Reliability of point efficiency estimates in regulatory applications: evidence from the English and Welsh water industry

Abstract

In this study, we have estimated a panel data Cobb-Douglas stochastic variable cost frontier to model the operating expenditure of the water-only companies in the English and Welsh water industry. The results are used to build confidence intervals for the point efficiency estimates. Our results show that, contrary to some previous studies in other sectors, the confidence intervals’ sizes are relatively small. Nonetheless, even in this case, grouping companies in efficiency bands on the basis of point efficiency estimates as Ofwat (Office of Water Services), the regulator of the English and Welsh water industry, does might lead to a one-band misclassification for 25% of the water-only companies. The computation of confidence intervals might, therefore, enhance the transparency and reliability of the whole comparative competition regime. This paper suggests that, especially when noise is large relative to inefficiency, confidence intervals should be routinely used alongside point estimates in regulatory applications.