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The Road Not Taken

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

allocative inefficiency because of the purported difficulty in measuring input prices; in general, the issue of non-optimal factor mix has typically been ignored in many regulated industry studies. (Economist M.J. Farrell originally illustrated the example in the 1950s.) 1

  1. Farrell, M.J., " The Measurement of Productive Efficiency," , Series A, Part III, Vol. CXX, 253-290.

Growth vs. Income: A Profit-Productivity Menu

Given the asymmetric information on initial efficiency levels and a desire to maximize the efficiency response among distributors, the authors 1 and others proposed a variant of the FCC's productivity menu. Distributors could choose a combination of productivity growth and earnings return: higher productivity growth would be permitted higher returns on equity. The menu offered combinations from 1.25 percent productivity growth and 10 percent ROE up to 2.5 percent productivity and 15 percent ROE. 2 Some observers argued that such a menu would disadvantage more efficient utilities by requiring them to make the same percentage improvement as inefficient utilities for the same ROE. 3 In its PBR decision, the board rejected the menu and opted for a single, fixed factor of 1.5 percent. 4

In research undertaken after the initial PBR process, we found electricity distribution monopolies in Ontario operating at significantly different levels of efficiency: on average, utilities are 35 to 40 percent less efficient than the best practice firms. 5 And, similar to the earlier research from the 1980s, we too find that allocative inefficiency is about twice as large as technical inefficiency (i.e., about two thirds of the mean total inefficiency). Indeed, just as some stakeholders noted, we find a key determinant of allocative inefficiency is overcapitalization induced by a utility's reliance on third-party contributed capital to fund infrastructure requirements. 6

  1. Ontario Energy Board consultant and staff, respectively.
  2. Ontario Energy Board Staff Report, , June 1999.
  3. Indeed, in an unregulated market, the profits of the most efficient utility would be determined by its cost level relative to the cost level of less efficient utilities.
  4. Ontario Energy Board Decision with Reasons, , Jan. 18, 2000.
  5. Specifically, we find technical inefficiency averages 18 percent, with some distributors almost 40 percent less efficient than the best producers. Allocative inefficiency averages 26 percent, with some distributors almost 50 percent less efficient than the best producers. Total inefficiency was found to exceed 40 percent among many of the utilities examined (, they would need to reduce total costs by more than 40 percent while holding output constant to match the efficiency of the best practice firms). Cronin, F.J. and S.A. Motluk, "Inter-Utility Differences in Efficiency," presented at the Canadian Economic Association meetings, May 2001.
  6. Cronin, F.J., S.A. Motluk, "Agency Costs of Third Party Financing and the Effects of Regulatory Change on Utility Costs and Factor Choices," submitted for publication.

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