Discussion Papers

Marcus Stronzik

Revenue Cap vs. Yardstick Competition: Incentives to Invest and Innovate

No. 379 / September 2013

(full version only available in German)

Summary

In 2010, the German government announced a new energy concept targeted at less carbon emissions, the promotion of renewable energy sources and energy efficiency measures as well as the phase-out of nuclear power until 2022. Against the background of the current discussions regarding the implications of the shift in German energy policy for energy networks (especially the need for high investments in electricity grids) we analysed the differences of two forms of incentive regulations, revenue cap and yardstick competition, with regard to investment and innovation incentives. The main difference of these two forms of network regulation is the exogeneity of the cost base, which determines the allowed revenues of network operators. Pure exogeneity means that the cost base cannot be influenced by the regulated firm. The starting point under a revenue cap are the individual costs of the regulated operator, whereas yardsticking rests on the average costs of comparable network operators others than the regulated one. Thus, revenue caps are characterised by mostly endogenous costs, whereas the cost base under yardstick competition is mainly exogenous.

From a theoretical point of view, yardstick competition provides better investment and innovation incentives than revenue caps because of the exogenous cost base. Besides the avoidance of the well-known ratchet effect caused by cost endogeneity, yardsticking with purely exogenous costs allows the investor to keep all informational rents and thus safeguards high investment incentives. Furthermore, up- and downside risks are treated symmetrically, which avoids distortive effects. The latter cannot be guaranteed by revenue caps. On the other hand, due to longer regulatory periods revenue caps provide more stable framework conditions. However, this can be compensated by granting higher cost of capital that take into account higher revenue risks associated with yardsticking. This corresponds with the fact that yardstick competition is usually much closer to real world competition than cap approaches.

Theoretical considerations are substantiated by two different international examples of yardstick competition. Norway and The Netherlands have switched from a cap regulation to yardsticking for electricity networks in 2007. Afterwards, network investments have increased substantially in both countries.

Regarding Germany, the current regulatory framework of revenue caps for energy networks provides a sound basis for switching to yardstick competition. Due to the high number of regulated network operators, a DEA-based approach developed by Agrell et al. (2005) may fit best. Because of the expected investment requirements the implemented and the revenue cap accompanying quality of service regulation (electricity) and the investment measures (a kind of investment budget) may be preserved as they are well suited to promote network investments. Other features of the current regime (e.g. the special treatment of small operators) are problematic under a new framework of yardsticking and might be abandoned.

Discussion Paper is available for download.

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