Cost efficiency analysis of electricity distribution networks: Application of the StoNED method in the Finnish regulatory model

Electricity distribution network is a prime example of a natural local monopoly. In many countries, electricity distribution firms are regulated by the government. In Finland, the regulator estimates the efficient cost frontier using the data envelopment analysis (DEA) and stochastic frontier analysis (SFA) methods. This paper reports the main results of the research project commissioned by the Finnish regulator for further development of the efficiency estimation in their regulatory model. The key objectives of the project were to integrate a stochastic SFA-style noise term to the nonparametric, axiomatic DEA-style cost frontier, and take into account the heterogeneity of firms and their operating environments. To estimate the resulting stochastic semi-parametric cost frontier model, a new method called stochastic nonparametric envelopment of data (StoNED) is proposed. Based on the insights obtained in the empirical analysis using real data of the regulated networks, replacing the currently used DEA and SFA methods by the StoNED method is recommended.