, the regulator is ommitted to set p in order to maximize (5) with probability, but with probability 1, the regulator happens to be opportunisti and sets p to maximize (6). 28 Finally, the rm s ost is realized, output is produed, and payo s are realized. Our sequene of events (the rm makes its hoies before the regulated prie is set) is onsistent with Bortolotti et al. (2011) and Cambini and Rondi (2012) whih nd that leverage Granger auses regulated pries, but not vie versa. 3 The regulated prie In stage 2 of the game, the regulator sets p to maximize the ex ante objetive funtion (5) with probability and the ex post objetive funtion (6) with probability 1. Sine the two funtions di er only with respet to k, we an rewrite the regulator s objetive funtion 26 Our approah di ers from De Fraja and Stones (2004) and Stones (2007) where the regulator, rather than the rm, hooses the apital struture of the rm. These papers also assume that the regulator must set p to ensure that the rm never goes bankrupt and shareholders earn their required rate of return. Our approah also di ers from Lewis and Sappington (1995) who study the optimal design of apital struture in a model that involves a risk-averse regulator (a prinipal) and a risk-neutral regulated rm (an agent) under alternative assumptions regarding the prinipal s ability to ontrol the agent s apital struture. 27 Without this assumption, there is another link between investments, apital struture, and ownership struture. Taking this link into aount requires a theory of publi ownership whih endogenizes the state s stake in the rm. Suh a theory is beyond the sope of the urrent paper. 28 More formally, one an think about the game as having three stages: Nature hooses the regulator s type (ommitted or opportunisti) in stage 1, the rm s managers hooses k and D in stage 2 without observing nature s hoie, and in stage 3, the regulator sets p given his type. 14
ompatly as (V (k) p) (p 2 (1 ) (p; D) T Ik) 1 ; (7) where I is an indiator funtion whih equals 1 with probability (the regulator keeps his ommitment to the regulatory rule) and equals 0 with probability 1 (the regulator behaves opportunistially and ignores k when setting p). It should be noted that at the extreme when 1, the regulator ares only about onsumers and hene sets a ost-based prie that simply overs the rm s expeted osts. At the opposite extreme when 0, the regulator ares only about the rm and sets p V (k); this prie is independent of the rm s ost. In general then, the regulated prie is more responsive to ost as dereases. Using (7), we an now solve the problems of both ommitted and opportunisti regulators by simply maximizing (7) with respet to p. Using the same steps as in Spiegel (1994), the solution to the maximization problem is given by 8 D 1 (k; I) + D D 1 (k; I) ; >< D + D p 1 (k; I) < D D 2 (k; I) ; (D; k; I) D 1 (k; I) + + M (D; I) D 2 (k; I) < D D 3 (k; I) ; >: D 1 (k; I) + + (1 ) T D > D 3 (k; I); where D 1 (k; I) (1 ) V (k) + + Ik; (9) 2 M(D; I) (1 ) T D + (2 ) Ik 2 ; (10) 1 + (1 ) T D 2 (k; I) (1 ) 1 + (1 ) T V (k) + + Ik 2 ; (11) 1 + (1 )(1 ) T and D 3 (k; I) is smaller than the value of D for whih D 1 (k; I) + + M (D; I) D. This solution is obtained under the assumption that < V (0) (the regulator is not too proonsumer). If this assumption is violated, then D 1 (k; 0) 0, though none of our results V (0) 2 is a eted. The regulated prie is illustrated in the following gure: (8) 15
Figure 1: Illustrating the regulated prie as a funtion of D for I 0 (the solid red line) and I 1 (the dashed blue line), holding k xed To interpret Figure 1, note that if we ignore nanial distress, i.e., assume that (p; D) 0, then the prie that maximizes (7) is given by D 1 (k; I) +. So long as D D 1 (k; I), this prie overs the rm s ost plus its debt obligation even in the worst state of nature. 29 Hene, indeed (p; D) 0 for all D D 1 (k; I). However, one D > D 1 (k; I), a prie of D 1 (k; I) + leaves the rm suseptible to nanial distress. So long as D does not exeed D 1 (k; I) by too muh, the regulator nds it optimal to set p D + to keep (p; D) 0. However, when D > D 2 (k; I), this strategy is no longer optimal for the regulator beause the resulting marginal loss in onsumers surplus beomes too large relative to the bene t of preventing nanial distress. The regulator now allows the rm to harge a prie premium, given by M(D; I), to lower the probability of nanial distress. Although the prie premium M(D; I) is inreasing with D, its slope is less than 1; hene p is now smaller than D +, and as a result, (p; D) > 0. When D > D 3 (k; I), it is no longer optimal for the regulator to o set the e et of debt on the likelihood of nanial distress. Consequently, (p; D) 1, so p is now onstant and equals D 1 (k; I) + + (1 )T. 29 As mentioned above, if is relatively large, then D 1 (k; I) 0 and the regulator annot ignore the possibility of nanial distress, no matter how small D is. 16
It is easy to see from equations (9) and (11) that D 1 (k; 1) > D 1 (k; 0) and D 2 (k; 1) > D 2 (k; 0), and moreover, it is easy to hek from (8) that p (D; k; 1) p (D; k; 0): a ommitted regulator (who takes k into aount) sets a weakly higher prie than an opportunisti regulator (who ignores k). To limit the number of di erent ases that an arise, we make the following assumption: Assumption 1: D 1 (k; 1) < D 2 (k; 0). Assumption 1 ensures that the parameters of the model are suh that there exists an interval of D for whih p (D; k; 1) p (D; k; 0). 30 A su ient ondition for Assumption 1 to hold is that the soial surplus absent nanial distress is su iently large: V (k) 2 k > k (1 ) (1 ) T : Assumption 1, together with the fat that D 2 (k; 0) < D 2 (k; 1), implies that, as Figure 1 shows, D 1 (k; 0) < D 1 (k; 1) < D 2 (k; 0) < D 2 (k; 1): 4 The hoie of apital struture Assuming that the apital market is perfetly ompetitive, the market value of new equity and debt is exatly equal in equilibrium to their expeted return. Hene, outside investors (debtholders and possibly new equityholders if the rm also issues new equity) must break even. This implies in turn that the entire expeted pro t of the rm, p C, net of the sunk ost of investment, k, must arue to the original equityholders. To write down the rm s objetive funtion, let (D; k; I) (p (D; k; I); D) be the probability of nanial distress, whih is obtained by substituting p (D; k; I) into equation (1). Now, reall that with probability, the regulator is ommitted to take k into aount, in whih ase the regulated prie is p (D; k; 1) and the probability of nanial distress is (D; k; 1). With probability 1, the regulator is opportunisti, so the regulated prie and 30 Absent Assumption 1, p (D; k; 1) > p (D; k; 0) for all D, although none of our main results is a eted. 17
probability of nanial distress are p (D; k; 0) and (D; k; 0). Using these expressions and equation (4), the expeted payo of the rm s managers is given by Y (D; k) p (D; k; 1) (1 ) (D; k; 1) T k 2 + (1 ) p (D; k; 0) (1 ) (D; k; 0) T k : (12) 2 The rm s managers hoose the rm s debt level, D, and investment, k, to maximize Y (D; k). The following proposition haraterizes the equilibrium hoie of debt. The proof, as well as all other proofs, is in the Appendix. Proposition 1: In equilibrium, the regulated rm will issue debt with fae value D 2 (k; 0) if <, and will issue debt with fae value D 2 (k; 1) if >, where (1 ) (1 ) T : (13) 1 + (1 ) (1 ) T Proposition 1 shows that the rm s apital struture depends on, whih re ets the degree of regulatory independene. In what follows, we will say that the regulator is independent if > (the regulator s ability to ommit to take k into aount is relatively high) and non independent if < (the regulator s ability to ommit is relatively low). Proposition 1 shows that the rm issues more debt when it faes an independent regulator. Note from (13) that the threshold above whih we onsider the regulator as independent is dereasing with both and : other things equal, a more pro-onsumer regulator (a higher ) who faes a less privatized rm (a higher ) is onsidered independent for a larger range of values of. We now establish two orollaries to Proposition 1. Corollary 1: When the regulator is non independent ( < ), the regulated prie is equal to D 2 (k; 0) + with probability 1. When the regulator is independent ( > ), the regulated prie is equal to D 2 (k; 1) + with probability and D 1 (k; 0) + + M (D 2 (k; 1); 0) with probability 1, where D 2 (k; 1) + > D 1 (k; 0) + + M (D 2 (k; 1); 0). The expeted regulated prie when > is therefore Ep (k) D 2 (k; 1) + (1 ) (D 1 (k; 0) + M (D 2 (k; 1) ; 0)) + : (14) 18
Corollary 1 shows that the regulated prie is fully antiipated when the regulator is non-independent ( < ), but not when the regulator is independent. This result may seem surprising beause an independent regulator has a greater ability to ommit to the regulatory rule and determine the regulated prie. However, preisely for this reason, the regulated rm is able to issue in this ase debt with a larger fae value. This debt level in turn indues an opportunisti regulator to at di erently than a ommitted regulator. The next orollary deals with nanial distress. When the regulator is non independent ( < ), the rm issues debt with fae value D 2 (k; 0). Sine by Corollary 1, the resulting regulated prie is D 2 (k; 0)+, the rm is immune to nanial distress even when the highest ost shok is realized. When the regulator is independent ( > ), the rm s debt is D 2 (k; 1). With probability, the resulting regulated prie is D 2 (k; 1) +, whih ensures one again that the rm never beomes nanially distressed. But with probability 1, the regulated prie is D 1 (k; 0) + + M (D 2 (k; 1); 0); sine this prie is below D 2 (k; 1) +, the rm now beomes nanially distressed when the ost shok is su iently large. Corollary 2: When the regulator is non independent ( < ), the rm is ompletely immune to nanial distress. When the regulator is independent ( > ), the rm is immune to nanial distress with probability (the regulator is ommitted); with probability 1 (the regulator is opportunisti), the rm beomes nanially distressed when is su iently high. Corollary 2 shows another impliation of Proposition 1: the regulated rm may beome nanially distressed only when the regulator is independent. As before, the reason is that in this ase, the rm allows itself to issue debt with a higher fae value. With probability 1, the regulator happens to be opportunisti, and sets a regulated prie that leaves the rm suseptible to nanial distress with a positive probability. With Proposition 1 in plae, we an now examine how the equilibrium debt level is a eted by the main exogenous parameters of the model, holding the rm s investment level, k, xed. Proposition 1 already shows that the rm will issue more debt under independent ( > ) than under non independent ( < ). In the next proposition, we examine how debt is a eted by the other two main exogenous parameters: the state s stake in the regulated 19
rm,, and the measure of regulatory limate (i.e., how pro-onsumer the regulator is),. Proposition 2: Holding k xed, the debt level of the regulated rm is higher the lower and are. Combined, Propositions 1 and 2 imply that if we onsider a ross setion of regulated rms that di er in terms of the degree to whih they are privatized (the value of ) and in terms of the regulatory environment they operate in (the values of and ), then other things equal, rms should be more leveraged when they are more privatized ( is lower) and when they fae more independent and more pro- rm regulators ( is higher and is lower). These preditions are by and large onsistent with Bortolotti et al. (2011) who study a omprehensive panel data of 92 publily traded EU utilities over the period 1994 2005 and nd that rms tend to be more leveraged if they are privately ontrolled (i.e., the state s stake in the rm is below 50% or below 30%) and regulated by an IRA. Moreover, using the same data set reveals that the market leverage of the 26 utilities that were privatized during the sample period inreased by 14:6 perentage points on average after privatization (market leverage is de ned as the book value of debt divided by the sum of the book value of debt and the market value of equity). 31 Although these results were established without ontrolling for investments, Proposition 7 below shows that Propositions 1 and 2 generalize to the ase where k is determined endogenously. 32 Intuitively, equation (4) shows that the rm disounts a larger fration of the ost of nanial distress when is higher either beause the managers of (partially) state-owned rms are less about osts or due to the soft budget onstraint. By impliation then, rms with a lower fae a higher ost of nanial distress, so the regulator, who takes into aount 31 A number of papers, inluding Meggison, Nash and Randenborgh (1994), D Souza and Meggison (1999), and Dewenter and Malatesta (2001) found the opposite result. These papers, however, examine privatized rms from all setors, not just regulated rms. Bortolotti et al. (2002) examine a sample of privatized regulated teleoms and nd that for the most part, privatization does not have a signi ant e et on leverage. 32 Bortolotti et al. (2011) do not have a diret measure of the regulatory limate and hene annot study the e et of the regulatory limate on leverage and on pries. Their analysis shows however that rms have a lower leverage when the government is more right-wing. Cambini and Rondi (2012) nd a similar result in a study that examines 15 EU Publi Telommuniation Operators (PTOs) over the period 1994-2005. To the extent that right-wing governments are more pro- rm, this nding is inonsistent with Proposition 2. 20
the ost of distress, sets a higher regulated prie, p. In equilibrium, the rm issues the largest D whih still ensures that if the regulator is ommitted, the rm will be ompletely immune to nanial distress. Consequently, more privatized rms with lower, enjoy a higher p, and are therefore able to issue a higher D in equilibrium. The reason why D is higher when is low is more subtle sine now there are two opposing e ets. On the one hand, other things being equal, p (D; k; I) is higher when is low (the regulator is more pro- rm), so the rm has an inentive to raise D. But on the other hand, a derease in makes p (D; k; I) less responsive to ost and hene D has a weaker e et on p (D; k; I). It turns out that the rst e et is always stronger, so a derease in indues the rm to raise D. Finally, sine other things being equal, p (D; k; I) is higher when the regulator is independent, the rm will also issue a higher D when it faes an independent regulator. Next, we examine how the regulated prie is a eted by and. As in the ase of Proposition 2, for now we hold k xed. In Setion 5, we will show that our omparative statis results ontinue to hold even when k is determined endogenously. Proposition 3: Holding k xed, the expeted regulated prie is higher when the regulator is independent ( > ) than it is when the regulator is non independent ( < ). Moreover, the expeted regulated prie is dereasing with both the state s ownership stake, and with the measure of regulatory limate. The result that the regulated prie is dereasing with the state s ownership stake is onsistent with Kwoka (2002) who shows that after ontrolling for ost di erenes, the pries of publily-owned eletri utilities in the U.S. are 4:4% heaper, on average, than the pries of investor-owned utilities. Moreover, together with Proposition 2, Proposition 3 implies that if we hold k xed, then any hange in the parameters, and shifts p and D in the same diretion. This implies in turn that in a sample of regulated rms that di er from eah other only in terms of, and, the rm s debt and regulated prie should be positively orrelated. This nding is onsistent with Bortolotti et al. (2011) and with Cambini and Rondi (2012). The latter paper shows that the leverage of Publi Teleommuniation Operators (PTOs) has a positive e et not only on regulated retail rates, but also on the wholesale aess fees 21
that PTOs harge alternative operators who wish to aess the PTOs networks. Finally, reall from Corollary 2 that the rm never beomes distressed if <. When >, the rm beomes distressed only when the regulator is opportunisti and sets a prie p (D 2 (k; 1); k; 0) D 1 (k; 0) + + M (D 2 (k; 1); 0). Sine the probability of this event is 1, the overall probability of nanial distress when > is (1 ) I (k), where, using equation (1), I (k) p (D 2 (k; 1); k; 0) D 2 (k; 1) 1 {z } (D 2 (k;1);k;0) D 2(k; 1) D 1 (k; 0) M (D 2 (k; 1); 0) k : 1 + (1 ) T (15) The following result is an immediate onsequene of equation (15): Proposition 4: Holding k xed, the probability of nanial distress when an independent regulator happens to be opportunisti, I (k), is inreasing with,, and k and is independent of. Under a non-independent regulator, the rm never beomes nanially distressed. At a rst glane, Proposition 4 seems ounterintuitive sine Proposition 2 implies that the rm issues less debt, D, when and are higher. Hene it might be thought that the rm would be less suseptible to nanial distress. Yet, Proposition 3 shows that when and are higher, the regulated prie, p, is also lower. It turns out that the derease in p has a stronger e et on the probability of nanial distress than the derease in D, so overall, nanial distress beomes more likely. 5 The equilibrium level of investment Having haraterized the equilibrium hoie of debt, we next turn to the hoie of investment. Consider rst the ase where <, and reall from Corollaries 1 and 2 that in this ase, D D 2 (k; 0). The regulator in turn sets a prie D 2 (k; 0) +, whih ensures that the rm is ompletely immune to nanial distress. By equation (12) then, the expeted payo of the 22
rm is Y NI (k) Y (D 2 (k; 0) ; k) D 2 (k; 0) + (2 ) 2 k: (16) When >, the rm issues debt with fae value D 2 (k; 1). Now, with probability, the regulator is ommitted and sets a regulated prie p (D 2 (k; 1); k; 1) D 2 (k; 1) +, whih ensures that the rm never beomes nanially distressed. With probability 1, the regulator is opportunisti and sets a prie p (D 2 (k; 1); k; 0) D 1 (k; 0) + + M (D 2 (k; 1); 0); with this prie, the rm beomes nanially distressed with probability I (k). Substituting these expressions in equation (12), using the de nition of M (D 2 (k; 1); 0), and rearranging terms (see the proof of Proposition 5 for details), the rm s expeted payo is Y I (k) Y (D 2 (k; 1) ; k) (1 (1 )) V (k) (1 ( )) k (17) (1 ) 1 + (1 ) T 2 : 1 + (1 ) (1 ) T Using Y NI (k) and Y I (k) we establish the following result: Proposition 5: The equilibrium level of investment, k, is independent of the degree of regulatory independene,, when <, but is inreasing with when >. Consequently, the rm invests more when the regulator is independent (i.e., > ) than when the regulator is non independent (i.e., < ). Sine regulatory independene in our model is assoiated with a smaller degree of regulatory opportunism, Proposition 5 is onsistent with Lyon and Mayo (2005) who show that a greater threat of regulatory opportunism leads to less investment. Having fully haraterized k and shown how it is a eted by regulatory independene, we are now ready to examine how k is a eted by the state s stake in the rm,, and by the regulatory limate,, whih re ets the degree to whih the regulator is pro-onsumers. Proposition 6: The equilibrium level of investment, k, is dereasing with and. If in addition V 0 (k) V 00 (k) is nondereasing, then the negative e ets of and on k are larger when the regulator is independent, i.e., when >. To see the intuition for Proposition 6, reall from Proposition 2 that when and are higher, the regulator sets a lower regulated prie. Consequently, the marginal bene t of 23
investment falls and the rm invests less. Proposition 6 shows that these e ets are stronger when the regulator is independent, i.e., when >. Propositions 5 and 6 imply that other things being equal, rms should invest more when they fae an independent regulator, when they are more privatized (i.e., is lower), and when they fae a more pro- rm regulator (i.e., is lower). These preditions are onsistent with a number of empirial ndings. Wallsten (2001) studies the investment of Teleoms in 30 Afrian and Latin Amerian ountries from 1984 to 1997. Among other things, he nds that privatization ombined with regulatory independene is positively orrelated with investment in apaity and phone penetration. Privatization alone, however, is assoiated with few bene ts, and is negatively orrelated with interonnetion apaity. Henisz and Zelner (2001) study data from 55 ountries over 20 years and nd that stronger onstraints on exeutive disretion, whih improves their ability to ommit not to expropriate the property of privately-owned regulated rms, leads to a faster deployment of basi teleommuniations infrastruture. Gutiérrez (2003) examines how regulatory governane a eted the performane of teleoms in 22 Latin Amerian ountries during the period 1980 1997 and nds that regulatory independene has a positive impat on network expansion and e ieny. Alesina et al. (2005) examine the aggregate levels of investment in the transport, teleommuniations, and energy setors in 21 OECD ountries over the period 1975-1998. Among other things, they show that a larger ownership stake of the state is assoiated with lower levels of investment. Egert (2009) shows that inentive regulation implemented jointly with an independent setor regulator has a strong positive impat on investment in various network industries (eletriity, gas, water supply, road, rail, air transportation, and teleommuniations) in OECD member ountries. Finally, Cambini and Rondi (2011) study a panel of 80 publily traded EU teleoms, energy, transportation, and water utilities over the 1994-2004 period and nd that they invest more when an IRA is in plae, and when the IRA (when it exists) has a larger degree of formal independene. Next, reall that Propositions 1-4 examined the e ets of regulatory independene, privatization, and the regulatory limate on the rm s debt level, regulated prie, and the probability of distress, holding k xed. We now show that these results ontinue to hold even after the endogenous hoie of k is taken into aount. 24