A New Perspective: Investment and Efficiency under Incentive Regulation.

• Author: Poudineh, Rahmatallah

1. INTRODUCTION

   In recent years, achieving a sustainable electricity sector, security of supply, and reliability of service have emerged as overarching energy policy objectives in many countries. A sustainable energy economy is highly dependent on decarbonising the electricity sector. Meanwhile, further electrification of the energy is generally regarded as desirable for a sustainable energy-economy. These objectives are pursued through large scale deployment of renewable energy resources, more efficient use of energy, and active participation of the demand side.

   Achieving the above goals requires a transformation of the electricity networks through expansion of grids, adoption of new technologies for managing the variability of the supply side, accommodating an active demand side, and focused research and development. Such transformation can only be reached through substantial capital investments. Given the anticipated scale of the required investments in the coming years, ensuring sufficient and efficient investments in the networks presents itself as a policy and regulatory priority.

   Following the liberalisation of the electricity industry since the early 1990s, many sector regulators have recognised the potential for cost efficiency improvement in the networks through incentive regulation aided by cost benchmarking and productivity analysis. Although benchmarking has achieved efficiency improvements (mainly in operating costs), new challenges have emerged as how to address the issue of network investments. The challenge is whether a regulatory scheme can be designed to provide the right incentives for the delivery of cost effective services while ensuring there is no systematic underinvestment or overinvestment. Hence, regulators need to balance the cost and risk of underinvestment against the cost of overinvestment in maintaining and modernising the networks.

   Incentive regulation accentuates static cost efficiency while investment is a dynamic and long term activity. On the other hand, benchmarking is a relative concept in the sense that a firm's efficiency depends not only on its own performance but also on the performance of other companies. The paradoxical effect of incentive regulation concerning investment and the peculiar specifications of total cost benchmarking complicate the relationship between investment and cost efficiency under incentive regulation with the ex-post regulatory treatment of investments.

   This paper analyses the relationship between cost efficiency and investments under incentive regulation with ex-post regulatory treatment of capital expenditure using the case of electricity distribution networks in Norway. The contribution of this paper is two-folded. Firstly, we introduce the concept of "no impact efficiency" as a revenue-neutral efficiency effect of investment under incentive regulation which makes the firm "investment efficient" and immune from cost disallowance in benchmarking process. Secondly, we estimate the "observed" efficiency effect of investment in order to compare this with no impact efficiency and discuss the implication of cost benchmarking for network investments in Norway. Despite the important role of regulatory treatment of capital expenditure, using benchmarking total costs, for investments behaviour and efficiency improvement in the networks, the topic has not been formally studied in the empirical literature.

   The next section discusses the relationship between network investments and incentive regulation with reference to the Norwegian regulatory regime. Section 3 describes the methodology used to conceptualise the efficiency implications of investment under incentive regulation and also presents the stochastic frontier analysis procedure. The empirical results are presented and discussed in Section 4. Section 5 is the conclusions.

2. INVESTMENT AND REGULATION

   Electricity network companies are regulated natural monopolies and hence, investments by these firms are not governed by market mechanisms where decisions are normally based upon expected higher returns than the cost of capital. In a regulated environment such as the electricity networks, the investment behaviour of firms is strongly influenced by their regulatory framework and institutional constraints (Vogelsang, 2002; Crew and Kleindorfer, 1996). The low-powered regulatory regimes such as pure "rate of return regulation" are often associated with poor incentive for efficiency. Averch-Johnson (1962) showed that regulated monopolies have an incentive to over-invest when the allowed rate of return is higher than the cost of capital.

   Incentive-based regimes such as price or revenue caps aim to overcome the efficiency problem by decoupling prices from utilities' own costs. However, they also give rise to new challenges regarding the level of investments. The issue of cost efficiency at the expense of investments or service quality has been discussed in the literature (see e.g., Giannakis et al., 2005; Rovizzi and Thompson, 1995; Markou and Waddams Price, 1999). In addition, when rewards and penalties are weak or uncertain, the incentives for cost reductions outweigh the inducement to maintain quality of service and investment (Burn, and Riechmann, 2004). Furthermore, implementing incentive regulation is complicated and an evaluation of the associated efficiency is more difficult than it is often implied (Joskow, 2008).

   The empirical evidence concerning investment behaviour of firms under incentive regime is not conclusive. While some initially argued that incentive regulation will lead to underinvestment, subsequent empirical works demonstrated that the outcome of the incentive regulation concerning the investment behaviour can be in either direction. Waddams Price et al. (2002), state that a high-powered incentive regulation might lead to overinvestment. Roques and Savva (2009) argue that a relatively high price cap can encourage investment in cost reduction as in an unregulated company. Nagel and Rammerstorfer (2008), on the other hand, show that a strict incentive regulation regime is more likely to create disincentive for investment. However, it is generally agreed that in incentive regulation regimes, due to the separation of firms' own cost from prices, the motivation for cost reducing investment is higher than under the rate of return regulation models (Ai and Sappington, 2002; Greenstein et al., 1995; Cambini and Rondi, 2010).

   Thus, the main challenge of the regulator is to design the right incentives in order to prevent any systematic overcapitalisation or underinvestment. The ability to disallow excessive costs can help regulators achieve more efficient levels of investments which otherwise firms would tend to overinvest in risky projects (Lyon and Mayo, 2005). However, following periods of cost disallowances there is a greater possibility of disincentive for investments.

   The regulatory opportunistic behaviour is also a concern for the regulated firms as this introduces uncertainty into the regulatory contract. Gal-Or and Spiro (1992), for example, argue that a sudden shift in the regulatory regime which allows for the use of cost disallowance instruments will decrease the propensity to invest. Thus, the presence of uncertainty in regulation influences investment behaviour of network companies. Under uncertainty, delaying investments may be beneficial even though a project may recover its capital costs (Dixit and Pindyck, 1994). There is also non-regulatory uncertainty, such as future demand, that the regulated company needs to take into consideration when deciding to invest.

   From the regulatory viewpoint, it is important that decisions influencing the investment level of the firms are based upon economic efficiency. For example, the cost of reducing service interruptions through investments should be lower than the socio-economic costs of service interruption. In effect, the regulator seeks an efficient level of investment in the grid although realising this goal through regulation is a challenging task. On the one hand, theory does not provide clear indications of the conditions under which "efficient" levels of investment are achieved and which factors lead to over or underinvestment (von Hirschhausen, 2008). On the other hand, the empirical evidence from cases of overinvestment or underinvestment is rare. Therefore, the outcome of incentive regulation regarding investments is ambiguous, and that regulators, in practice, tend to adopt a combination of different incentive mechanisms in order to achieve their objectives.

   2.1 Power Sector Reform and Network Regulation in Norway

   Norway was among the first countries, after Chile and the UK, which embarked on power sector reform by unbundling the different elements of the electricity industry across the value chain. The generation and retail supply which are potentially competitive were separated from the transmission and distribution that are natural monopolies. Therefore, the distribution and transmission networks are subject to economic regulation. The Norwegian Water Resource and Energy Directorate (NVE) were appointed as the sector regulator since Norwegian Energy Act came into effect in 1991. Unlike the other countries where the regulatory reform was often accompanied by transfer of ownership, the Norwegian power industry mainly remained under the state or local municipalities' control after the reform. Also, companies that are involved in both monopolistic (distribution or regional transmission) and competitive businesses (generation or retail supply) are required to keep them separated legally and/or financially. (1)

   In the early years of the reform, there were approximately 230 distribution networks and 70 generation units in Norway. The high number of utilities reflects the dispersed nature of the hydroelectric resources as the main source of power generation as well as the historical development of the sector in the...