Pergamon PIh S0957-1787(97)00009-X UtilitiesPolicy, Vol. 6, No. 4, pp. 293-301, 1997 © 1997 ElsevierScience Ltd. All rights reserved Printed in Great Britain 0957-1787/97 $17.00+ 0.00 Regulation through comparative performance evaluation Kirsty Powell* and Stefan Szymanskit Ofwat used comparative performance regulation in the 1994 periodic review of prices. We consider such a regulatory mechanism when there are technological spillovers. The regulator cannot observe firms effort and must design a regulatory contract which induces the socially optimal level of cost reduction. The extent to which cost reducing activities are non-appropriable is shown to affect the optimal choice of regulation. In general, comparative performance regulation is optimal and yardstick competition emerges only as a special case. However, when spillovers are spread evenly across an industry, an optimal comparative regime does not exist. © 1997 Elsevier Science Ltd. All rights reserved Keywords: regulation; spillovers;yardstickcompetition Introduction Dissatisfaction with the traditional cost of service regulation has generated enormous interest in the design of regulatory mechanisms in recent years, at both a practical and theoretical level. Attention in the literature has focused on theoretically optimal solutions to specific problems, usually involving information constraints. For examples see Baron and Myerson (1982), Demski and Sappington (1984), Laffont and Tirole (1986), Schma- lansee (1989), Sibley (1989), Holmstrom and Milgrom (1990), and Lockwood (1995). A variety of practical regulatory mechanisms and their implications for welfare have also been presented. For example, Glaister (1987) illustrates regulation through an output related profit tax, Sappington and Sibley (1988) introduce the notion of an incremental surplus subsidy, Braetigam and Panzar (1993) examine the impact of changing from rate of return to price cap regulation, while analysis of the The authors are with the Management School, Imperial College of Science, Technologyand Medicine, 53 Prince's Gate, Exhibition Road, London, SW7 2PG, UK. * Tel: 0171 594 9144, Fax: 0171 823 7685, e-mail:k.powell@ic.ac.uk t Tel: 0171 594 9107, Fax: 0171 823 7685, email: s.szymanski@ic.a- c.uk properties of price caps and sliding scale (or profit sharing) regulation has been presented by Burns et al. (1995) and Mayer and Vickers (1995). One of the more important theoretical insights, referred to as yardstick competition, is due to Shleifer (1985) who proposed that regulating a firm's price by setting it equal to some function of the realised cost of similar firms in its industry can produce socially efficient outcomes. This idea was adopted during the privatisation process and in the development of the regulatory regime for the water industry. ~ The Office of Water Services (OFWAT), the economic regulator of the UK water industry, refer to yardstick competition as comparative performance evaluation. A type of comparative perform- ance analysis was used during the price cap setting process at the first full review of prices since privatisa- tion in 1989. 2 Essentially, price caps for individual firms for the next ten years were set on the basis of comparative efficiency analysis in both operating and capital expenditure. This method of setting price deter- minations largely on the basis of historical costs is different from the theoretical yardstick scheme in that the regulatory contract is based on ex ante cost realisations rather than ex post cost realisations. Nonetheless, the underlying principle of this hybrid price cap and yardstick regime is regulation through comparative performance evaluation. This paper develops a simple model of regulation through comparative performance evaluation. The price function employed allows the regulator to set a firm's price based on a combination of its own efficiency submissions and on a judgement of the relative efficiency of its rival firms, which closely mirrors Ofwat's price setting methodology. The key insight of the paper 3 is that the optimal form of regulation depends on the extent to which the benefits of cost reducing activities, such as R&D, are appropriable by the firm, and the extent to which they 'spillover' to other firms. In general, we show that comparative performance regulation is optimal, while yardstick competition in the sense of Shleifer (1985), emerges as a special case. We also show that where the benefits of cost reducing activities accrue 293