Developing Marginal Cost-Based Rates

1. Developing MarginalCost-Based Rates Kelly Eakin Senior Vice President Christensen Associates Energy Consulting APPA Business and Financial Conference Austin, TX September 25, 2007

2. 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

3. Business Objectives • Revenue Sufficiency • Maximizing stakeholder value

4. Outline • Economics Basics • The Regulatory Dilemma • Incorporating Marginal Cost Pricing Principles into Cost of Service Analysis • A Simple Stylized Example • Conclusions

5. Economics Basics

6. 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

7. The Demand Curve Price P1 P2 D = marginal benefit Q1 Q2 QuantityDemanded

8. 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

9. 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

10. 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

11. 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

12. 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)

13. 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

14. 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

15. 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

16. 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

17. 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

18. The Efficiency of Competition Firm Industry MC ATC S = MC P P D = MB q Q = nq

19. 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

20. The Invisible Hand

21. The Regulatory Dilemma

22. 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

23. 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

24. Natural Monopoly $ ATC MC D Q

25. 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

26. The Not-So Invisible Hand of Regulation > “Cost-of-Service” Study Intervenor Discovery > Staff & Intervenors Prefile Testimony Staff & Intervenors Present Witnesses Company Presents Witnesses File Case Company Files Rebuttal Commission Order Commission Decision Submission of Briefs Cross Examination on Rebuttal > >

27. 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

28. The Natural Monopoly Dilemma: P=MC is efficient but revenue inadequate $ ATC ATC Losses P MC D Q Q*

29. The Natural Monopoly Dilemma: P=ATC collects enough revenue but is inefficient $ Efficiency Loss ATC P = ATC MC D Q Q* Q

30. “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

31. “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

32. “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

33. Incorporating Marginal Cost Pricing Principles into Cost of Service Analysis Cost of Service Basics

34. Why investigate cost of service? • Improve understanding of the business • Help with rate design • Requirement for rate case

35. 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

36. 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

37. 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

38. 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

39. Simple Stylized Example

40. Three Customer Classes

41. Marginal Costs(Assuming constant marginal cost)

42. Cost Structure(Millions)

43. 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

44. Alternative Allocations of Common Cost

45. Cost Recovery Through Energy Pricing Only($/kWh)

46. 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

47. Recall the Efficiency Loss Triangle from Pricing Away from Marginal Cost $ Efficiency Loss ATC P = ATC MC D Q Q* Q

48. Economic Efficiency Analysis • The efficiency loss or deadweight loss (DWL) in each market can be approximated as DWL ≈ -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

49. Efficiency Loss from Markup Pricing(Millions)

50. Efficiency Loss as a Percentage of Class Revenue