Estimating the marginal cost of quality improvements: The case of the UK electricity distribution companies

The main aim of this paper is to develop an econometric approach to the estimation of marginal costs of improving quality of service. Estimating marginal costs of quality can help energy regulators to design more effective incentive mechanisms for network utilities to achieve optimal quality levels and reduce welfare losses due to sub-optimal quality. We implement this methodology by way of applying it to the case of the UK electricity distribution networks. The proposed method allows us to measure the welfare effect of the observed quality improvements in the UK between 1995 and 2003. Our results suggest that the regulatory incentives to reduce service interruptions have not been strong enough to achieve economically efficient levels of service quality. We, find that the incentives to encourage utilities to reduce network energy losses have led to to performance improvement. We estimate that the observed improvements in quality during the period of the study only represented about 20% of the potential customer welfare gains, hence leaving considerable scope for further economically efficient improvements in service quality.

► We show how to estimate the marginal cost of quality. ► We show that regulatory incentives affect firm performance. ► We show how to measure welfare gains from the improving quality.