The role of efficiency estimates in regulatory price reviews: Ofgem's approach to benchmarking electricity networks
Section snippets
The theoretical underpinnings of the use of benchmarking
Incentive regulation suggests that the price charged by a regulated monopolist should be set independently of its own costs. Ideally at the average economic cost of a group of comparable firms (Shleifer, 1985). There are two problems with this approach. First, it is difficult to find a group of strictly comparable firms. Second, it is risky to pay no attention to actual costs: this can result in bankrupting the firm if the price cap is too tight; or allow the firm to earn politically
Ofgem's general approach
Electricity supply in the UK was restructured and substantially privatised in 1990. Accompanying RPI-X regulation was introduced at privatisation and an independent regulatory agency, Offer (now Ofgem) was established. This gives the UK a substantial amount of experience with RPI-X regulation in the electricity sector. RPI-X price control reviews have implemented a 55% real reduction in the price of electricity distribution (since 1995) and a 30% real reduction in electricity transmission
Assessment of Ofgem's approach to benchmarking
The first thing that is striking from the above description is that benchmarking is only one part of a much larger framework within which X factors are set.
For United Utilities (and all the other companies), benchmarking has only effected the operating cost part of their allowed revenue (7 under RAV in Table 1). In addition it is necessary to make assumptions about what operating costs should be benchmarked and how fast the company should be assumed to be capable of catching up with the most
How Ofgem's benchmarking could be improved
The most important factor limiting the use of benchmarking by Ofgem is the lack of panel data to facilitate analysis over time and to provide more data points.
Panel data would increase the robustness of the parameter estimates in the regression analysis and facilitate the inclusion of additional variables directly into the cost function. Given that Ofgem have data from 1991 to 1992 this should currently give them data from 13 years to 2003–2004. This would allow robust testing of cost driver
Conclusions
In closing we offer two sets of conclusions.
First, on the use of benchmarking to date by Ofgem:
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Lack of comparable data has limited the sophistication of the benchmarking undertaken.
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The need to produce some justifiable X factors calculated on a reasonably consistent basis to use in negotiations with the companies has forced Ofgem to proceed with benchmarking in spite of practical difficulties.
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There has been a substantial data collection and standardisation effort which has produced numbers that
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The author acknowledges the help of Jonathan Mirrlees-Black and Hannah Nixon at CEPA, Ofgem and the participants at the LBS conference for which this material was originally prepared. Stephen Littlechild and Jon Stern provided extensive comments on an earlier draft. All opinions expressed in this paper are those of the author and does not necessarily reflect the views of any third party. All remaining errors are his responsibility.