Persistent and transient productive inefficiency in a regulated industry: electricity distribution in New Zealand

The productive efficiency of a firm can be decomposed into two parts, one persistent and one transient. So far, most of the cost efficiency studies estimated frontier models that provide either the transient or the persistent part of productive efficiency. This distinction seems to be appealing also for regulators. During the last decades, public utilities such as water and electricity have witnessed a wave of regulatory reforms aimed at improving efficiency through incentive regulation. Most of these regulation schemes use benchmarking, namely measuring companies' efficiency and rewarding them accordingly. The purpose of this study is to assess the level of persistent and transient efficiency in an electricity sector and to investigate their implications under price cap regulation. Using a theoretical model, we show that an imperfectly informed regulator may not disentangle the two parts of the cost efficiency; therefore, they may fail in setting optimal efficiency targets. The introduction of minimum quality standards may not offer a valid solution. To provide evidence we use data on 28 New Zealand electricity distribution companies between 1996 and 2011. We estimate a total cost function using three stochastic frontier models for panel data. We start with the random effects model (RE) proposed by Pitt and Lee (1981) that provides information on the persistent part of the cost effciency. Then, we apply the true random effects model (TRE) proposed by Greene (2005a, 2005b) that provides information on the transient part. Finally, we use the generalized true random effects model (GTRE) that allows for the simultaneous estimation of both transient and persistent efficiency. We find weak evidence that persistent efficiency is associated to higher quality, and wrong efficiency targets are associated to lower quality compliance.