Department of Business and Economics
Regulating Local Monopolies in Electricity Transmission: A Real-world Application of the StoNED Method

Abstract:
The Finnish electricity market has a competitive energy generation market and a monopolistic transmission system. To regulate the local monopoly power of network operators, the government regulator uses frontier estimation methods (e.g., Stochastic Frontier Analysis (SFA) and nonparametric Data Envelopment Analysis (DEA)) to identify excessive transmission costs, taking into account outputs and the operating environment. We describe the new regulatory system developed for the Finnish regulator, which is based on the method Stochastic Non-smooth Envelopment of Data (StoNED) and utilizes panel data to detect the excessive costs from random noise.

The literature of productive efficiency analysis is divided into two main branches: the parametric SFA and nonparametric DEA. StoNED is a new frontier estimation framework that combines the virtues of both DEA and SFA in a unified approach to frontier analysis. StoNED follows the SFA approach by including a stochastic component. In contrast to SFA, however, the proposed method does not make any prior assumptions about the functional form of the production function. In that respect, StoNED is similar to DEA, and only imposes free disposability, convexity, and some returns to scale specification.
The main advantage of the StoNED approach to the parametric SFA approach is the independence of the ad hoc parametric assumptions about the functional form of the production function (or cost/distance functions). In contrast to the flexible functional forms, one can impose monotonicity, concavity and homogeneity constraints without sacrificing the flexibility of the regression function. Additionally, the main advantage of StoNED to the nonparametric DEA approach is robustness to outliers, data errors, and other stochastic noise in the data. In DEA the frontier is spanned by a relatively small number of efficient firms, however, in our method all observations influence the shape of the frontier. Also many standard tools from parametric regression such as goodness of fit statistics and statistical tests are directly applicable in our approach. This is collaborate work with Timo Kuosmanen of the Business School at Aalto University.