Incentives for Optimal Scale in the Regulation of Electricity Distribution Companies

Electricity distribution companies are natural monopolies and need to be regulated to protect customers from the abuse of monopoly power. In Norway, the recent regulation model applied by the Norwegian Water Resources and Energy Directorate is a combination of revenue cap and yardstick regulation. Constant returns to scale (CRS) is assumed to give incentives for optimal scale. In this paper, we investigate the implications of six scale assumptions in the benchmarking models, including Koopmans frontier, which has not been used in regulation contexts before. An empirical analysis of the Norwegian network companies shows customers are under limited protection when the convexity assumption is relaxed. Efficiency differences under different scale assumptions are considerable, especially for small and large companies. Inefficient small companies do not receive incentives to expand under specific scaling assumptions. Some larger companies have reference sets under CRS dominated by relatively small companies, which is less prevalent under Koopmans. By studying the case of Hafslund we find the Koopmans technology to be more practical than all the other scale assumptions if merging is conducted. The effects on company profitability and customer prices show that compared to CRS, some assumptions are in favor of small companies and they may keep more revenue, leading to the monopoly power abuse on their customers and limited incentives are given in the setting of restructuring company scales.