Incentives in regulatory DEA models with discretionary outputs: The case of Danish water regulation

Emil Heesche (ehe@kfst.dk) and Peter Bogetoft
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Emil Heesche: Danish Competition and Consumer Authority

No 2021/04, IFRO Working Paper from University of Copenhagen, Department of Food and Resource Economics

Abstract: Data Envelopment Analysis (DEA) based cost norms have attractive properties in the regulation of natural monopolies. However, they are also sensitive to the choice of cost drivers. When some of the cost drivers are discretionary, this may lead to suboptimal incentives. When a regulated firm compares the marginal change in its cost norm with its marginal cost of changing the discretionary output, the gains from adjusting the output will be very context specific. It is therefore unlikely that the regulation will induce socially optimal output levels. In this paper, we analytically and numerically examine the impacts of including a discretionary quality indicator in the benchmarking model used to regulate Danish water firms. We show that the eight-year catch-up period allowed in this regulation gives strong incentives to reduce costs since the firms can keep possible cost reductions for several years before the cost norm fully internalizes the cost reduction potentials. On the other hand, this scheme also provides very weak quality incentives since it takes eight years before the extra cost of increasing quality is fully internalized in the cost norm.

Keywords: Data Envelopment Analysis; incentives; regulation; discretionary outputs; water sector (search for similar items in EconPapers)
JEL-codes: C02 C14 C51 C52 C61 C67 L51 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2021-05
New Economics Papers: this item is included in nep-ore and nep-reg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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