Aligning Quality Incentives and Tariff Adjustments: The Case of the Brazilian Electricity Distribution Sector

Abstract This study investigates the role of aligning tariff adjustments and quality incentives in a Price cap regulatory regime. According to theory costs and quality are positively related. If additional resources are needed to improve service quality, a high cost high quality utility could be at a disadvantage when tariffs are adjusted by an X-factor that does not include quality. The regulator of the electricity distribution sector of Brazil has set up a public ranking of utilities according to quality compliance at the same time that a quality component is added to the X-factor, in 2013. We develop a stochastic cost frontier integrating all components of the X-factor to rank the utilities based on this integrated efficiency. Comparing this rank with the regulator’s public rank we argue that the resulting differences highlight the importance of using the same factors to rank and adjust tariffs in the sector. Otherwise, incentives would be misplaced with respect to factors used in cost adjustments. In addition, our findings reveal that the utilities’ cost behavior with respect to quality depends on the volume of energy delivered. We believe these results could be considered by the regulator when setting incentives and considering factors to adjust tariffs.