Valuing Regulatory Flexibility: A Real Options Approach to Cost–Benefit Analysis
Citation: 103 Geo L.J. 797 (2015)
There is increasing pressure on federal agencies to justify regulatory actions with rigorous quantitative assessments.1 The past several decades have seen a marked increase in regulatory agencies’ use of a cost–benefit analysis framework to determine whether regulations should be issued. To perform these analyses, regulators attempt to convert the expected benefits and costs of a proposed regulation into dollar figures, and then assess whether the expected benefits justify the costs. The Obama Administration has sought to expand the use of cost–benefit analysis by applying the analytical method to regulations that have already been promulgated. This retrospective review process, often referred to as “regulatory lookback,” allows agencies to evaluate whether ex ante predictions of regulations’ impacts have proven accurate over time. Armed with empirical information about regulations’ effects, agencies can make course corrections, including taking ineffective or duplicative regulations off the books.
This Note argues that a regulatory agency’s initial economic analysis of whether to issue a regulation should explicitly incorporate the value of that agency’s authority to revisit the regulation in the future and, potentially, amend or repeal it. Because the approaches that regulatory agencies have traditionally used to predict regulations’ costs and benefits do not incorporate the value of the flexibility afforded by regulatory lookback, this Note advocates for an alternative approach to cost–benefit analysis known as real options valuation (ROV).
Regulatory cost–benefit analyses are complex and costly efforts, but the basic framework typically employed by regulatory agencies is simple: agencies estimate the expected annual benefits and costs of a regulation into the future, and then discount those benefits and costs to present value. This approach is equivalent to a common form of financial analysis called discounted cash flows. Although regulators seek to issue regulations where the benefits will exceed the costs, regulators are invariably acting under conditions of uncertainty. Like the rest of us, regulators can only guess at what the future holds. Even under ideal circumstances, regulators may be limited to predicting a distribution of likely costs and benefits. Although the expected benefits may exceed the expected costs of a proposed regulation, thus yielding a positive net present value (NPV), there is no assurance that the expected results will actually come to pass, on either side of the balance sheet.
Further complicating matters is that regulators often must respond to poorly understood threats, where further study is unlikely to resolve the uncertainty regulators face. In such instances, issuing a regulation and studying its actual effects may be the only way to resolve this regulatory uncertainty. Once a regulation is promulgated and takes effect, new information is generated, and regulators can attempt to make empirical measurements of the actual costs and benefits. Regulatory lookback provides a formal avenue for regulators to collect and act upon this new information. For example, an empirically beneficial regulation could be expanded, or an empirically harmful regulation could be altered or even taken off the books.
This dynamic puts regulators in a position that is analogous to that of an option holder: regulatory agencies have the opportunity, but not the obligation, to act in response to information that will be generated in the future. The capacity of regulators to respond to future circumstances creates option value—the value of the opportunity to expand, otherwise alter, or abandon an existing regulation. Critically, this optionality yields value in addition to the net benefits of the regulation itself. That is, the total value of a newly issued regulation includes both the net benefits of that regulation and the value of the option to act in the future. The question then becomes, how should agencies account, ex ante, for the flexibility provided by regulatory lookback, a form of ex post regulatory review?
Part I of this Note begins by briefly reviewing the controversial history of cost–benefit analysis and the increasing efforts to utilize cost–benefit principles retrospectively. The Note then describes the typical technique employed in conducting cost–benefit analysis and why regulatory lookback renders that approach inadequate.
Part II turns to options valuation, beginning with an overview of financial options and real options. The Note then discusses how real options are valued, and describes other legal or policy settings where real options analysis has been employed. Part II concludes with an explanation of why real options are better suited to regulatory cost–benefit analysis than traditional valuation techniques.
On a practical note, Part III is a case study of the Food and Drug Administration’s proposed Foreign Supplier Verification Program (FSVP). The Note first looks at how the Food and Drug Administration (FDA) assesses the worthiness of FSVP using traditional cost–benefits analysis based on the discounted cash flows method, and how regulatory lookback changes that analysis. Next, the Note employs a simplified model to demonstrate how the same proposed regulation would be valued using a real options-based technique that accounts for the FDA’s ability to react to the success or failure of the regulation. The two models yield dramatically different results, illustrating the significance of valuing the flexibility that regulatory lookback provides.
Part IV discusses the implications of adopting a real options approach to cost–benefit analysis, as well as limitations of both an options-based approach in general and of the specific analysis set forth in this Note.