Unobserved Heterogeneous Effects in the Cost Efficiency Analysis of Electricity Distribution Systems

Agrell, Per Joakim [UCL] Farsi, Mehdi [Faculty of Economics and Business, University of Neuchatel] Filippini, Massimo [Department of Economics, University of Lugano] Koller, Martin [Department of Management, Technology and Economics, ETH Zurich]

The purpose of this study is to analyze the potential effects of unobserved heterogeneity on the cost efficiency measurement of electricity distribution systems within the framework of incentive regulation schemes such as price- or revenue cap. In particular, we decompose the benchmarking process into two steps: In the first step, we attempt to identify classes of distribution system operators functioning in similar environments and with comparable network and structural characteristics. For this purpose, we apply a latent class model. In the second step, best practice is obtained within each class, based on deterministic and stochastic frontier models. The results show that the decomposition of the benchmarking process into two steps and the consideration of technology classes can reduce the unobserved heterogeneity within classes, hence, reducing the unexplained variation that could be mis-specified as inefficiency.