2004 IEEE International Conferenceon Electric Utility Deregulation, Restructuring and Power Technologies (DRPT2004) April 2004 Hong

Kong

Benchmark regulation and efficiency

o f electricity distribution
i n a restructured power sector

Hugh Rudnick Raul Sanhueza

Pontificia Universidad Catolica de Chile
Abstract- A growing challenge in the restructuring of
the electrical sector, where competition is introduced
in the generation area, is to achieve equivalent
efficiencies in the electrical distribution service, an
activity that develops in a monopolistic environment.
This summary discusses this challenge and the
regulatory methodologies under application and/or
evaluation that try to take to that efficiency
improvement. The complementary presentation will
give an overview of such tariff regulations and world-
wide experiences. Special emphasis will be given to the
concepts of model companies and distributim added
value and their application in Latin America.
I. INTRODUCTION
Electrical distribution companies, being
network industries, aim to the transport and distribution of
electric power from specific points in high or medium
voltage lines to end c o n s w r s at appropriate voltage
levels for industrial and residential usage. This activity is
organized in public service utilities that obtain power
supply through contracts with generators.
During the last decade, many countries and
geographical areas of the world have made drastic
transformations in their electrical sectors, both in terms of
segmentation and privatization of state monopolies.
Because of these transformations, a big change in the role
of the State has been witnessed. The State has transformed
itself from a producer and enterprissowner agent into an
agent that regulates those stages of the electrical sector
that become natural monopolies, such as electrical
distribution. The challenge is to stimulate an efficient
service in distribution, similar to that that would be
achieved in a competitive environment.
To regulate electrical distribution, most Latin-
American countries that have started this transformation
have adopted a “benchmark” scheme, using the concept
of an efficient company that is a company that is adapted
to demand and that operates under an optimal investment
and operations plan. Under this scheme, to force
companies to be efficient, the regulator fixes prices
according to the costs of an efficient company, designed
from square one and without considering actual
companies. The actual company will get a normal
profitability only if it is capable of emulating the efficient
company, reducing its operating and investment
Universidad de Tarapaca
expenditure, thus minimizing the present value of its
costs. In general, this regulation has implied a reduction
trend in distribution tariffs.
11. DISTRIBUTION REGULATION
CHALLENGES
The distribution activity is characterized by the
constant investments to be made to render good services
and to achieve the various scale conomies that can be
attained by companies when developing their facilities
and their management and operation. Although
economies of scale add up efficiency, they also make the
revenues generated through a marginal cost tariff not to be
enough to cover these companies’ total costs. Likewise,
the strong interdependence of investments and the long
capitahecovery period give origin to a costs fimction that
is clearly under-additive for the relevant demand range.
This takes to conclude that it is more socially efficient to
have a single company instead of several companies
operating in a same geographicalarea. In this manner, and
as it is a matter of guaranteeing maximum coverage, with
the highest quality and least price possible, single
distribution companies are justified and they are allowed
to operate as a natural monopoly.
Under monopolistic conditions, production is
associated to economic efficiencies and consumers have
no possibilities to choose, and that makes it necessary to
regulate the service in order to prevent unreasonable
practices (poor quality, low coverage, high prices). For
that purpose, the regulator establishes the rights and
obligations of distribution companies, assigning
concession zones to install, operate and exploit public
service distribution networks. Likewise, the regulator
establishes price levels and creates incentives that allow
management improvement, since there is no market
competitionto promote them.
In this manner, the primary goal of any
regulatory scheme is to provide the appropriate incentives
to companies to force them to be efficient and through an
adequate price signal, to make them to be able to transfer,
in the long term, part of their benefits to the users given
their efficient investment and operating policies. These
incentives will be available for the companies only if the
regulator can show a certain level of commitment and
stability. This commitment and stability results fiom
ensuring the regulator follows certain general principles

0-7803-8237-4/04/$17.00020041EEE
9
2004 IEEE Intemational Conference on Electric Utility Deregulation, Restructuring and Power Technologies (DRPT2004) April 2004 Hong Kong
on transparency, efficiency, stability and
straightforwardness [Rudnick and Raineri, 19971.
Based on these principles, the regulation of
natural monopolies is made through different approaches.
They differ from each other because they follow, at
different levels, the principles ndicated before. Studies
about these schemes applied to distribution systems can
be found in [Gomez 19991, [Jamasb and Pollitt, 2001al.
Regarding costs associated to the activity that is
intended to be remunerated, they are associated to the
network explo itation, maintenance and expansion
components. They can be grouped into the following
items:
* Investment costs associated to network expansion
* Capital costs regarding interests and related to asset
depreciation
* Exploitation costs including losses, monitoring and
network maintenance
* Administrativecosts and fixed overhead
* New consumer connection costs
* Network usage metering and billing costs
Each one of these costs is indistinctly affected
by climatic, geographical and demographic factors that
are extemal to the companies. This reveals that tariff
regulation is a very complex and demanding process,
considering:
The need to adequately identi@ and value the different
components
The need to fairly and transparently weight the influence
of factors such as network type - rural or urban -
overhead or underground lines, and the type and density
of consumption present in the company’ s activity
*The convenience of emitting signals to encourage the
adoption of more efficient behaviours by the companies
performing in the concession areas.
111. REGULATORY METHODOLOGIES
Most regulatory schemes use comparison
procedures or benchmarking as a methodology. In
incentive regulation, efficiency is measured against a
previous benchmark and the results deliver the
information required to compare the companies’
operation and allow the identification of the actions
required to drive efficiency improvements.
In the development of the various incentive
regulation methodologies, a primary source of
differentiation has been the level of emphasis put on the
10
relationship existing between regulated revenues and
costs. According to this differentiation, performance can
be measured in relation to references that are correlated or
uncorrelated to the companies’ cosb. Another simpler
classification to measure performance is the one used in
[Jamasb and Pollitt, 2001al. It is based on differentiating if
the reference is represented by a maximum theoretical
fiontier or an average performance expression. In both
cases, i is necessary to bear in mind that the presence or
absence of a consideration of specific costs for the
companies, allows the benchmarking to discriminate
primarily changing the character, scope and behaviour of
the regulatory process.
When frontier methods are used to compare the
companies’ operation, it is common to do so considering
if they are more or less efficient. This notion is closely
linked to the factors that determine the production
function and it is determined with efficiency and
productivity indices or measurements.
At a primary level, the concept of productivity is
relatively easy to define. It is the quotient between the
amount of product (output) and amount of input (input)
for a specific production situation. In the productivity
results that can be obtained for the units, there is influence
by the differences in production technologies, differences
in the production process efficiency and the differences
due to exogenous variables, also called environmental
variables [Weyman-Jones, 19921, [Pollitt, 19951, that
affect production. The productivity component resulting
from efficiency differences in the production process is
often called “productive efficiency”.
Productive efficiency is defined as the capacity
of a company to produce a given product at a minimum
cost. To reach that minimum cost, the company must use
its inputs in an efficient manner (technical efficiency) and
must choose the correct input combination given their
relative price (assignment efficiency). The first case -
technical eficiency - is defined in function of the
possibility of production and it is measured as the quotient
between observed production and the maximum potential
attainable production, given a set of inputs, or as the
quotient between the minimum total input potential
required and the total effectively used, given a set of
outputs. In the second case - assignment efficiency - the
optimal efficiency can be defined in terms of costs,
revenues, profits or any other company target that is
subject to amount and pice restrictions. Hence, this
efficiency component has a purely economical character.
In this manner, productive efficiency requires both
components, technical and assignment efficiency.
2004 IEEE International Conference on Electric Utility Deregulation, Restructuring and Power Technologies (DRPT2004) April 2004 Hong Kong
Obtaining efficiency measurements for a group
ofcompanies, through data analyses oriented to determine
a maximum production or minimum cost (frontier),
implies using various methods, among which there are
econometric and linear programming techniques.
The development of the econometric
methodology starts with the introduction of deterministic
frontier models in 1968 and it is further developed with
the stochastic frontier models [Aigner, Love11 and
Schmidt, 19771, weeusen and Van Den Bmck, 19771.
The notion that deviations fi-om the boundaries can not be
totally under the control of the company that is analyzed,
but rather there is a random component due to extemal
effects that are normally distributed and that component
has the effect of favouring or not favouring the company' s
production is introduced in the stochastic frontier analysis
(SFA).
On the other hand, the data envelopment
analysis (DEA) was developed with the linear
programming technique. This methodology was
introduced by Chames, Cooper and Rhodes (1978),
where they try to establish which companies of the
sample determine the envelopment area or efficient
production frontier. The radial distance of a company to
the frontier provides the efficiency measurement.
Therefore, companies that are on the frontier (the ones
that determine it) are considered efficient, while the ones
that are far from the frontier are considered inefficient.
Therefore, once one has defined the
methodologies to estimate the efficiency frontier, the need
arises to specify the type of frontier to be estimated. This
can be done through a production function or by means of
a cost function. A production function correlates the
amounts produced in function of the inputs used, while a
cost function correlates the total production cost in
fimction of the level of products and the input prices.
In general terms, there are no differences when
deciding if it is better to estimate a cost function or a
production function, although it is important to bear in
mind claims that favour the use of one or the other under
certain circumstances. In this sense, with the use of
production boundaries it is possible to recover information
only about the technical efficiency and not from the
assignment efficiency, while with the cost frontier
estimation, information about the technical efficiency and
from he assignment efficiency is included, despite the
fact that it is necessary to make additional assumptions to
separate both components. On the other hand, when the
companies' comparison is of an intemational character, it
is more practical to use production boundaries instead of
cost boundaries. In the use of production boundaries,
11
variables that have physical units that have a more
homogeneous character among different countries are
used, while the cost frontier estimation needs the use of
variables with denomination in various currencies, taking
to an additional complication when data comes from
companies fiom different countries. Likewise, the cost
frontier estimation has the disadvantage that, in general,
companies are reluctant to make their cost data more
transparent and that it is also necessary to know their input
costs.
Among the altematives to determine efficiency
boundaries, intemational experiences report a large
number of methodologies. For example, Pollit [Pollitt,
19951, studies the effect of ownership, public versus
private enterprise, on generation, transmission and
distribution companies' efficiency, and also reports on the
results obtained fi-om SBA, DEA and Least Squares
methodologies. The [Filippini M., Wild J. and Kuenzle
M. (2001)l shdy determines scale efficiencies and
distribution companies costs, also reporting results
obtained h m the SBA methodology. The DEA
methodology is also used to determine the relative
efficiency of companies in maximumrevenues regulatory
processes in New South Wales [PART, 19991 and cap
prices in the German electrical transmission and
distribution sector P T E , 19991.
IV. BIBLIOGRAPHY
AIGNER D.J., LOVELL C.A.K & SCHMIDT P.J. (1977):
Formulation and estimation of stochastic frontier
production hnctions models, Journal of Econometrics 6:
pp 21-37.
CHARNES A., COOPER W. & RHODES E. (1978):
Measuring the efficiency of decision making units.
European Journal of Operational Research, 2(6), 429-444.
FILIPPINI M., WILD J. & KUENZLE M. (2001): Scale
and cost efficiency in the Swiss electricity distribution
industly: evidence from a frontier cost approach, CEPE
Working Paper Nr. 8, Zurich.
GavIEZ T. (1999): Incentive regulation for distribution
companies under electricity competition. Lawrence
Befkeley National Laboratory, LBNL Intemal Report.
GCMEZ T. (1999): Regulacion de la distribucion de
energi a electrica en un marco de competencia. Esquemas
Basados en Incentivos. 6" Jomadas HispaneLusas de
Ingenieri a Electrica. Lisboa, Portugal. 7-9 Julio.
IPART (1999) Efficiency and Benchmarking Study of the
NSW Distribution Businesses. Commissioned by the
Independent Pricing and Regulatory Tribunal of New
South Wales, Prepared by London Economics. Sydney.
JAMASB T. & POLLIT M. (2001a): Benchmarking and
regulation of electric@ distribution and transmission
utilities: lessons from intemational experience, DAE
Working Paper 01/01, Department of Applied Economics,
University of Cambridge.
MEEUSEN W. & VAN DEN BROECK J. (1977):
Efficiency estimation from Cobb-Douglas production
functions with composed error. Intemational Economic
Review, Vol. 18, N" 2,435-444.
2004 IEEE International Conference on Electric Utility Deregulation, Restructuring and Power Technologies (DRPT2004) April 2004 Hong Kong

[9] DTE, Netherlands Electricity Regulatory Service, (1999).

Price Cap Regulation in the Electricity Sector". Hague.
[lo] POLLITT M. (1995): Ownership and performance in V. BIOGRAPHIES
electric utilities, Oxford University Press, Oxford.
[1 I ] RLJDNICK H. & RAINERI R. (1997): Chilean distribution
tariffs: incentive regulation, chapter in book (De)
Regulation and competition: The electric industry in Chile.
Ilades-Georgetown University, pp. 223-257.
[I21 SANHUEZA, RLJDNICK, H. & LAGUNAS, H. (2004),
"DEA efficiency for the determination of the electric
power distribution added value", accepted for publication,
IEEE Transactions on Power Systems.
[13] WEYMAN-JONES T. (1992): Problems of yardstick
regulation in electricity distribution, in Bishop, Kay and
Mayer. The regulatory challenge. Oxford University Press.
the economic operation,
planning and regulation of
electric power systems. He
has been a consultant with
utilities and regulators in
Latin America, the United
Nations and the World Bank,
mainly on the design of
transmission and distribution
open access tariffs.
h.rudnickrdieee.orq
www.ing.puc.cl/power
... ....., ..... . .. l..-.
Raul Sanhueza, obtained
I_

his B.Sc. degree in Electrical

Engineering at University of
Concepcion and his M.Sc.
degree from Catholic
University of Chile. He is an
Asistant Professor at
Universidad de Tarapaca.
His research interests
involve the planning,
economic operation and
regulation of electric power
systems.
resanhue@puc.cl

Thanks to Fondecyt for its financial support.

12