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The Road Not Taken

Revisiting performance-based rates with endogenous market designs.
Fortnightly Magazine - March 2004

each competitor. Initial efficiency differences among utilities are revealed by using correlated cost information from like firms. Allocative inefficiency is benchmarked by using total cost comparisons, not just data on changes in output/input ratios. And, rather than regulator-imposed productivity factors and adjustment periods, potential efficiency improvements and the adjustment periods are revealed by endogenizing the process through the tournament ().

It is illustrative to note Scheifer's comments in the original paper outlining the concept. Schleifer states that YC works because it "does not let an inefficient cost choice by a firm influence the price and transfer payment that that firm receives. It is essential for the regulator to commit himself not to pay attention to the firms' complaints. … Unless the regulator can credibly threaten to make inefficient firms lose money … cost reduction cannot be enforced." 6

Recent Misapplications of 'Yardstick Competition'

Recently, regulators in Europe, the UK, Australia, and the United States have structured with "so-called" yardstick paradigms based on a limited time series of partial costs (generally ignoring capital costs and line losses). In many of these jurisdictions deterministic frontier techniques are employed. Unfortunately, such PBR implementations have selected the worst of both paradigms. Using data-intensive but "quick fix" applications, regulators have opted to preserve the traditional exogenous process, with a new twist: benchmarking on partial costs that produces unstable peers and significant biases in inter-utility efficiency rankings.

In these applications, utilities have been benchmarked for differences in technical efficiency but not allocative (due to the difficulty of calculating input prices) and regulators have opted for notable efficiency improvements as mentioned above. Our research has examined such applications in detail: First, we find such frontier paradigms are unstable. Firms judged to be efficient in one period are judged inefficient in the next period and so on. Second, we find that a utility's technical inefficiency is not necessarily correlated with its allocative inefficiency. Thus, one cannot assume one can over-penalize based only on the calculated technical inefficiency (assuming it was done correctly) to compensate for unknown but suspected allocative inefficiency. Third, we find significant differences in calculated efficiency between the partial-cost approach and one based on total costs, which produces a better estimate of both technical and allocative efficiency. Not surprisingly, such attempts to yardstick benchmark on partial costs have created sizeable distortions in efficiency rankings and X factors. 7

The PBR toolkit available to regulators is a powerful regulatory incentive mechanism and can work to achieve a more socially optimal outcome if applied correctly. Proper efficiency benchmarking is critical. Rather than the data-intensive, regulator-imposed, exogenous framework traditionally implemented in North America, or the partial cost/partial efficiency "quick fix" benchmarking recently employed in Australia, Holland, and California, among other jurisdictions, we suggest the adoption of endogenous shadow-market, yardstick competition. This approach simplifies the regulatory process and handles issues such as the principal-agent problem and allocative inefficiency and initial efficiency differences with elegant simplicity. Exogenously determined YC as practiced recently only should be implemented with cost-per-unit comparisons based on full costs, including capital and line losses, as well as calculated input