Economics of Electiricty Network Regulation Essay

DISCUSS the rationale for economic regulation of energy networks in general and the use of “incentive regulation” approaches in particular and (2) pros and cons of using benchmarking methods in incentive regulation of the networks. The rationale for economic regulation of energy of energy networks is to remove monopolisation in naturally monopoly characteristic industries, helping to create a more natural market. Energy is a resource that is so key to development. By regulating the energy networks, it can potentially allow for a much wider consumer base and assist in development through allocative efficiency The UK government, under conservative governance, went under an extensive privatisation in the 1980’s. By 1990 they had ventured into extensive electricity sectors reforms- ”The most ambitious exercise in the whole UK privatisation programme” (Yarrow 1994, to transform a stagnant, inefficient industry with high capital costs and low returns, into a competitive industry.

Unbundling the generation, transmission, distribution and supply services and introducing competition in generation and supply (T. Jamasb 2000) Privatisation, has led to incentive based schemes. Incentive based schemes are used to encourage good performance and efficiency improvements in the energy networks. Schemes have been around since the early days of industrialisation, with an early example of the sliding scale for town gas in 1855. They are effectively used to, ”mimic competitive market pressures”(1). There are different incentive schemes. Rate of return regulation (ROR), has a major flaw in that it does not reward improvements in efficiency and cost savings and instead rewards over- capitalisation. An alternative to ROR, is Price Cap (RPI-X) Regulation, where operators must work under a ceiling price, which is adjusted to take account of inflation, through RPI and efficiency factor ‘X’.

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Firm’s can increase profits, if they improve productivity and are below the efficiency factor X. Its main flaw is that it has sales maximisation properties and cost of regulation is high. Yard stick regulation, first proposed in 1985 by Shleifer, requires regulators to set price caps, based on collecting cost information, other than the firm’s own- creating a hypothetical firm..(2) This hypothetical firm provides the best yardstick for measuring incentives. There is concern into the degree in which operating firms and circumstances are comparable, using Yardstick Regulation (T. Jamasb). Other incentive schemes include Partial Cost Adjustment, Sliding Scale and Revenue Cap Regulation.

Most of the reforms using incentive regulation schemes use Benchmarking to measure a firm’s performance and efficiency. Using benchmarking, actual performance is compared in relation to the benchmark performance. Benchmarking is nearly always used by independent regulators. Benchmarking allows firms and individuals to manage the future in terms of predicting energy costs. Price fixes reduce uncertainty amongst markets. Another benefit of benchmarking is that as suppliers have to work within boundaries, they are forced to increase efficiency if they are to continue to make returns on the same scale To assess the effectiveness of benchmarking, we need to look at the long-term scale.

If successful, benchmarking will reduce performance gap amongst firms. The wait to see if benchmarking performs can be years and this may be seen by some as a con. International benchmarking, also throws up some problems. Comparability issues can result between countries, which means regulators have to liaise with one another. Current rates must be used, and differences in external factors influencing the price must be taken into account. Economic regulation is needed in energy markets, to promote fairer market conditions and to prevent monopolisation in a sector key to our future. Benchmarking is a means to regulating energy markets, and with some adjustments can prove to be successful.


Benchmarking and Regulation of Electricity Transmission and Distribution Utilities: Lessons from international experience, T Jamasb, & M Pollitt, 2000 Yardstick and Incentive Issues in UK Electricity Distribution Price Controls, Thomas Weyman-Jones, 2001


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