The Estimation of an Average Cost Frontier to Calculate Benchmark Tariffs for Electricity Distribution

In this paper we have examined the scale and cost inefficiency of a sample of Swiss electricity distribution utilities. To do so, we have considered estimation of a stochastic frontier average cost model using the approach suggested by Schmidt and Sickles (1984) for panel data. A translog cost function was estimated using panel data for a sample of 30 municipal utilities over the period 1992-1996. The results indicate the existence of economies of output and customer density and economies of scale. Moreover, the findings on cost inefficiency show that a majority of the distribution utilities is not producing at the minimum level of the cost and that a possible application of the frontier methodology employed in this paper relates to the regulation and benchmarking of the delivery rates. Introduction The privatization and the deregulation of the electric power sector were introduced in many countries, including England, Norway, Chile and New Zealand. In Switzerland, as in other European countries, several proposals exist to institute changes in the electricity market and therefore move to competition. All these proposals contain as a central element of the reform the introduction of Third Party Access (TPA). With the introduction of TPA, the electricity distribution utilities are obliged to allow nondiscriminatory access to all companies that wish to send electricity over the utility’s transmission and distribution lines for sale at the final consumer level. This open access must be accompanied by clear and specific tariffs for the transmission and distribution services, which implies a functional unbundling. As a result, the distribution utilities at the local level, which are the object of our study, must separate their different functions: the delivery of electricity and the retail sale of electricity. With the introduction of TPA, an unbundled distribution utility should charge itself the same rate for distribution that it charges other electric utilities that want to utilize its distribution lines. Because the electricity distribution utilities will still have a monopoly franchise to deliver electricity within their services territories, a rate regulation by the regulatory commission is necessary. Otherwise, the distribution utilities could raise the rates above what they would be in a competitive market. This raises the problem of determining proper rates for the delivery of electricity at the local level. In Switzerland there exists a proposal that suggests setting the rates for the delivery of electricity so that they equal the average distribution cost measured in Swiss francs per kWh. According this proposal, therefore, each distribution utility should set the delivery rate at the level of the own average cost.