Quality frontier of electricity distribution: Supply security, best practices, and underground cabling in Finland

- Cost regulation may create adverse incentives to lower the service quality.
- We model the frontier of service quality using a semi-nonparametric approach.
- Our nonparametric frontier accounts for stochastic noise and heteroscedasticity.
- We estimate how underground cabling and location affect interruption costs.
- We compare our quality frontier with the current quality regulation in Finland.

Electricity distribution is a prime example of local monopoly. In most countries, the costs of electricity distribution operators are regulated by the government. However, the cost regulation may create adverse incentives to compromise the quality of service. To avoid this, cost regulation is often amended with quality incentives. This study applies theory and methods of productivity analysis to model the frontier of service quality. A semi-nonparametric estimation method is developed, which does not assume any particular functional form for the quality frontier, but can accommodate stochastic noise and heteroscedasticity. The empirical part of our paper examines how underground cabling and location affect the interruption costs. As expected, higher proportion of underground cabling decreases the level of interruption costs. The effects of cabling and location on the variance of performance are also considered. Especially the location is found to be a significant source of heteroscedasticity in the interruption costs. Finally, the proposed quality frontier benchmark is compared to the current practice of Finnish regulation system. The proposed quality frontier is found to provide more meaningful and stable basis for setting quality targets than the average practice benchmarks currently in use.