Incentives in Regulatory DEA Models with Discretionary Outputs: The Case of Danish Water Regulation

Data Envelopment Analysis (DEA) based cost norms are widely used to regulate natural monopolies like water, electricity, and gas networks. In the typical application, demand is considered fixed and non-controllable (non-discretionary), and the challenge is to incentivize the monopoly to provide the demanded services at the lowest possible costs. In this paper, we investigate the incentives of a DEA based regulation when some of the demand dimensions, the cost drivers, can, in fact, be controlled by the monopoly. In such cases, the classical DEA based regulation may lead to suboptimal incentives. Specifically, we examine both analytically and numerically the impacts of including a discretionary quality indicator in the benchmarking model used to regulate Danish water firms. We show that the catch-up period allowed in this regulation gives strong incentives to reduce costs since the firms can keep possible cost reductions for several years before the cost norm fully internalizes the cost reduction potentials. However, on the other hand, this scheme also provides weak quality incentives since it takes several years before the extra cost of increasing quality is fully internalized in the cost norm.