developing marginal cost-based rates kelly eakin senior vice president christensen associates energy...
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Developing MarginalCost-Based Rates
Kelly EakinSenior Vice President
Christensen Associates Energy Consulting
APPA Business and Financial ConferenceAustin, TX
September 25, 2007
September 2007 2 CA Energy Consulting
Objectives of Presentation
Provide a framework to evaluate social gains from marginal cost pricing and address the challenge of fixed cost recovery
Identify key determinants to marginal cost pricing gains
Look for ways to incorporate pricing efficiency principles into cost of service analysis
September 2007 3 CA Energy Consulting
Business Objectives
Revenue Sufficiency
Maximizing stakeholder value
September 2007 4 CA Energy Consulting
Outline
Economics Basics The Regulatory Dilemma Incorporating Marginal Cost Pricing
Principles into Cost of Service Analysis A Simple Stylized Example Conclusions
September 2007 6 CA Energy Consulting
Demand
Consumers are willing to pay for a good because it brings them some benefit or satisfaction
As more of a good is consumed, the additional or marginal benefit decreases (law of diminishing returns)
Consequently, the consumer’s willingness to pay for another unit of a good decreases as consumption increases
Law of Demand: Consumers will buy more of a good a lower prices, other things the same
Price Elasticity of Demand: — A measure of customer price responsiveness
— εD = % change in quantity demanded ÷ % change in price
September 2007 7 CA Energy Consulting
The Demand Curve
Price
QuantityDemanded
D = marginal benefit
P1
P2
Q1 Q2
September 2007 8 CA Energy Consulting
Costs
Costs reflect the “supply side” of a market For goods to come to market, a supplier
needs to expect at least to recover (variable) costs
September 2007 9 CA Energy Consulting
Cost Measures (1)
Total Costs— Variable Cost – costs associated with the
inputs that change as production levels change— Fixed Cost – costs that remain the same
regardless of the production level, sometimes called “sunk costs” (e.g., capital costs)
— Total Cost = Variable Cost + Fixed Cost or TC=VC+FC
September 2007 10 CA Energy Consulting
Cost Measures (2)
Average Cost Concepts— Average Variable Cost (AVC)
• Variable cost per unit of output: AVC=TVC/Q— Average Fixed Cost (AFC)
• Fixed cost per unit of output: AFC/Q• AFC decreases as output increases (spreading out the
overhead)— Average Total Cost (ATC)
• Cost per unit of output: • ATC = TC/Q• ATC = AVC +AFC
The utility industry term “average embedded cost” corresponds closely to the economic term average total cost
September 2007 11 CA Energy Consulting
Cost Measures (3)
Marginal Cost (MC)— Marginal cost measures how cost changes as
an additional unit of output is produced— MC = ∆TC/∆Q = ∆TVC/∆Q — Marginal cost is the supply schedule for a
competitive profit-maximizing firm— A supply schedule is more ambiguous if there
is a lack of competition or the firm is not a profit maximizer
September 2007 12 CA Energy Consulting
Cost Measures (4)
Fixed Costs— Common cost—overhead costs that occurs
regardless of product lines offered, production levels or customer classes served
— Class-specific fixed cost—costs that do not vary with production levels but that are avoidable if a customer class is not served
— Product-specific fixed cost—costs that do not vary with production levels but that are avoidable if a product line is not produced
— Fixed cost recovery can introduce price distortion and resulting social value loss (called economic inefficiency)
September 2007 13 CA Energy Consulting
Cost Measures (5)
Incremental Cost (ICi)— Incremental cost indicates the additional cost of
adding a product line or serving another customer class
— Subtle differences from marginal cost• Discrete change instead of incremental change
• May involve some product/class specific fixed (but avoidable) costs
• ICi = TC – TC without Qi = TC – TC(~ Qi)
Average Incremental Cost (AICi)— AICi = ICi/Qi
— Important concept in investigating cross-subsidies
September 2007 14 CA Energy Consulting
Cost Concepts (6)
Finally, pulling in some cost of service concepts— Attributable costs (or directly assigned costs) are those
costs that can be assigned as “caused” by serving a customer class• Variable costs • Class-specific fixed costs• Product-specific fixed costs for products serving only one
customer class— Non-attributable costs—those costs that occur
regardless of whether a particular customer class is served• Common costs• Product-specific fixed costs for products serving all customer
classes
September 2007 15 CA Energy Consulting
Cross-Subsidization
Charging some more than attributable cost so that others pay less than their attributable cost
Different criteria for cross-subsidization— Price vs. Average Total Cost— Price vs. Average Variable Cost— Price vs. Marginal Cost— Price vs. Average Incremental Cost
Cross-subsidization involves — Inefficiency— Fairness issue
September 2007 16 CA Energy Consulting
Cross-Subsidization
Pi < AICi — Revenue from class less than its incremental cost— Serving the class adds to the overhead contribution required from
other classes— Other classes would pay less if this class were not served— The class is receiving a cross-subsidy from other classes
Pi = AICi — Revenue just covers incremental cost but class makes no
contribution to overhead— No impact on other classes— No cross-subsidy
Pi > AICi — Revenue from class more than its incremental cost— the class makes a contribution to overhead— Other classes would pay more if this class were not served— No cross-subsidy
September 2007 17 CA Energy Consulting
Economic Efficiency
Economic efficiency occurs when resources are used in a way that generates the greatest economic value
Price = Marginal Cost is the efficiency condition— P > MC too little produced; additional value would
exceed additional cost— P < MC too much produced; additional cost of last
unit more than offsets additional value— P=MC maximum net benefit; no way to reallocate
resources to increase economic value
September 2007 18 CA Energy Consulting
The Efficiency of Competition
P
q
Firm
ATCMC
P
Q = nq
D = MB
S = MC
Industry
September 2007 19 CA Energy Consulting
The Efficiency and Fairness of Competition
Efficiency— P = MC → economic output distributed to consumers in a
manner that achieves the greatest economic value— MC = ATC → production is allocated among producers so that
total production cost is minimized
Fairness— P = ATC → producers just break even covering their variable
costs and earning a fair rate of return on capital investment; also called earning “normal profit” of “zero economic profit”
— This condition is the result of no barriers to entry or exit
The result of individuals pursuing self-interest, but the outcome is as if an “invisible hand” of a benevolent planner allocated the resources
September 2007 22 CA Energy Consulting
Alas, competition and efficiency may not prevail
Industry might not be competitive— Barriers to entry— Large economies of scale
Firms might not be profit-maximizers— Public power has stakeholders rather than shareholders— Other non-profit organizations have objectives other
than maximizing profit Revenue adequacy still a requirement, but
efficiency may not be a result
September 2007 23 CA Energy Consulting
Natural Monopoly
Economies of scale exist if average cost decreases as a firm’s production increases
A natural monopoly has economies of scale over a large range of production relative to market demand— One firm can produce market output at a lower
total cost than can two or more firms— Often have large overhead costs resulting from
heavy capital investment (i.e., capital intensive industries)
— Often involve basic needs such as water, electricity
September 2007 25 CA Energy Consulting
Rationale for Regulation
Promoting competition is inefficient in a natural monopoly situation— Instead rate regulation is the policy
prescription— Called public utility regulation— Trying to achieve competitive-type (invisible
hand) outcomes via regulation
September 2007 26 CA Energy Consulting
The Not-So Invisible Hand of Regulation
Intervenor Discovery
File Case
Company Presents
Witnesses
Staff & Intervenors
Prefile Testimony
Company Files Rebuttal
Cross Examination on Rebuttal
Submission of Briefs
Commission Decision
Commission Order
Staff & Intervenors
Present Witnesses
>>
>
>
“Cost-of-Service” Study
September 2007 27 CA Energy Consulting
The Natural Monopoly Dilemma
A natural monopoly presents the regulator with a dilemma— Left unregulated, the monopolist could charge
high prices resulting in inefficiency and a transfer of wealth from customers to the monopolist
— Setting P=MC results in efficiency but insufficient revenues
— Set P=ATC collects sufficient revenues but is inefficient
— Issue becomes more complex with multiple products and customer classes
September 2007 28 CA Energy Consulting
The Natural Monopoly Dilemma: P=MC is efficient but revenue inadequate
$
Q
ATC
MCD
ATC
P
Q*
Losses
September 2007 29 CA Energy Consulting
The Natural Monopoly Dilemma: P=ATC collects enough revenue but is inefficient
$
Q
ATC
MCD
P = ATC
Q*Q
Efficiency Loss
September 2007 30 CA Energy Consulting
“Solutions” to the Pricing Dilemma
Simple markup pricing— Absolute markup: raise prices above marginal
costs by the same amount to all classes — Proportional markup: raise prices above
marginal costs by the same percent to all classes
September 2007 31 CA Energy Consulting
“Solutions” to the Pricing Dilemma (2)
Differential markup pricing — Raise prices above marginal costs by different
percentages to different classes— Ramsey Pricing raises prices differentially to
minimize inefficiency• Price inverse to the elasticity of demand
• Same pattern as what a monopolist would do, only to lesser magnitude
September 2007 32 CA Energy Consulting
“Solutions” to the Pricing Dilemma (3)
Non-linear pricing— Collect some fixed costs via a non-volumetric
charge (i.e., not per kWh or per kW)— If all fixed costs were collected non-
volumetrically, then per unit charge could be set at marginal cost
September 2007 33 CA Energy Consulting
Incorporating Marginal Cost Pricing Principles into Cost of Service Analysis Cost
of Service Basics
September 2007 34 CA Energy Consulting
Why investigate cost of service?
Improve understanding of the business Help with rate design Requirement for rate case
September 2007 35 CA Energy Consulting
Basic Steps for a Traditional Cost of Service Study
Determine the Overall Revenue Requirement Establish the customer classes Attribute the attributable costs Allocate the non-attributable costs Set rates to achieve the revenue requirements
September 2007 36 CA Energy Consulting
A Modified Approach: Marginal Cost-Based Cost of Service
Determine the Overall Revenue Requirement Establish the customer classes Attribute the attributable costs Set preliminary prices at marginal costs Conduct preliminary cross-subsidy analysis Mark up prices to subsidized classes to eliminate
cross-subsidies Calculate revenue insufficiency Mark up prices to all classes to achieve revenue
requirement Introduce revenue-neutral non-linear pricing to
improve pricing efficiency
September 2007 37 CA Energy Consulting
Challenges of the New Approach
Estimating the marginal costs— Costly to make numerous unbundled marginal cost
estimates• Estimating marginal costs of ancillary services, transmission
and distribution services is not trivial• Nevertheless, these marginal costs should be understood for
business reasons beyond cost-of-service studies Incorporating demand response into cost of service
analysis— Essential for the pursuit of efficiency— Not a comparative disadvantage vis à vis traditional
approach Attributable costs may be a small fraction of total
costs
September 2007 38 CA Energy Consulting
Advantages of a Marginal Cost-BasedCost-of-Service Approach
Based on principles of economic efficiency Knowledge of marginal cost has many
useful business purposes separate of a cost-of-service study
Less arbitrary allocation of costs May decrease the extent of cross-
subsidization
September 2007 40 CA Energy Consulting
Three Customer Classes
Customers Additional
Sites
Average Customer Annual Usage (kWH)
Residential 1,000,000 0 10,000
Commercial 50,000 10,000 100,000
Industrial 1,000 0 1,000,000
September 2007 41 CA Energy Consulting
Marginal Costs(Assuming constant marginal cost)
Customers(annual)
AdditionalSites (annual)
Energy($/kWH)
Residential $ 100 $ - $ 0.10
Commercial $ 1,000 $ 500 $ 0.06
Industrial $ 5,000 $ - $ 0.04
September 2007 42 CA Energy Consulting
Cost Structure(Millions)
Fixed Costs
Customer Cost
Extra Site Costs
Energy Cost TOTAL
Common Cost $ 400 $ - $ - $ - $ 400
Residential $ 80 $ 100 $ - $1,000 $1,180
Commercial $ 15 $ 50 $ 5 $ 300 $ 370
Industrial $ 5 $ 5 $ - $ 40 $ 50
TOTAL $ 500 $ 155 $ 5 $1,340 $2,000
September 2007 43 CA Energy Consulting
Approaches to Allocating Common Cost
Method A: Divide total fixed costs by total usage— Ignores that some fixed costs are attributable— Ignores that marginal costs differ across classes— Allocation implicitly achieved by charging same price
per kWh across all classes Method B: Assign attributable fixed costs and
allocate common cost on a per kWh basis Method C: Assign attributable fixed costs and
allocate common cost according to shares of attributable costs
September 2007 44 CA Energy Consulting
Alternative Allocations of Common Cost
Method A Method B Method C
Residential $ 70 $ 250 $ 295
Commercial $ 255 $ 125 $ 93
Industrial $ 75 $ 25 $ 13
TOTAL $ 400 $ 400 $ 400
September 2007 45 CA Energy Consulting
Cost Recovery Through Energy Pricing Only
($/kWh)
Method A Method B Method C
Residential $ 0.125 $ 0.143 $ 0.148
Commercial $ 0.125 $ 0.099 $ 0.093
Industrial $ 0.125 $ 0.075 $ 0.063
September 2007 46 CA Energy Consulting
Incorporating Demand Response
Assume the following price elasticities of demand (εD)
εD
Residential: -0.05
Commercial: -0.10
Industrial: -0.20
* Also assuming linear demand curve and using Method B prices and stipulated usage as the reference point
September 2007 47 CA Energy Consulting
Recall the Efficiency Loss Triangle from Pricing Away from Marginal Cost
$
Q
ATC
MCD
P = ATC
Q*Q
Efficiency Loss
September 2007 48 CA Energy Consulting
Economic Efficiency Analysis
The efficiency loss or deadweight loss (DWL) in each market can be approximated asDWL ≈ -½ εD (Q/P) (P-MC)2
Pricing inefficiency requires both— Price differing from marginal cost— Existence of price responsiveness (εD≠0)
Determinants of the magnitude of value loss— Amount of fixed cost to be recovered— Size of the price distortion— Marginal cost— Price responsiveness
September 2007 49 CA Energy Consulting
Efficiency Loss from Markup Pricing(Millions)
Method A Method B Method C
Residential $ 1.09 $ 3.23 $ 3.94
Commercial $ 10.67 $ 3.84 $ 2.67
Industrial $ 9.63 $ 1.63 $ 0.68
TOTAL $ 21.40 $ 8.71 $ 7.29
September 2007 50 CA Energy Consulting
Efficiency Loss as a Percentage of Class Revenue
Method A Method B Method C
Residential 0.09% 0.23% 0.27%
Commercial 1.71% 0.78% 0.58%
Industrial 7.71% 2.18% 1.08%
TOTAL 1.07% 0.44% 0.36%
September 2007 51 CA Energy Consulting
Non-linear Marginal Cost PricesMonthly Customer Charge
Monthly Additional Site Charge
Energy Charge ($/kWh)
Residential
Method A $ 20.83 $ 0.10
Method B $ 35.83 $ 0.10
Method C $ 39.58 $ 0.10
Commercial
Method A $ 533.33 $ 41.67 $ 0.06
Method B $ 316.67 $ 41.67 $ 0.06
Method C $ 262.50 $ 41.67 $ 0.06
Industrial
Method A $ 7,083.33 $ 0.04
Method B $ 2,916.67 $ 0.04
Method C $ 1,875.00 $ 0.04
September 2007 52 CA Energy Consulting
Non-linear Marginal Cost Prices
The price schedules listed in the preceding table are all economically efficient
The fixed charges are rolled into the customer charge
The customer charge may be too steep to for some customers within a class
— For those classes can reduce the customer charge and increase the energy charge
— Use the marginal cost pricing as starting point for adjustment
— Inefficiency introduced by raising the energy charge might not be great for very inelastic demand
September 2007 54 CA Energy Consulting
Foundation of a Foundation
Cost of Service analysis provides a necessary foundation for a rate case or rate setting
Marginal cost pricing principles provide a foundation for the COS foundation
— Structurally sound: revenue recovery without cross-subsidies
— Level: achieve competitive-type efficiency— Earthquake proof: framework that allows easy and
appropriate response to competitive threats and other market dynamics
September 2007 55 CA Energy Consulting
Summary
Marginal cost pricing principles and cost-of-service objectives are compatible
Simultaneous pursuit of revenue sufficiency and maximum stakeholder value
Recovery of fixed cost is the big challenge Recovery of fixed cost via fixed charges the most
efficient High fixed charges may not be feasible for some
customer classes
September 2007 56 CA Energy Consulting
Summary
Being diligent on figuring out all variable costs reduces the fixed cost recovery burden
Getting prices aligned with marginal cost is more important for classes with greater price responsiveness, which also tend to be the competitive at-risk customers
Foundation of a Foundation
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