Estimation of Long Run Capacity Costs

1. Estimation of Long Run Capacity Costs Gas TCMF 26th April 2006

2. Aims • To clarify different approaches that can be used for pricing capacity • Long run marginal costs (LRMCs) and incremental costs (LRICs) • Why different approaches can be taken and their implications • Supply and demand assumptions • To explain current approaches for entry/exit capacity pricing • To set out potential options for consideration

3. For a small (marginal) change in capacity, the marginal cost at Q approximates the gradient of the cost curve at Q The price of capacity at the level Q is based on the marginal cost at Q Long run costs assume that investment can be made to accommodate a change in capacity (c.f. short run costs = no investment made) Estimation of Long Run Marginal Costs (LRMCs) Cost gradient at Q ~ y/x = marginal cost change in Cost y x Small change in Quantity = marginal increment Q Quantity (Capacity)

4. Estimation of Unit Incremental Costs (LRICs) • In general, y/x no longer approximates the gradient of the cost curve at Q • The interpretation given to y/x is a unit incremental cost of moving from the capacity level Q to the new capacity level • The LRIC does not represent the price at the new capacity level • LRIC based prices will signal costs of providing additional capacity Cost y/x = incremental cost change in Cost y x Large change in Quantity Q Quantity (Capacity)

5. LRMCs at Different Capacity Levels • LRMCs at Q1 and Q2 are used to set prices for capacity levels of Q1 and Q2respectively • The same marginal increment is used in calculating each LRMC • Prices generated will signal costs of maintaininga higher capacity level = forecast future LRMCs • The change in total cost can be also be estimated Cost change in Cost marginal increment marginal increment Large change in Quantity Q1 Q2 Quantity (Capacity)

6. Marginal Costs (LRMCs) Generates the route costs of capacity Targets costs of maintaining a given capacity level at Users requiring that capacity Represents the price for a given capacity level Unit Incremental Costs (LRICs) Generates the route costs of moving to an increased capacity level Targets investment costs at Users, but not necessarily only those requesting additional capacity Represents the average price over the increment in capacity Marginal Costs and Unit Incremental CostsWhy are they applied?

7. Marginal Costs (LRMCs) Easier to understand? Can be modelled using a single Pricing model Implicit assumption that investment has been made to generate the required capacity level Costs can be targeted at Users by ensuring commitment model/economic test recovers appropriate revenues Unit Incremental Costs (LRICs) More difficult to understand how price schedules calculated Requires more sophisticated modelling for larger increments Implicit assumption that investment needs to be made to generate the required capacity level Post-investment marginal costs may reduce significantly due to economies of scale Marginal Costs and Unit Incremental CostsImplications

8. Marginal Costs (LRMCs) Currently only applied for administered exit capacity charges Single “central” supply/demand case used with small increment to generate entry-exit route costs An option could be to define supply substitution/load absorption rules to generate realistic multiple base cases to reflect large changes in capacity level Unit Incremental Costs (LRICs) Currently provides basis for entry UCAs and entry capacity reserve prices Single “central” supply/demand case used with varying increments to generate entry-exit route costs An option could be to remove the indivisible increment assumption to generate more appropriate results i.e. calculate total system reinforcement costs rather than route costs Marginal Costs and Unit Incremental Costs Supply and Demand Assumptions

9. Where are long run costs used (and why)?Current assumptions

10. Where are long run costs used (and why)?Current assumptions

11. Where are long run costs used (and why)?Current assumptions

12. Where are long run costs used (and why)?Current assumptions

13. Where are long run costs used (and why)?Current assumptions

14. Where are long run costs used (and why)?Current costing assumptions

15. Gas TCMF - Areas for Review

16. Alternative approach (1): Decoupling UCAs and LRIC based incremental capacity prices * Could be based on price schedules or a single price

17. Alternative approach (2): Decoupling UCAs and System LRIC for Entry incremental prices

18. Alternative approach (3): Decoupling UCAs and LRMC based incremental capacity prices * Assumes investment has been made, could be based on price schedules or a single price