The role of benchmarking for yardstick competition

With the increasing interest in yardstick regulation, there is a need to understand the most appropriate method for realigning tariffs at the outset. Benchmarking is the tool used for such realignment and is therefore a necessary first-step in the implementation of yardstick competition. A number of concerns have been raised about the application of benchmarking, making some practitioners reluctant to move towards yardstick based regimes. We assess five of the key concerns often discussed and find that, in general, these are not as great as perceived. The assessment is based on economic principles and experiences with applying benchmarking to regulated sectors, e.g. in the electricity and water industries in the UK, The Netherlands, Austria and Germany in recent years. The aim is to demonstrate that clarity on the role of benchmarking reduces the concern about its application in different regulatory regimes. We find that benchmarking can be used in regulatory settlements, although the range of possible benchmarking approaches that are appropriate will be small for any individual regulatory question. Benchmarking is feasible as total cost measures and environmental factors are better defined in practice than is commonly appreciated and collusion is unlikely to occur in environments with more than 2 or 3 firms (where shareholders have a role in monitoring and rewarding performance). Furthermore, any concern about companies under-recovering costs is a matter to be determined through the regulatory settlement and does not affect the case for using benchmarking as part of that settlement.