Regulatory Incentives for Investments in Electricity Networks - CRNI ...

External effects can also be included in the cost-benefit analysis. For example an expansion of
the transmission system can bring substantial environmental benefits by avoiding air emissions
otherwise caused by local generation and by reducing the need to procure local air offsets needed
for generation. 17 If the environmental costs are internalised (i.e. included in the investments costs
and in the operation and maintenance costs) the benefits will be automatically accounted for via
the avoided costs. If it is not the case, they should be additionally quantified provided that
sufficient information is available.
4.2 Hindsight Efficiency Analysis Using Total Costs
Under this approach, the problem of investment assessments is effectively bypassed. The
regulator does not need to form an opinion on whether a given investment proposal should be
allowed or not. Rather, the regulator considers the actual total costs (including the capital costs
of new investments) incurred by the network operator and sets the efficiency increase factor
based on an efficiency assessment (benchmarking) of these costs.
The efficiency assessment can be made by comparing the existing companies and using
traditional benchmarking techniques, such as Data Envelopment Analysis (DEA), Corrected
Ordinary Least-Squire (COLS) or Stochastic Frontier Analysis (SFA). When the data sample is
small or incomplete, such techniques cannot be applied effectively. Engineering network models
provide an alternative approach that can be used to fill the gap that traditional benchmarking
techniques cannot cover. In contrast to the traditional techniques, engineering network models do
not rely on existing alternative options, but rather create these options on the basis of
predetermined economic and engineering criteria.
The efficiency incentives of this approach come from the fact that in each regulatory period, the
efficiency increase requirements are set on the basis of performance achieved in previous years.
If the firm manages to increase productivity, its efficiency score will be higher in future periods
and consequently the required efficiency increase will be lower. An additional advantage of this
approach is that it provides an incentive to the service provider to be indifferent to the mix of
inputs and to deliver its required output at the lowest total cost.
The threat that capital costs of investments may be rejected, or partially disallowed, in the
process of benchmarking provides an incentive to the regulated company to only undertake
efficient investment. Such an incentive is considered necessary because the regulated company is
likely to hold better information than the regulator about the prospective efficiency of a proposed
investment. Therefore, by making the company accept the consequences of its investment
decisions, the probability that inefficient investment will take place is weakened. On the other
hand, the regulatory threat that capital costs of investments can be disallowed due to the ex-post
benchmarking could discourage regulated companies from implementing even good investment
projects. Also, there may be capital expenditure that is planned and conducted in good faith that
eventually proves “imprudent” on an ex-post basis. Moreover, the credibility of the efficiency
analysis depends on the data quality, adequacy of the model specification and the robustness of
17 Such reductions may also have secondary effects. They may assist in allowing new industries with higher
economic value to enter the local area by avoiding negative impacts to the local water and natural gas supplies
otherwise required for local generation. Also transmission upgrade may reduce the construction of additional
infrastructures such as gas pipelines, pumping stations, and water and waste treatment systems.
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