Finding the Right Yardstick: Regulation under Heterogeneous Environments

Revenue cap regulation is often combined with systematic benchmarking to reveal the managerial inefficiencies when regulating natural monopolies. One example is the European energy sector, where benchmarking methods are based on actual cost data, which are influenced by managerial inefficiency as well as operational heterogeneity. This paper demonstrates how a conditional nonparametric method, which allows the comparison of firms operating under heterogeneous technologies, can be used to estimate managerial inefficiency. A dataset of 123 distribution firms in Norway is used to show aggregate and firm-specific effects of conditioning. By comparing the unconditional model to our proposed conditional model and the model presently used by the Norwegian regulator, we see that the use of conditional benchmarking methods in revenue cap regulation may effectively distinguish between managerial inefficiency and operational heterogeneity. This distinction leads first to a decrease in aggregate efficient costs and second to a reallocation effect that affects the relative profitability of firms and relative customer prices, thus providing a fairer basis for setting revenue caps.