Many consumers may sigh when looking at their electricity bill because the share of electricity transmission and distribution in the final sum of the bill may seem unreasonably high. However, tariffs might be even higher without the incentive scheme developed by researchers and Finnish Energy Authority, which promotes the efficient operation of electricity transmission companies.
‘It is challenging to build and maintain a reliable electricity distribution network in a sparsely-populated country like Finland with very demanding environmental conditions, and naturally, it costs something’ says Timo Kuosmanen, Professor of Business Mathematics and Statistics.
‘We have, nevertheless, succeeded in keeping our electricity transmission and distribution tariffs at a low level by European standards and in fact, the average electricity distribution tariffs paid by our households are the lowest in the Nordic countries.’
Keeping electricity transmission costs under control has required systematic development and cooperation that researchers of the Aalto University School of Business and have engaged in with the Finnish Energy Authority since the 1990s. The development work has been exceptional, as the same group of researchers has managed to take the advances they have made in basic research areas such as mathematics and statistics into applied research in energy economics, and to further apply them to support policy decisions with great significance for society as a whole.
‘We have developed an incentive scheme that forces local monopolies to compete in a virtual market place in terms of costs and reliability of service. An electricity transmission company can increase its profit if it operates with lower costs than its peers. In this way, the method creates an incentive for monopoly companies to operate cost-effectively. The Finnish Energy Authority has applied our latest method in the regulation of electricity distribution firms since 2016’, Timo Kuosmanen says.
Building an electricity grid is very expensive, and consequently, it is a textbook example of a natural monopoly. In Finland, there are currently about 80 local monopolies in electricity distribution. In addition, legislation updated in 2013 requires strengthening of the electricity transmission grid in order to secure the availability of electricity under exceptional conditions, such as Finland's winter storms. As public finances are scarce, the funding of a weatherproof electricity grid requires private investment.
‘Private investors need guarantees of a reasonable return on equity, but blatant profiteering in provision of a critical service such as the distribution of electricity should be prevented. The incentive scheme that we have developed is an important tool in this’, Timo Kuosmanen notes.
Development of the incentive scheme has taken several years, during which the Energy Authority and the electricity distribution companies have faced each other in court. However, the court cases have also proven to be useful.
‘The court cases drew attention to clear needs for improvement in the statistical models that our incentive system utilized, and the researchers successfully responded to those needs. Therefore, the court cases helped to speed up the development of incentive regulation into its current form’, Timo Kuosmanen points out.
The regime developed in Finland is also attracting international interest, because digitalisation and adapting to climate change require strengthening of the distribution networks in different parts of the world.
‘Finland's incentive system can be directly used as a model for other European countries where incentive regulation is currently at a similar stage as ours used to be some 10 - 15 years ago. In other regions such as South American countries, high transmission fees and poor reliability of supply also raise pressure to update the incentive schemes, Timo Kuosmanen says.
Another indication of international influence is that a study recently published by the University of Turku shows that Timo Kuosmanen, with his publications, is the most internationally visible Finnish professor in the specialised fields of business economics. Last year Kuosmanen was invited as a keynote speaker to several international congresses, and in late May and early June his research group presented the latest results of their research at the world congress of the International Association for Energy Economics in Montreal.
Information on the publication:
Kuosmanen T. (2018) Conditional Yardstick Competition. Technical Report, version 2.0.
Link to the publication
Other publications on the topic:
Kuosmanen, T. (2012) Stochastic semi-nonparametric frontier estimation of electricity distribution networks: Application of the StoNED method in the Finnish regulatory model, Energy Economics 34(6), 2189-2199.
Kuosmanen, T., A. Saastamoinen, T. Sipiläinen (2013) What is the best practice for benchmark regulation of electricity distribution? Comparison of DEA, SFA and StoNED methods, Energy Policy 61, 740-750.
Saastamoinen, A., T. Kuosmanen (2016) Quality frontier of electricity distribution: Supply security, best practices, and underground cabling in Finland, Energy Economics 53, 281-292.
Professor of Management Science
Aalto University School of Business
tel. +358 40 353 8393