Promoting efficiency – To what extent do incentives actually lead to improved efficiency?

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[Response by Sophie Trémolet and Diane Binder, November 2010]

One of the most important functions of regulation is to promote efficiency, measured with regard to both inputs and outputs. Input costs should be reduced continuously for the same or higher outputs (i.e. more or equal quantity or quality of service). Incentives can be introduced with a number of tools, including price regulation, assignment of risks and rewards, penalties and benchmarking. A way to increase the effectiveness of incentives is to use a mix of these tools, depending on sector characteristics such as the level of competition, the strength of institutions and the independence from political interference.

While in the UK, the pioneering country fro RPI-X regulation, significant cost cuts were observed after the introduction of the system, the impact of incentive regulation on improved efficiency is not always clear-cut, in particular with regards to quality measurements. A study of the effect of incentives on retail telephone service quality in the United States found that the impact was mixed. In that case, some aspects of service quality appeared to improve under incentive regulation (such as speed and reliability with which a new service was installed) while others deteriorated (such as the number of service quality complaints) (Sappington, 2003). On reverse, Shirley and Ménard (2002), in a study where they compare net gains from different reform experiences, give the example of Santiago, where incentive-based price regulation led to improved efficiency. In that example, the tariff was to be adjusted annually from inflation and adjusted every five years to cover the marginal and average costs of an efficient benchmark firm (empresa modelo). As a result, operators had an incentive to align their costs down to the level of an efficient firm. In addition, although Santiago’s operator was a state-owned enterprise, the government curtailed its borrowing and forced the company to finance most investment from retained earnings, which acted as a powerful incentive for increased efficiency.

The effectiveness of incentives varies with a number of factors, as set out below.

  • The nature of the firm . State-owned enterprises do not react to incentives in such effective ways as private firms do. [1]
  • The type of contracts (and the related assignment of responsibilities). For instance, in a lease contract, it may be difficult to assign incentives to the contractor to keep assets in good condition because of the separation of investments and operating decisions (Shirley and Ménard, 2002).
  • The credibility of the regulating entity : if the operator doubts that the rewards promised under the contract or by the regulator will be paid or that the penalties will be enforced, it will take actions to protect its interests, which may go against the efficiency objectives. The same goes in the case of benchmarking (Burns et al., 2006): its effectiveness to improve efficiency depends both on the credibility of the regulator and on the impact of the benchmark on the value of the firm and performance targets.
  • The relevance of targets : Setting the appropriate targets can incentivize utilities for improved performance. However, it is not an easy task, due to the difficulty to gather good quality data (information asymmetry). Targets must be achievable but not easily overshot [2].
  • The strategic behavior of utilities , which may create virtual efficiencies in the hope of gaining rewards. For instance, a firm may shift costs from operating to capital costs or influence the choice of variables in order to affect measured relative performance (Jamasb et al., 2002).
  • The existence of continuous monitoring. Annual monitoring of company performance is important to ensure that companies maintain or improve the level of service provided. The information needed has to be provided by companies annually and some form of independent reporting is essential to ensure its credibility. This has been done in Gabon, for example, where the government chose to contract out some regulatory functions, including the monitoring of coverage performance over a five-year period, to external experts. The resulting study is then used to assess whether the concessionaire has met its coverage obligations. If not, it is liable to penalties, whose amount is determined by the study: incentive-based tariff regulation alone may lead to a reduction in quality and under-investment towards increased service coverage[3]. To lead to improved efficiency in service, it should be combined with monitoring quality and performance. Performance control can include licensing and certification rules, minimum quality standards, provision of information to customers, service coverage targets, etc. For instance, to ensure real productivity gains in the water sector in England and Wales, Ofwat introduced quality service monitoring in its first price review (1994), and has reinforced this aspect in later reviews (Booker, 1998). In Great Britain, Ofgem uses statistical and engineering benchmarking studies and forecasts of planned maintenance outages to develop targets for the number of customer outages and the average number of minutes per outage for each distribution company. These targets are accompanied by penalties and rewards when outages fall outside of a certain band.

 

Footnotes

  1. See questions related to state-owned enterprises, State-Owned Enterprises of the FAQ.
  2. See related question in FAQ: “What are reasonable efficiency targets?“
  3. See previous question in the FAQ about trade-offs when introducing incentives.