Marginal Efficiency Effect of Environmental Variables: The Case of the Norwegian Electricity Distribution Networks

Efficiency analysis lies at the heart of incentive-based regulation of electricity distribution networks. Most regulatory authorities have graduated from using exclusively ex ante (rate of return based) reviews of firms’ expenditures to relying also on ex post assessments of their costs – the latter are underpinned by benchmarking techniques (Poudineh and Jamasb, 2014). However, an assumption underlying these frontier analysis and efficiency measurement techniques is that all units share the same production technology and face similar environmental conditions. In the framework of electricity distribution companies, this assumption is unrealistic as exogenous environmental factors could also affect the efficiency of firms. Existing literature recognises the fact that the cost efficiency and quality of service performance of electricity distribution network operators can be affected by various firm-specific non-discretionary factors (environmental conditions) that are beyond the control of the management, such as geographical and climatic conditions. But this typically uses factor analysis to reduce the number of environmental factors into a few composite indices and applies second stage regression or pooled versions of stochastic frontier models to examine the effect of the composite environmental parameters on the efficiency of utilities. In contrast with this conventional method that studies the effect of environmental factors in isolation, exogenous environmental factors may in fact impact directly on the structure of technology by which the inputs are converted to output, or they may influence the efficiency with which inputs are converted to output. The question then arises over how the marginal effects of these environmental variables should be computed, and more importantly, whether both inefficiency (efficiency) and its marginal effects should be based on the same formula. Models in which the environmental variables enter into the mean and/or the variance of inefficiency have been proposed in some earlier studies. In this work we investigate the determinants and marginal efficiency effects of exogenous environmental variables using a balanced panel of 128 Norwegian electricity distribution companies observed from 2004 to 2010.

By: Rahmat Poudineh , Anupama Sen

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