Endogenous system-wide output prices in incentive regulation

Abstract

We propose a simplification of frontier-based regulation currently implemented in several countries and demonstrate its potential application to the regulation of the Brazilian electricity transmission sector. A common regulation uses Data Envelopment Analysis (DEA) to estimate a cost function and mandates that firms adjust their costs to the DEA-estimated best-practice costs. Nevertheless, as DEA allows for individualized pricing of the services, such a DEA-based regulation may be challenging to understand and predict. Moreover, it may encourage strategic behavior in the selection of service profiles, thereby reducing competitive pressure on other firms with similar profiles. This could adversely affect the industry structure, leading to firms with suboptimal scales and scope. Therefore, instead of individualized output prices, we propose the use of a common set of endogenously determined prices that minimizes the total costs to end consumers, while ensuring individual rationality and incentive compatibility. We also present an extended approach that enables the regulator to strike a balance between rewarding well-performing agents and encouraging underperforming agents to save costs, while maintaining a minimal deviation from an expected aggregated payment. Achieving this balance is vital for incentivizing the agents to innovate and invest in more sustainable facilities in the electricity sector, promoting advancements in technology, energy efficiency, and environmental sustainability. Using Brazilian data, we demonstrate that the proposed incentive mechanism is operational and offers substantial advantages over the existing regulatory framework.