Edited by Michael A. Crew and David Parker
Chapter 6: Performance Benchmarking in Utility Regulation: Principles and the UK’s Experience
David Parker, Thoralf Dassler and David S. Saal Introduction1 In the UK, the privatization of utility industries has led to the development of regulatory regimes to prevent monopoly abuse. There are two main methods of economic regulation, namely cost of service, alternatively known as rate of return regulation, and price-cap regulation. In very broad terms, whereas cost of service regulation sets prices based on operating expenditure (OPEX) and capital expenditure (CAPEX) figures with an allowance for a normal profit, price-cap regulation places a ceiling on prices or revenues. As is now recognized, price-cap regulation provides incentives for management to economize on OPEX and CAPEX. As a result, all privatized utilities in the UK have been subject to price-cap regulation. An approach to determining the revenue required to meet efficient costs would be to base future revenue on the costs achieved by the firm in previous years, adjusted for any known exceptional items or expected cost changes. The problem with this approach, which is essentially identical to the method adopted under cost of service regulation, is that incentives for cost efficiency are reduced. Where management expects that cost increases can be passed through to consumers, there is little incentive to reduce them. Moreover, if future OPEX and CAPEX funding is based on the firm’s forecasts of its own costs, there will be an incentive for management to pad these costs. The objective of incentive based utility regulation is, therefore, to establish an incentive compatible set of cost comparisons that can be...
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