Conditional Yardstick Competition in Energy Regulation

Yardstick competition is a regulation regime that forces local monopolies to compete against a variable cost or total cost benchmark. The variable cost benchmark ignores the fixed capital, creating a strong incentive to over-invest, whereas the total cost benchmark assumes all costs to be variable, ignoring the investment risk. We propose theoretical, methodological, and operational advances to increase applicability of yardstick competition in energy regulation. In the proposed conditional yardstick regime capital is treated as a fixed input, and the local monopolies compete against the variable cost conditional on the fixed input. We develop a benchmarking method that can handle multiple outputs, heterogeneity, and shape constraints to ensure incentive compatibility. We discuss the real-world application of the proposed regime to the Finnish electricity distribution firms in 2016-2023. We argue that smarter regulation of network industries can contribute to lower risk premiums and help to achieve win-win solutions both in terms of reliability and affordability.