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The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished.

Regulation is an information problem. In this paper we show that benchmarking can have an important role to play in extracting information and providing efficiency incentives. However, the effectiveness of this role depends both on the credibility of the regulator to undertake a comparative efficiency analysis, and the impact of the benchmarking on the value of the firm. These are both affected by the policy framework within which the regulator operates. In Britain the regulator is not obliged to undertake any benchmarking, and the impact of the benchmarking that has been undertaken has been relatively low. These conditions have the effect of diminishing incentives for both information provision by the companies and model developments by the regulator. In the Netherlands, the impact on business value is high because benchmarking sets the price differentials from which a yardstick competition model – required by law – is implemented. These twin conditions of high credibility and high impact on value both sharpen incentives for the businesses to reveal information at the time of the benchmarking and also provide a stimulus for the regulator to properly account for firm-specific effects. In Austria, where similar conditions to the Netherlands have been established, we described the regulator's attempts to improve the robustness of the cost drivers in the model.

This chapter examines the challenges of the energy-only market, in particular with increasing shares of (subsidized) renewable plant capacity, and considers the circumstances under which intervention in the form of a capacity market may be appropriate. The ‘energy-only’ market, which rewards power plants (and demand-side response providers) for the MWh they produce, is the bedrock of EU internal electricity market design. It can, in principle, ensure the right balance between the additional cost of capacity and reliability of electricity supplies. However, its ability to do so rests in large part on investors in capacity being able to trust that they will be able to profit from high wholesale prices during times of scarcity. In practice, several market failures, compounded by policy and regulatory uncertainty, may prevent this from happening, resulting in less than the optimal level of reliability being delivered. These concerns have led several EU Member States to provide additional remuneration via capacity mechanisms, to ensure the optimal level of reliability. These have predominantly been used to support existing fossil fuel and hydro generation capacity. However, as the electricity sector transitions towards Net Zero, designs will need to adapt to accommodate other forms of capacity, including RES, demand-side response, and new forms of storage.