1. Frontier Economics Limited 150 Holborn London, EC1N 2NS The Frontier Economics Network Boston  Cologne  London  Melbourne www.frontier-economics.com The application of quality of service data to regulatory proceedings Phil Burns 17 May 2003

2. 2 Overview lEmerging regulatory themes lHow does quality fit into the regulatory framework? lKey issues for operators

3. 3 Emerging regulatory themes lAcross Europe there is a growing emphasis on incentive-based regulation of state, municipal and privately owned firms lRegulators are increasingly focused on ensuring that: m Strong incentives for cost reduction does not diminish service quality; and/or m Companies are provided with incentives to improve service quality m Relative quality performance is taken into account when comparing relative cost performance through benchmarking lSince there is no commonly agreed treatment of quality in incentive-based regimes, both regulators and companies need to develop the regime that best suits the specific policy and economic environment

4. 4 Incentives to maintain and improve service quality lRegulators often want to provide companies with incentives not only to achieve an efficient level of cost, but also to provide an appropriate level of quality. lThey can either deal with quality within the price control or establish a separate quality regime, which must however, be consistent with the price regime in order to provide balanced incentives lWhatever the approach, the same broad questions arise: m What should be the structure of the marginal payment scheme for quality performance? m Should targets be set on an firm-specific or comparative basis? m What should be the level of the marginal payment and the target level of quality?

5. 5 The effect of different incentive structures Higher quality Lower quality Marginal cost of quality for Company A Marginal cost of quality for Company B Marginal cost Quality Incentive scheme Y Q A,Y Incentive scheme Z QBQB Q A,Z A constant payment rate will encourage the operator to find the level of quality where the marginal cost and payment are equalised A stepped payment rate (in extreme, revocation of the operating licence if quality falls too low) will tend to encourage operators to converge on the ‘acceptable’ quality level

6. 6 Absolute or relative targets lRelative targets on quality might appear attractive as it removes the need for the regulator to set ex ante targets lBut awarding a prize for the best relative performance can provide perverse incentives m Firms may put in excessive effort and end up delivering too much quality m Firms might give up on quality as they have no chance of winning the prize lA comparative scheme for both inputs (costs) and outputs (quality) is likely to result in confused incentive effects and the possibility of perverse outcomes

7. 7 Payment levels and the target level lThe achieved level of quality will be sensitive to the level of the marginal payment lThe distribution of payments between the company and customers/regulator will be sensitive to the level of quality at which the target is set lThe values of each are not known with any great certainty. Therefore, regulators tend to proceed with care to ensure either that quality does not become inadequate or excessive, and that large quality payments do not flow between operators and customers

8. 8 Evolution of the IIP in Britain lThe existing IIP (Information and Incentives Project) quality mechanism is similar in nature to the generic marginal fines/rewards scheme m With a cap and collar m Marginal rewards/fines differ by company m Rewards/fines not calibrated to reflect social benefit of quality m Targets based upon firm-specific information on the number and duration of interruptions, not relative information (except for telephone response times) lOver time, Ofgem will gather more information and gain more experience from initial experiences of the IIP to allow it to be fine tuned in the future

9. 9 Key issues for operators lIncorporating a quality regime into a regulatory framework is a strategic issue. It defines the operator’s: m Investment and operating behaviour m Attitude to quality of service m Incentives to improve efficiency m Status in the political and social environment lAll of the instruments in a quality regime are therefore of significant importance to the operator: m The level and structure of the implicit and explicit payments m The target level of quality m The basis for uprating targets and payments m The integration of the regime within the price control system lThe operator can develop its business strategy by determining the quality regime that meets its requirements, and using this as a basis for a dialogue with the regulator

10. 10 Frontier Economics Limited in Europe is a member of the Frontier Economics network, which consists of three separate companies based in Europe (London & Cologne), Melbourne and Boston. The companies are each independently owned, and legal commitments entered into by any one company do not impose any obligations on other companies in the network. All views expressed in this document are the views of Frontier Economics Limited.