Abstract
‘The uncertainty about future regulation —known as regulatory risk —has been systematically documented in regulated industries. In the popular debate, regulatory risk is perceived as welfare detrimental because it deters investment activities. In this paper, we investigate the role of regulatory risk in a vertically related market where an upstream regulated firm decides whether to vertically integrate and provides noncontractible investment for the supply of an essential input to downstream competitors. 

Contrary to the common view, we find that, under certain circumstances, some degree of regulatory risk is ex ante socially beneficial. We show that, when the regulator sets the regulatory policy after the vertical industry structure has been established, some degree of regulatory risk is ex ante socially beneficial. Regulatory risk makes vertical integration profitable and stimulates high upstream investment at a lower social cost. This occurs for moderate costs of high investment and firms’ small risk aversion. Our analysis is presented in a fairly general setting without imposing any particular assumptions on either functional forms or the mode of downstream competition. Establishing a unified framework that incorporates regulatory risk, vertical integration and upstream investment, our work sheds new light on some empirically documented determinants of vertical integration. We provide theoretical corroboration for the identification of regulatory risk as a source of institutional uncertainty that facilitates vertical integration. Our results are also consistent with the empirical findings that indicate the positive effect of uncertainty about firms’ cash flows upon vertical integration and illustrate the role of risk management in the firms’ incentives to vertically integrate. Our analysis provides further support for the well-established empirical evidence about the relevance of upstream investment to vertical integration.’