Many countries use benchmarking within the water and sewage industry: regulators, companies or associations. A look at other countries is important to gather a broader understanding of
benchmarking and the use of regulation within the water sector. Furthermore, a brief look at the electricity industry might provide an even more comprehensive view since electricity is also a distribution network. This review into other countries and the electricity sector will help us gain perspective on the Water Department’s methods.
8.1.1 Other Countries using Benchmarking in the Water Sector
The water and sewage industry was privatized in 1989 in England and Wales and an independent regulator was formed called OFWAT (Sørensen 2010). OFWAT’s main purpose is to set the prices that companies are allowed to charge their customers while allowing firms to perform their
function (Byatt 2013). Currently, OFWAT regulates 34 privately owned water and/ or sewage firms (Ofwat 2013b).The industry is regulated with price caps that are reset every five years (Sørensen 2010), and the price caps use TOTEX when setting the final price cap (Ofwat 2009). It should be noted that OFWAT is trying to implement a menu of contracts approach, but this is being met with some industry resistance (Ockenden 2012). Price caps have an industry component to account for the technological advances, as well as a company specific factor to account for savings over the industry. DEA and other unspecified tools are used to evaluate the company specific factor (Thanassoulis 2000a). OPEX and CAPEX have been separately benchmarked (Ballance 2006;
Cubbin2005), but to what extent they are used in the price setting is not transparent (Ballance 2006). OFWAT has recently implemented benchmarking with TOTEX for certain areas (Ofwat 2013c), as OFWAT believes this will better prepare firms for the changing climate (Ockenden 2012).
When using DEA, OFWAT only allows multi-product companies (both sewage and water) to
constitute the frontier since the infrastructure, size, and costs are larger for these firms compares to the single product firms (Thanassoulis 2000b). Along with price cap regulation, OFWAT has some characteristics of sunshine regulation since OFWAT publishes results regarding the firm’s
performance (Marques and De Witte 2010). OFWAT uses these results to either reward or punish the firms by increasing or decreasing the price limit (Sørensen 2010). This is also the case in Scotland, where benchmarking is used to set price limits as well (Marques and De Witte 2010).
The Netherlands uses the sunshine regulation (De Witte and Saal 2010). The industry is all public domain and is currently 10 firms, but has been as large as 60 firms in the 1990s (Marques and De Witte 2010). Sunshine regulation was self-imposed by the industry to avoid privatization and regulation. Therefore the industry has entered into a voluntary benchmarking with published results every few year since the late 1990s (Marques and De Witte 2010; Sørensen 2010).
Since sunshine regulation has arisen, the industry has increased its efficiency by 21%, and increased transparency has been credited to many mergers (Marques and De Witte 2010).
Portugal is similar to the Netherlands in the sense that it uses sunshine regulation, although for Portugal this is compulsory (Marques and De Witte 2010). Portugal has approximately 300
municipal owned firms, which are allowed to enter contracts with privatized firms that account for 18% of the industry (Marques and De Witte 2010). Although, only the private firms are covered by the sunshine regulation (Marques and De Witte 2010), which does not make the regulation all-encompassing.
Thus, it can be seen that countries are starting to use benchmarking in regulation, but that there are several different approaches on how to implement this. There is definitely interest in benchmarking and most European countries have considered benchmarking in some form or another (Marques and De Witte 2010).
Of the information we found on water-regulation in other countries, there are similarities to the Danish regulation and benchmarking but no exact regulation match. As mentioned before, the countries that are most comparable to Denmark are England and Wales (by OFWAT) since their regulations seem to include some of the same elements as the Danish (e.g., DEA-based
benchmarking used in the price-setting, as well as the regulatory method in price cap regulation).
Lessons can be learned from other countries. Sunshine regulation might be a less expensive form of incentives, and some states in Australia believe that the cost of benchmarking does not outweigh the benefits (Lowry and Getachew 2009). The Water Department can also use OFWAT as inspiration in the following ways: investigate why OFWAT believes the costs are higher for multi-product firms since there are 22 firms that are multi-product in the Danish water sector, benchmarking with TOTEX, implementation of longer lag times, etc.
8.1.2 The Electricity Industry
From the 1980’s, reforms have occurred in network industries, including electricity (Jamasb and Pollitt 2000), as inefficiencies were found to be substantial (Agrell et al. 2005). The approaches of the reforms vary across countries, but many of the reforms are in relation to improving efficiency with competition, privatization, or price regulation (Jamasb and Pollitt 2000). The electricity supply is organized differently than the water industry because there is a generation, transmission, and distribution aspect to the industry (Jamasb and Pollitt 2000). Many reforms focus on the supply aspect (Jamasb and Pollitt 2000). Although the industry differs, there are still lessons that can be learned from this natural monopoly, since many academic and efficiency studies have looked at the electricity sector.
An article by Jamasb and Pollitt (2000) looked at over 25 different articles that researched
regulation and benchmarking in the electricity industry. Articles varied in the expanse of coverage, (i.e., single country or countries, method of benchmarking, inputs, outputs, etc.) (Jamasb and Pollitt 2000). Overall findings varied, which led to the conclusion that many different factors affect the results (Jamasb and Pollitt 2000):
A study into only one country found evidence of economies of scope in small UK firms.
Another study into Greek electricity firms found efficiency in urban areas when using DEA, whereas urban efficiency was not found using econometric models.
In a study of the Turkish electricity market, firms that were offered private franchise opportunities were shown to have higher efficiency levels compared to those that were not offered franchising.
On a multi-country level, studies of the benchmarking tools, DEA, SFA, and COLS concluded that ownership did not affect performance.
The differences in methods and results are important because it is further proof that regulation is complicated, and there is no absolute way to regulate (Jamasb and Pollitt 2000).
In the article, the authors submitted surveys to many countries and made their own conclusions based off the responses (Jamasb and Pollitt 2000). It was found that the first countries to implement market-oriented reforms (Norway, UK and Chile) also now use benchmarking within their
regulation.
Implementing benchmarking within reforms has occurred in over 20 countries, although the use of benchmarking varies; some countries use frontier-oriented methods, while others do not. Jamasb and Pollitt (2000) also discovered that lag times vary between three to five years; most countries implement the benchmarking into price or revenue caps; and the regulator is normally independent (Jamasb and Pollitt 2000). It was found that at the time the article was published, Great Britain, Norway, Netherlands, New South Wales, and Colombia were using DEA as benchmarking in the price-setting process (Jamasb and Pollitt 2000).
Other articles, not discussed in Jamasb and Pollitt’s (2000) encompassing article have also looked at aspects of the electricity market. Jacobsen and Jensen (2011) discovered that as of 2011, 8 out of 19 European countries have implemented incentive regulation for the distribution aspect of electricity.
This can also be linked to what Haney and Pollitt (2011) said about regulators being influenced by their neighbor (regional effects). Haney and Pollitt (2011) furthermore discussed that within the electricity sector, the size and political environment of a country influence benchmarking. An article by Giannakis et al. (2005) argues that Norway, which has a high number of utility firms at
approximately 180, performs DEA with multiple inputs and outputs and uses these results directly in the price cap regulation, whereas in New South Wales, where only a few distribution firms exist, there is no direct relation to the benchmarking and price setting (Giannakis et al 2005).
An interesting article by Niesten (2010) discusses how the Dutch regulators try to implement a quality factor ( ) into the price cap regulation using benchmarking. The -factor is a measure of a company’s network user’s interruptions multiplied by the time of the interruption and then divided by all the network users of the company. If the quality of a company is higher than the market average, that company gets a higher -factor and is thereby allowed to charge higher consumer-prices, the average interruption duration of the companies in the market. This is to encourage the companies to invest in their network and thereby increase the quality level (Niesten, E. 2010).
The Danish electricity sector went through reform in 1999 (Hauch 2001). The reform hoped to increase efficiency through competition, as well as increase environmental aspects of the sector (Hauch 2001). The electricity industry was divided into competitive activities or natural monopoly activities; the natural monopolies were to be regulated whereas the competitive activities allowed free competition (Hauch 2001). The current regulation is a revenue cap, including a benchmarking aspect to increase efficiency (Energitilsynet 2012).
Overall, the electricity industry can provide some guidance in the water sector reform, but as discussed, many factors influence the reform or efficiency. Therefore, it is of relevance to review other sectors, countries, and models as guidance, although keeping in mind that every situation is different.
8.2 Discussion of the Danish Regulation
The Danish regulation is a mix of regulation methods and considered to be incentive-based price regulation (Sørensen 2010). Incentive-based regulation’s aim is to complement other methods to induce better behavior within the industry (Haney and Pollitt 2011). At a high level, the Danish regulation is considered to be a revenue cap (price cap), but when the Danish regulation is
examined more closely, it can be seen that there are aspects of several regulatory methods. As seen in section 4.4.3.1 The Price Limits in the Danish Water Sector, the Water Department looks at all the costs (TOTEX) and sets a limit on revenue for the firm. The firm can then recover most of its costs, including investments, although the investments are benchmarked, and therefore not all risk for the firm has been eliminated. The investments are benchmarked in the sense that the cost of the investment is compared to similar investments. Thus, companies are supplemented for their investments to the extent that they correspond to similar investments in the market (to avoid inefficient investments) (Forsyningssekretariatet 2012b). Therefore, investments have a yardstick regulatory aspect to them.
An important characteristic of the Danish regulation is the lag time. Many of the differences between price caps and rate of return regulation disappear when the price controls are reset (Newbery 1998) and currently, the controls are reset yearly in the Danish market; therefore, the revenue cap may be the main method of regulation but it does have some characteristics of rate of return (lower risk to firms). An important factor associated with revenue and/or price caps is that the lag time allows firms to reduce costs, since the firms would be allowed to keep any savings to their costs accrued at that time, providing incentives to the firm. This is not the case in the Danish market, since zero profit is allowed, and the Water Department will modify the price to allow any previous profit to be given back to the consumers.
The incentive factor within a revenue cap is diminished from the short lag times and zero profits; in order to offset this, the Water Department tries to induce incentives to the firms by adding a
competitive aspect on efficiency to the regulation.
Within the revenue cap, there are benchmarking factors that penalize the firm if it is not considered one of the best (most efficient), which is also comparable with yardstick regulation since the
benchmarking is used as a competitive approach (Sørensen 2010). The penalty or competitive approach originates from benchmarking OPEX using DEA. Therefore, although investments are benchmarked to encourage smart investments, the efficiency and competitive aspect of the regulation is in relation to the firm’s OPEX.
The Danish regulation also tries to increase transparency within the industry, and therefore publishes the results yearly, which is a form of sunshine regulation. It is not clear if the Water Department hopes to embarrass the firms, as in the Netherlands, but nevertheless, the results are published.
Overall, the Danish regulators use factors from several different regulation methods to create their water regulation. The unique Danish regulation coincides with recent trends/thoughts that
economic theory in regulation needs to be supplemented with practical solutions or unique arrangements (Jamasb and Pollitt 2000).