Regulatory efficiency decomposition for utilities’ parallel subsystems

Abstract

Natural monopolies, such as the utility industry, are usually a regulated sector. Prices and tariffs are generally established by considering a benchmark analysis, such as data envelopment analysis, and are based on utilities observed data. Such analysis, by defining a regulatory efficient frontier that should be pursued by economic regulated companies, benchmarks best practices, and stimulates utilities to operate in an efficient manner, so that, tariff may be reduced by cutting off allowed expenditure of inefficient utilities. In general, regulatory efficient frontier is estimated based on observed costs and services by considering the whole utility as a decision making unit. In practical operations, however, utilities may run numerous parallel individual subunits, known as subsidiaries. Although the regulator generally cannot observe individual subsidiary costs and services, managers might want to know the optimal strategy to deal with efficient costs of each one, i.e., how an eventual expenditure cut off might be fairly allocated among subsidiaries. For such a strategy, this paper proposes a data envelopment based analysis that considers the internal structure of an analyzed utility. Considering that the utility runs homogeneous parallel subsystems, the proposed approach allows the decomposition of utility efficiency score onto its subsidiaries. Indeed, the proposed model is a relaxed approach of another model previously proposed in the literature. It considers the subsidiaries as parallel subsystems, so that managers can fairly allocate the eventual cut off in their subsidiaries. To shed light on the proposed analysis, this paper uses didactic and illustrative examples.