policy on energy pricing

Policy on energy pricing

Michael G. Webb

The pricing of particular fuels, such as electricity, gas and oil, should be considered in terms of the development of pricing policies for the energy sector as a whole. The pursuit of an eff icient al location of resources will require that energy prices are related to their marginal costs. This simple prescription may have to be modified to a l low for the achievement of other objectives, such as prof i tabi l i ty and income distr ibution.

The author is Senior Research Fellow at the Institute of Social and Economic Research, University of York, Heslington, York, Y01 5DD, UK.

Energy pricing policy is concerned with a number of interrelated questions: What should be the relationship between the price of gas and the price of electricity? How should the energy market be divided between coal, gas, electricity and oil? At what rate should a resource such as natural gas be depleted? To what extent should energy prices be used to achieve income distribution objectives?

Clearly questions such as these can only be answered in the context of a specific choice criterion which permits ranking on a scale of better and worse the consequences of different pricing policies. They can only be answered in a specific institutional setting, which will define the environment within which energy pricing decisions have to be taken and any constraints which may exist on the freedom of choice - for example, whether the energy industries are in the public sector or in the private sector but subject to regulatory control.

This paper is basically concerned with some economic principles of energy pricing in a market type economy in which there is consumer sovereignty. Thus resources will be allocated via the production processes in line with the preference of consumers as revealed by their purchases of goods and services. Prices play the crucial role of coordinating instruments in this allocative process.

Objectives

Pricing policies are concerned with both the level and structure of tariffs. Traditionally in most countries both of these aspects have been judged in terms of a utility's financial performance. However, while financial effects are important, from the national point of view there are other effects which should be considered.

The choice of pricing policy for any particular fuel will depend on the objective(s) and constraints of the supplying utility. The efficient allocation of resources between the different energy industries will require that they all pursue a common set of objectives. These objectives should be consistent with national objectives, which will be concerned with both the allocation of resources within the energy sector and between that sector and other sectors of the economy.

Clearly it is not possible to generalize about the relevant set of objectives - each nation must take its own decisions. But the discussion of pricing policies cannot proceed in the absence of the specification in an operational way of objectives. For purposes of analysis and discussion the following three objectives will be considered:

ENERGY POLICY March 1978 53


1 Cost is defined in the economist 's sense of opportunity cost. Since resources are scarce, to use them for one purpose precludes their use in alternate ways. The cost of using resources in any one way is the best alternative use which is thereby foregone. The measure of cost in terms of foregone alternatives is called opportunity cost. 2The UK government introduced a system of financial targets for the control of the nationalized industries in a White Paper, The Financial and Economic Obligations of the Nationalised Industries, Cmnd 1337, HMSO, London, 1961. During the period 1971-74 the financial target policy was largely abandoned as the government used the pricing policies of the nationalized industries as a control variable in an attempt to reduce the rate of inflation. This policy was abandoned in late 1974, since not only were the resulting relatively low prices increasing the demand for capital by the nationalized industries, but also the resulting financial deficits were causing problems for the management of the money supply. 3 The essential difference between general and partial equilibrium analysis is that while the former deals explicitly with the interrelationships between the various sectors of an economy, the latter considers one sector in isolation on the assumption that the interrelationships between it and other sectors are sufficiently small to be ignored. 4 R. Turvey, Economic Analysis andPublic Enterprises, Allen and Unwin, London, 1971.

• economic efficiency in the allocation of resources; • achievement of financial targets; • the meeting of income distribution aims.

Economic efficiency This objective is concerned with the allocation of a nation's resources between all their possible uses. An allocation would be said to be efficient if it was impossible to reallocate resources so as to make some consumers better off (in their own judgment on the assumption of consumer sovereignty) without making others worse off. In broad terms this objective requires that the price which a consumer pays for an extra unit of a good (which measures its value to him) should equal the cost consequences to the energy industry and nation of supplying that unit (the incremental or marginal cost). 1 The price mechanism is used to signal to consumers the resource cost consequences of their consumption decisions.

With this objective, different tariffs should be judged in terms of the quality of the resource cost information which they convey to consumers, while allowing for any associated costs of implementation and administration.

One of the principal problems associated with this objective concerns the measurement of 'cost'.

Financial targets When the energy industries are in the public sector the fiscal impact of their proposed tariffs will concern government. Their gross trading surpluses may be an important source of government revenue, and this may be given official recognition in the setting of financial targets. 2

Fairness This aspect of pricing policies is concerned with questions of income distribution and the relative treatment of different consumers or consumer groups. Many governments are concerned to redistribute income towards the relatively poor. The question is to what extent are the pricing policies for energy an appropriate instrument for achieving this objective?

Marginal cost pricing The recommendation that energy prices should be related to their marginal costs in pursuit of economic efficiency can be derived from economic models which are formulated in either general or partial equilibrium terms. 3 As is well known, however, this derivation depends on some very restrictive and possibly unreal assumptions about the world. When the models are reworked using more realistic assumptions, the simple prescription that the efficiency objective can be achieved if all energy prices are set equal to their marginal costs has to be replaced by a number of, sometimes, very complicated pricing rules. However, the purpose of most of these rules is to determine how energy prices should deviate from their marginal costs when, for example, some other prices in the economy are not set equal to marginal costs. 4 This suggests that a workable approach to determining the set of energy prices given the efficiency objective is first to calculate the relevant set of marginal costs, and second to consider how prices based

54 ENERGY POLICY March 1978


on these costs may need to be adjusted in the light of various distortions existing within the economy and for the attainment of other objectives.

Ideally, marginal cost is a measure of the value of the extra resources required to produce another unit of output. It is a money measure of the value of the output sacrificed elsewhere by producing another unit of the good. In terms of the efficiency objective the general assumption is that if the price which a consumer is willing to pay for another unit exceeds the value of the extra resources required to produce it, then the allocation of resources will be improved if that unit is produced, and vice versa. The consumer's purchase decision is then based upon a consideration of relative resource costs.

If the set of energy prices is based on their marginal costs, then they will inform consumers which forms of energy can be used to satisfy their demands at relatively low resource costs and which forms can only do this at a relatively high resource cost.

Tariffs based on marginal costs are concerned with the resource commitments required to meet an increase in demand, are forward looking, and related to forecasts. This is in contrast to tariffs which are based on average accounting costs, which are backward looking and related to historical measurements. The latter may bear little relation to the resources required to meet an increase in demand. For example, some of the accounting costs may relate to capital assets which are specific in use and have no alternative use value (sunk costs). In times of inflation, historic costs are also likely to understate current resource costs.

In practice, the relating of prices to marginal costs poses a number of difficult problems. These include problems of measurement of marginal costs, the choice of price structure when to have prices at all times equal to marginal costs would involve impossibly complicated tariffs (as in the supply of electricity and natural gas), and the measurement of marginal costs in integrated supply systems.

5Two goods may be said to be complements (motor cars and petrol, electric space heaters and electricity) if a fall in the price of one good leads to an increase in the demand for the other good. The goods would be substitutes if a fall in the price of one good led to a decrease in the demand for the other good (oil, natural gas, coal are substitute forms of energy).

Measures of marginal costs

One problem of measurement of marginal costs which it is important to dismiss at an early stage concerns its variation with the time period over which it is to be measured. In general the measure of marginal cost is different depending on whether it is measured for a short or long time period. There is a considerable literature in which economists debated the advantages and disadvantages of setting prices equal to either short- or long-run marginal costs. Many economists now agree that this discussion misses the essential point, which is that the period over which marginal cost should be measured should be determined by the length of the period to which the tariff will relate.

For the energy industries there are a number of arguments in favour of the period being relatively long, and measured in years rather than months. These include that frequent changes in the structure of tariffs are expensive to administer, and that it takes time for consumers to adjust to them. But more important consumers of energy partly base their investment decisions on energy-using complementary products 5 on their views of the expected future prices of the different forms of energy. Prices relating to the long period are those required for efficient investment decisions. (In times of inflation



s R. Turvey and D. Anderson, Electricity Economics, Johns Hopkins University Press, Baltimore and London, 1977, Chapter 13. 7 T.A. Boley and D.L. Walker, 'The effect of prices and economic growth on consumers' energy requirements', World Energy Conference Paper No 1.3-5, Detroit, 1974. 8 R. Turvey, Optimal Pricing and Investment in Electricity Supply, Allen and Unwin, London, 1968.

the ,level o f charges may have to be changed fairly frequently, but such changes should not alter the structure of the tariff, unless this is desired for some other reason). The relevant question is how the industry's total costs vary with changes in its out/rot during this chosen period.

Whatever time period is selected, the measurement of marginal costs in the energy industries will often be complex because their operations should be considered on a system basis. This is often clearest in the case of interconnected supply systems operated by electricity and gas utilities. In these cases the set of required marginal costs can be obtained from the system optimization model used for investment planning. 6

In the case of electricity, assuming an objective of meeting estimated system demand at least discounted cost, this model will rank inherited plants in any day in order of merit (determined with reference to the plant's marginal operating costs) and can be used to read off the system marginal operating cost once the precise timing of any demand increment for electricity is known. The investment problem is to choose that mix of plant with different cost characteristics, eg hydro, gas-fired, oil-fired, which will enable forecast demand to be met at least discounted cost. The solution to this problem will recognize the interdependence between the outputs of inherited and newly constructed capacity in any period, since the operating cost characteristics (mainly fuel cost) of the latter plant will affect the number or hours for which the former plant is operated each period. If an increment in demand for electricity threatened to infringe the security constraints and would require the construction of new capacity (an increase in peak demand), its associated marginal investment cost should be calculated by taking the difference between the present value system costs associated with the new demand forecast and the equivalent figure for the previous demand forecast. 7,s The marginal cost of an additional load at the peak is thus equal to the sum of this marginal investment cost, the incremental manning and maintenance costs, and the system incremental running costs at that time.

It is worth considering briefly the implication of the efficiency objective for the calculation of marginal generating costs in mixed hydro/thermal systems when the extra output would be produced by hydro capacity. In general it would not be correct to argue that since these stations have a zero fuel cost their marginal generation cost would be given by reference to their marginal manning and maintenance costs. Their marginal generation cost should be calculated with reference to the marginal value of the water which they use where, in the absence of any alternative uses for the water, this is valued in terms of the kilowatt hours which it could be used to generate. These figures can be obtained from the investment planning model. While it is not possible to generalize, the basic idea underlying the calculation of these figures can be explained by the use of two simple examples. First, if there is spare generating capacity and when the water was not used to generate electricity it would be spilled, then the marginal generation cost would be simply the hydro station's marginal operating cost. Second, if there is spare capacity and when the water was not used to generate electricity it would be stored in a reservoir to replace potential thermal output, then the relevant marginal generation cost is the marginal generation cost of this


9 In the second of these examples a p re requ is i te fo r the a p p r o p r i a t e calculation of the marginal cost of the hydro station is that the marginal cost of the thermal plant has been properly calculated. It is important to notice that market prices may not be the appropriate basis for this calculation. Since the justif ication for a tariff related to marginal costs is the promotion of a more efficient allocation of a nation's resources, it fol lows that the required price base is the one which measures the alternative use vaiue of the resources. Because of external effects such as pollution, of transfer payments such as taxes and subsidies, and of various governmental policies such as minimum wage laws and foreign exchange control, market prices may be poor indicators of resource costs. When this happens the estimates of marginal costs should be based upon estimates of what economists call shadow or accounting prices, which are calculated to provide a more accurate measure of resource costs. 'Shadow" prices are calculated to reflect the real costs of inputs and the real benefits of outputs to society. See I.M.D. Little and J.A. Mirrlees, Project Appraisal and Planning for Developing Countries, Heinemann Educational Books, London, 1974, and United Nations Industrial Development Organisation, Guidelines for Project Evaluation, United Nations, New York, 1972. ~o R.M. Solow, 'The economics of resources and the resources of economics', American Economic Review, Vol 64, 1974, pp 1-14. ~ D.W. Pearce, ed, The Economics of Natural Resource Depletion, Macmillan, London, 1975.


thermal plant plus the hydro station's marginal operating cost (the resources which would be saved if the unit was not produced). 9

Consider now the problem of calculating the marginal running cost of the thermal plant. For simplicity, assume that it can be fuelled with domestically supplied oil which has recently been found with zero extraction costs in quantities which are small in relation to the world supply of oil. As long as the oil has a positive value it would be worth exploiting because the present value of the benefits would exceed the present value of the costs. The relevant questions are how should the oil be valued and at what rate should it be exploited?

The principles involved in answering the former question are the same as those used to determine the marginal cost of the hydro station - the alternative use value of the oil must be calculated. Assume that the country being considered places no restrictions on foreign trade and that its foreign exchange rate is market determined. Let the alternative to using the oil domestically as an energy source be its export at the world market price, which may be determined by a cartel as at present. If this price is $12 a barrel, then although the extraction costs are zero, this would represent the cost (potential earnings foregone) of using a barrel to generate electricity in the thermal station. If we allow for restrictions on foreign trade this 'cost' could be greater than $12. For example, suppose that the government has imposed quotas on a number of imports because of a deficiency of export earnings, and that they could be relaxed if some of the oil was imported. The value to the consumers of a marginal relaxation of a quota restriction may well be considerably in excess of $12, and it would be their willingness to pay for the additional items which could be imported which would represent the 'cost' of using the oil domestically rather than exporting it. It follows that the border price of oil may be taken as a minimum measure of its cost to the thermal power station.

The second question of the optimal rate to deplete the oil resource is very complex. The answer will depend upon the values given to a number of variables, such as the expected future price of oil, the value which future generations will place on the oil if it is left in the ground, the size of discount rate, the future prices of substitute fuels, future movements in technology, and the country's attitude to uncertainty, which will influence its views on having an independent fuel supply. Clearly the desired rate of exploitation can only be determined once a view is taken on the desired intertemporal distribution of income, and this will be reflected in the size of the chosen discount rate. It is beyond the scope of this paper to enquire into the economics of the depletion rate decision, ~°,H although it is clearly interrelated with the price of any depletable stock of energy in any subperiod.

The problem of the pricing of other domestic deposits of energy, such as coal or natural gas, can be determined using the principles used in the oil example. In each case the alternative use value of the resource must be calculated and a decision taken on the optimal depletion rate.

Energy and environmental costs

The energy industries are frequently a significant source of pollution. In the USA thermal power stations discharge about 50% of all sulphur oxides, 25% of all nitrogen oxides, and 25% of all particulate



a Short-run (one year) elasticity.

b Long-run elasticity.

lz The own price elasticity of demand for a good is a measure of the responsiveness of changes in the demand for that good to (small) changes in its own price. The cross price elasticity of demand is a measure of the responsiveness of the demand for one product (eg gas) given a (small) change in the price of another product (eg oil). 13 p.j . Joskow and M.L. Baughman, "The future of the US nuclear energy industry', Bell Journal of Economics, Spring 1976. 14 It should be noted that elasticity values calculated for periods before the 1973 energy price rises and subsequent changes in the pattern of energy supplies probably have little relevance to the post- 1973 period. See Report of the Working Group on Energy Elasticitites, Energy Paper No 17, HMSO, London, 1977.

Table 1. Energy price elasticities for the USA (1968-72)

Residential Price Price Price of Price and commercial of gas of oil electricity of coal

Gas consumption SR a -0.1 5 0.01 0-01 na LR b -1.01 0-05 0-17 na

Oil consumption SR 0.04 --0.18 0.01 na LR 0.19 --1.12 0.16 na

Electricity consumption SR 0-05 0.01 --0.19 na LR 0.17 0.05 --1.00 na

Industrial Gas consumption SR -0 .07 0.01 0.03 0.01

LR --0.81 0.14 0.34 0.15 Oil consumption SR 0.06 --0.11 0.03 0.01

LR 0.75 --1.32 0.34 0-14 Electricity consumption SR 0.06 0.01 --0.11 0.01

LR 0.73 0.13 --1.28 0.14 Coal consumption SR 0.06 0.01 0.03 -0 -10

LR 0.75 0.14 0.33 -1 .14

matter. Coal-burning plants pose particular environmental hazards which are relatively well known. In contrast, the hazards associated with nuclear plants are relatively unknown. It is much easier (but still difficult) to calculate the environmental costs associated with coal- fired than with nuclear plants.

If marginal costs are to measure the cost to the nation of particular consumption decisions, they should be measured to include marginal environmental costs. At present, however, environmental damage costs are both difficult to estimate and to put in monetary terms which are generally acceptable.

In this context is the very important question of the effect on energy use of a change in the relative price of different fuels. In many markets different fuels are substitutes for each other, and a change in their relative prices as a result of a differential adjustment made to incorporate environmental costs will affect the demands made for them. Of particular interest is the possible change in the demands for relatively clean and dirty fuels (say natural gas and high sulphur oil) as a result of a change in their relative prices. This clearly requires information on cross price elasticities of demand. 12 A problem which is posed by comparison of the demands for clean and dirty fuels is that while electricity is a clean fuel at its usage level it is frequently a dirty fuel at production level, causing thermal pollution, visual disamenity, as well as the emission of SO2, particulate matter, etc.

Table 1 presents a recent set of price elasticities for the USA. 13 The estimates are averages for the different states. They were estimated using cross-section data for 49 states for the period 1968-72. =4 To interpret the table, consider the effect on the industrial demand for the different fuels of a 10% increase in the price of coal, so making coal relatively more expensive. In the short run this would lead to a 1% fall in demand for coal by industrial consumers and a rise of 0.1% in the consumption of each of gas, oil and electricity. In the long run, given the full adjustment of stocks of equipment, etc, to the new set of relative prices, there would be a more substantial set of changes. The demand for coal by these consumers would fall by about 11% while the demand for each of the other fuels would increase by about 1.4%.

This analysis brings out clearly the interdependence of the demands for the various fuels and the necessity to consider both the short- and long-run effects of a change in the price of any one fuel. While these


is M.G. Webb, Pricing Policies for Public Enterprises, Macmillan, London, 1976.


results tell us nothing about the situation in other countries, it would be surprising if the demand for the different fuels was not responsive to variations in their relative prices. Each government must decide to what extent it wants energy prices to reflect environmental costs.

Time differentiated tariffs

The demands for the products of the various energy industries typically vary over time. For the coal and oil industries, these variations can be accommodated by varying stock levels, since their outputs can be stored at economic cost levels. However, this is not generally the case with electricity, or to a lesser extent with natural gas. The demands for the products of these industries typically vary over the day, week and year, and it would be prohibitively expensive (if not impossible) to be continually adjusting output capacity to these fluctuating demands. If the products of these industries are regarded as being non-storable at economic cost levels then an implication is that (for given reserve plant margins) their capacity requirements will be a function of their expected system peak demands.

It follows that the resource costs of meeting an increment in demand will be different depending on:

• whether it can be met without violating the reserve capacity constraints, when it will involve only incremental system running costs;

• whether it will infringe the reserve capacity constraints and will require additional investment; the relevant measure of marginal costs will then relate to the sum of system incremental energy costs, incremental investment costs (in say generation and transmission) minus any associated fuel costs savings, and incremental manning costs.

These two cases are generally referred to as the off-peak and peak respectively. ~5 The incremental cost within each period in any particular supply system will not be unique. In an electricity supply system which has a mix of plants of different vintages and technical types, which are operated in merit order to enable demand per period to be met at least cost, the incremental system cost will vary with the precise timing of the increment in demand. In these circumstances there may be literally hundreds of marginal costs in any day, varying with the time, location and voltage level of the demand increment. Relevant questions are thus the extent to which these cost differences should be reflected in the tariffs of particular consumer groups, how the price within each part of a tariff which is to reflect these cost differences should be calculated, and how the uniform price should be calculated for those consumer groups for whom it is decided for one reason or another that time differentiated prices would be inappropriate.

The question of the extent to which tariffs should reflect cost differences given the efficiency objective depends largely on three factors: (a) the costs of implementing and administering time- differentiated tariffs with different numbers of subdivisions, and the most important item here will be the costs of meters with different numbers of dials and time switches; (b) the benefits derived from time- differentiated as compared with uniform tariffs; (c) (related to (b)) the ease with which consumers can understand and thus react to the cost



Source: R.A. Peddle, 'Peak lopping and load shaping of the CEGB's demand', Seventeenth Hunter Memorial Lecture, Institution of Electrical Engineers, London, 9 January 1975.

18 Domest ic Tariffs Exper iment , Load and Market Research Report No 21, The Electricity Council, London, 1975.

Table 2. Significant differences in load shapes for average December/January/February weekday on the CEGB supply system.

1960-61 load shape 1972-3 load Difference applied to 1972-3 shape energy requirements

Peak (MW) 41 700 37 000 4 700 Trough (MW) 15 000 21 400 6 400 Morning pickup (MW) 23 500 11 000 12 500

information contained in more complex tariffs. Items (b) and (c) are unlikely to be important at the bulk supply

level, and thus the design of bulk supply tariffs can concentrate on their incentive effects.

At the retail level, since the costs of multi-dial meters do not vary with the amount of a consumer's consumption, it follows that the larger the consumer the more likely is it that the incremental benefits of moving from single price to time-differentiated tariffs will exceed the incremental costs. There is likely to be a strong case for having such tariffs for the larger domestic consumers as well as for industrial and commercial consumers.

When determining the number of running rates to include in a tariff, account must be taken of its desired incentive effects. Predominant among these is the need to inform consumers when an increment in demand would involve the use of a relatively large quantity of resources and when it would involve relatively little. Whatever number is chosen (and three is a common one at the bulk supply level where metering costs are not a very important consideration, distinguishing 'peak', 'night' and 'day' units), it will be necessary to group together times within a season or year when load is at about the same level. Each of these load levels in effect constitutes a 'step' in the relevant load duration curve. The weighted average incremental generating cost must be calculated for each level.

Whether or not it is worthwhile changing consumers from simple to more complex tariffs cannot be answered in the abstract. Each case must be determined by considering the incremental metering and other administrative costs against the estimated resource cost savings. Empirical evidence from England and Wales suggests that even for fairly large domestic consumers (consumption of 3000 kWh a year or more) it is only for relatively simple time- differentiated tariffs (a 'day' and 'night' differential as with the White Meter tariff) that item (b) exceeds item (a).~6

Time-differentiated tariffs for electricity are used in a number of countries, including France, the UK, and Sweden. In France about 20% of domestic consumers are on time-of-day tariffs. In England and Wales in 1973-74 over 22% of all sales to domestic consumers were made under the terms of time-differentiated tariffs. The introduction of time-differentiated tariffs has had a substantial effect on the shape of the demand curve on the (UK) Central Electricity Generating Board's supply system. It has been estimated that between 1960-1 and 1972-3 the use of such tariffs led to an improvement in the average daily load factor on that system from 72% to 86%, and a reduction in the latter year of 4700 MW in the peak demand on the average winter weekday (see Table 2).


~ZNationalised Industries: A Review of Economic and Financial Objectives, Cmnd 3437, HMSO, London, 1967. 18 The Financia l and Economic Obligations of the Nationalised Industries, Cmnd 1347, HMSO, London, 1961.


In electricity supply, and to a lesser extent gas, there are likely to be so many marginal costs that a perfectly cost-reflecting tariff would be impossibly complicated. The objective is to design relatively simple tariffs which represent a close approximation to an industry's actual cost structure. The measurement of this set of marginal costs will require the use of specific industry cost models.

Financial targets

The investment programmes of public sector energy industries, the ways in which they are financed, and the size of their gross trading surpluses are all of fiscal concern to a government. It is not uncommon for concern with the gross trading surplus to manifest itself in the setting of financial targets, as has been the case in the UK since 1961. =7,~8 These may be expressed as a requirement to earn a particular rate of return on average assets, where both may be defined in either net or gross terms, or to require the industries to self-finance a particular proportion of their planned investment programmes, or to earn a particular cash surplus over direct operating costs per period, say per year.

There are a number of reasons for preferring targets which are expressed in terms of cash rather than particular levels of self- financing, especially if a common target self-financing ratio was to be set to a number of different industries. In general, the level of self- finance can be expected to vary with the rate of growth of a particular industry, being lower as the rate of growth is faster. When prices are set equal to marginal costs, the prices charged to peak consumers will cover the incremental investment costs of new capacity. If these prices are increased because of the imposition of a self-financing target, then in effect present day consumers would be paying for the capacity requirements of future consumers. A specific case should be made out to justify such a policy. If, alternatively, the target is expressed in cash terms, it should be viewed as a form of indirect taxation. This interpretation is consistent' with a government's fiscal concern with the size of a utility's gross trading surplus. 'The cash flow requirement laid upon the public enterprise is equivalent to a set of taxes upon its products. To impose no such requirement would thus be equivalent to selling them tax-free in a world where many other things have to be taxed quite heavily'. 4 The cash form of expression for the financial target will be assumed for the remainder of this section.

The basic question is how the pricing policies which have been designed to satisfy the efficiency objective can be changed to permit the realization of the financial targets while minimizing the resulting distortion to the allocation of resources. A related question concerns the way in which these targets should be allocated to individual industries. From the efficiency point of view is it better to set a target for the energy industries as a group and then to derive from this the individual industry targets, or to set the individual targets and then to calculate the implied financial surplus for the group of energy industries?

At the level of principle, and ignoring questions relating to the availability of information, these questions can be answered relatively simply. An allocation of resources for which all prices equal marginal costs will be referred to as one which maximizes welfare. The problem is then to revise the prices charged by individual fuel industries so as



19W.j. Baumol and D.F. Bradford, 'Optimal departures from marginal cost pricing', American Economic Review, June 1 970. 20 R. Rees, Public Enterprise Economics, Weidenfeld and Nicolson, London, 1976. 21 Thus different grades of coal are substitutes for each other, as are peak and off-peak supplies of electricity for uses such as water heating and space heating using storage heaters. z= The extra revenue would then be paid out of the consumers' consumer surpluses from the consumption of electricity.

to permit them to achieve financial targets while minimizing the resulting loss of welfare.

The essence of the answer to this problem can be gleaned from the following simple example. Assume that a financial target has been set to an electricity utility which is selling both peak and off-peak electricity. For simplicity assume that the demand curves for each of these products is independent of the other and that the marginal cost of producing an extra unit of either product is unaffected by variations in the output of the other product. Finally, assume that in the expected range of prices the demand for peak electricity is totally unresponsive to changes in its prices (price elasticity of demand equals zero) while the demand for off-peak electricity is perfectly responsive to changes in its price (price elasticity of demand equals infinity). In this case the whole of the financial target should be allocated to the consumers of peak electricity. Since their demand is totally unresponsive to changes in its price, implementation of this pricing policy will not change the allocation of resources (except at a second stage via associated income effects).

For the assumptions made, the conclusion to be drawn from this example is that the deviation of price from marginal cost should vary inversely with the own price elasticities of demand of the various products. ~9 One interpretation of this is that the financial target should be allocated to the different products produced by a multiproduct enterprise according to 'what the market will bear'. The welfare loss associated with the imposition of the financial target will be minimized when the marginal welfare loss per marginal dollar contribution towards the financial target is the same for all products. 2°

In reality, the various products of a particular fuel industry are often substitutes for each other and the demand curves are interdependent. E1 This means that the deviation of price from marginal cost must allow for both own and cross price elasticities. The essential condition given in the last sentence of the previous paragraph must still hold, although the measurement of the marginal dollar contribution associated with a change in the price of any one product must allow for both the direct and indirect effects on the enterprise's revenue.

Are the results of this analysis of any practical significance when reliable data may not be available on the values of own price and cross price elasticities? There are a number of reasons why the answer is 'yes'. First, the analysis identifies the type of information which is required if 'better' (in terms of the stated objectives) pricing policies are to be formulated. Second, in the absence of that information it indicates the types of rough adjustments that can reasonably be expected to minimize welfare losses. For example, it suggests that if an electricity utility is selling its output using two-part tariffs it would be preferable to change the standing charge rather than the unit charge. 22 Third, the analysis suggests that the prices should be increased in accordance with estimates of 'what the market will bear' - this is a concept which is probably familiar to those responsible for taking pricing decisions in energy industires. Fourth, the analysis shows that in general the correct response to the imposition of a financial target would not be to increase all product prices above their marginal costs by an equal absolute or proportional amount.

A simple extension of the preceding analysis allows us to answer the second question posed above. The financial targets for the



individual energy industries, given an aggregate target for the set of energy industries, should be determined so that the required surplus is raised with the resulting marginal welfare loss being equal for each of these industries. If this was not the case the individual targets could be changed so as to impose a smaller aggregate welfare loss. For example, suppose that the ratio of marginal welfare lost per marginal dollar of surplus produced for a given allocation of the financial targets was 3 units in the electricity industry and 2 units in the gas industry. A reduction in the target for electricity by $1 would increase welfare by 3 units, while an increase in the target for the gas industry by $1 would reduce welfare by only 2 units. Thus for the same aggregate surplus but a different subdivision, welfare would be 1 unit higher. Only when the marginal welfare losses per doltar of surplus produced were the same for all industries would it be impossible to increase the level of welfare by marginal reallocations of the targets among the various industries.

The practical significance of this is that the financial targets should be higher for those fuel industries which face relatively price inelastic demand curves and lower for industries with relatively price elastic demand curves. 23

2z Note that the problem of allocating financial targets to the individual fuel industries is a special case of the determination of the financial targets for all public sector industries given an aggregate financial target for all such enterprises. The efficient set of targets will be that one which equates the marginal welfare loss of each target to each individual enterprise. See R. Rees, Public Enterprise Economics, Weidenfeld and Nicolson, London, 1976. 24 For some empirical evidence related to the UK see Paying for Fuel, National Consumer Council Report No 2, HMSO, London, 1977. 2~ A free allowance scheme for electricity has been introduced in Ireland. Its use in the UK was rejected by the inter- departmental group of officials which produced the report Energy Tariffs and the Poor, UK Department of Energy, London, 1976. z~ This is the US terminology. 27 Inverted tariffs for electricity were introduced in Japan in 1974 and in California in 1975.

Income distribution

An important factor in energy pricing policies is the extent, if any, to which they should be used to achieve income distribution objectives. A decision must be taken on this question, either explicitly or implicitly, since all pricing policies are associated with particular distributions of income. The implicit assumption of the marginal cost pricing policy is that $1 of benefit or cost has the same value irrespective of who receives or pays it. However, a set of energy prices which are related to marginal costs and weighted against those demands which are relatively price inelastic to permit financial targets to be achieved may be judged as unacceptable in terms of their effects on the distribution of income. The increase in energy prices since 1973 has focused attention on this question in many countries because of their adverse effects on the budgets of low income consumers. 24

The response of some governments and observers to this situation has been to suggest (sometimes implicitly) that the energy industries should be treated as social services. There have been suggestions that low income consumers should receive a free allowance of, say, gas or electricity per period. 25 A more common suggestion has been that gas and electricity utilities should introduce what are known as inverted or lifeline 26 tariffs. These are tariffs in which there is no standing charge and in which the unit price is higher for large consumers than for small consumers. A simple form of such a tariff is to have an initial block of fuel (say 1500 kWh per quarter) priced below cost and to charge all additional units at that rate which is required to make the tariff self-financing. 27 Larger consumers would cross-subsidize smaller ones, and in effect would be paying an indirect tax on each unit of their consumption charged at the higher rate.

The redistributional success of such tariffs requires that the level of electricity and gas consumption should be a good index of a consumer's income. Empirical evidence from a number of countries



28Paying For Fuel, National Consumer Council Report No 2, HMSO, London, 1977. 29 J.W. Howe, 'Lifeline rates - benefits for whom?', Public UtlTities Fortnightly, Vol 97, No3, 1976, pp 22-25. 3o Unless the social welfare payments were financed through the imposition of lump sum taxes, the taxes raised to pay for them would introduce distortions into the price system. If income taxes were raised there could be adverse effects on the supply of work effort and on the willingness to take risks. Ideally the choice between alternative methods of achieving the desired distributional objectives should be in terms of a general equilibrium analysis and of a comparison of the welfare losses resulting from each of the possible redistributional policies. That policy option which achieved the desired result with the minimum loss of welfare (both direct in the industry concerned and indirect through the raising of taxes) would be preferred. 31 Goods satisfying merit wants could be provided by the market in accordance with consumers' effective demands. However, their consumption is considered so meritorious that action is taken through the public budget to increase their provision to above the level provided by the market and paid for by private consumers. 32 R.A. Musgrave, Fiscal Systems, Yale University Press, New Haven and London, 1969, p 12. 33 In some countries these policy options may not be available because of the absence of a well developed social security system - this is the case in many developing countries. The manipulation of energy prices may then be the best policy instrument which is available to achieve distributional objectives. 34 It is not only the increase in energy prices that has an adverse effect on the budgets of low income consumers. Is it proposed that whenever an increase in a product price would have such an effect that the price of the product to low income consumers should be kept down through a process of cross-subsidization ?

shows that this is not always the case and that the poor are often relatively large consumers of gas and electricity. 28,29

This evidence is also relevant to another, somewhat similar proposal that two part and declining block type tariffs should be replaced by uniform rate tariffs. 2s These are tariffs with no standing charge and under which every unit is sold at the same price. These tariffs also involve the cross-subsidization of smaller by larger consumers. A common feature of these schemes is that they involve the introduction of distortions into the price system (compared with the set of prices related to marginal costs which is derived with reference to the efficiency objective with a financial constraint), and they are also discriminatory in their treatment of large and small consumers.

By opting for schemes which involve subsidizing the energy consumption of small consumers, rather than granting them offsetting cash increases in social welfare payments 3° which they could spend how they liked, it could be argued that implicitly it is being assumed that when it comes to energy consumption consumers are not to be treated as being the best judges of their own welfare. Energy is viewed as a good, satisfying what economists refer to as a merit want, 31 the important feature of which is that individual choice is replaced by collective choice. The decision to subsidize the energy consumption of some consumers is ' . . . based on the proposition that the decision making group is capable of superior judgment .. ?32

In market type economies it is generally presumed that consumers do know what is best for them, and it follows that a special case should be made out (and widely accepted) for each good which is to be treated as satisfying a merit want. Can this case be convincingly made out for energy for any particular group of consumers in any particular country?

There could be a more ominous reason for legislators to prefer to try to redistribute income by manipulating energy prices rather than operating through the social security system. 33 This is that the set of indirect taxes on the consumption of large consumers would be hidden and the embodying price/tariff changes may not require the introduction of legislation. But this would mean that these taxes would not be subject to the same scrutiny or assessed against the same criteria as other taxes. This would then truly be a case of taxation without representation!

Compared with policies which tackle poverty at the root causes 34 by increasing old age pensions and the like, income redistribution policies based on the use of inverted tariffs etc suffer from the disadvantage that they are non-selective - it is difficult to limit the increases in real income to the target group (small consumers who are rich will also benefit) and they give large consumers an incentive to try and beat the system if the tariff changes apply to only some fuels. If the price changes were restricted to gas and electricity, with coal and oil prices being related to their marginal costs, then the change in relative prices would give large consumers an incentive to reduce their consumption of gas and electricity, which would bring them benefits as small consumers, and to increase their consumption of coal and oil which are now relatively cheaper. Since this adjustment may require consumers to acquire new appliances its effects on consumer choice may be relatively long term.

The adverse effects on the budgets of the poor of increased energy prices can be viewed as a symptom rather than a basic cause of


3s M.G. Webb, Memorandum on Gas and Electricity Prices, Gas and Electricity Prices, Select Commit tee on Nationalised Industries, HCP 353, Session 1975-76, Appendix 9, London.


poverty. If this problem is tackled through the manipulation of energy prices there is a danger that the underlying basic causes will be left untouched. My own preference is to deal with income distribution (at least in developed countries) through the adoption of appropriate social security policies, and to relate energy prices to the efficiency objective. 35

Some concluding comments

It has been argued in this paper that the set of relative prices in the energy subsector of the economy should be determined with reference to a common set of objectives for the individual energy industries. Assuming an objective of an efficient allocation of resources it was shown that these prices should be related to their marginal costs. The term 'related to' rather than 'equal to' was used to allow for the costs involved in implementing and administering complex tariffs, for the ease with which consumers can understand them, for the meeting of any financial targets which may be set these industries, and for any significant price distortions which might exist elsewhere in the economy.

In conditions of limited information, risk and uncertainty, the instruction to a multiproduct enterprise to relate its prices to marginal costs will not determine a unique tariff, with regard to either its level of charges or its structure. The precise form of the tariff will depend upon the judgment of the tariff maker. This will clearly make for difficulties for the implementation of any monitoring system which might accompany such a pricing instruction. Nevertheless, while there will always be room for argument it should be possible to determine whether prices are reasonably related to marginal costs. Simple tests of this may have to suffice, including whether the measures of costs are forward looking and based upon forecasts rather than backward looking and related to historic accounting costs.


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