Cost of Service: Traditional Approaches and Economic Alternatives

1. Cost of Service: Traditional Approaches and Economic Alternatives American Public Power Association Utility Education Course Seattle, Washington October 22-24, 2003 John Kelly, Director of Economics and Research American Public Power Association

2. Outline • Introduction/Overview • A Few Important Economic Ideas • Allocating Common Costs and Problems with Doing So • Applications to the Electric Utility Industry • The Recovery of Common/Overhead Costs • So What?

3. I. Introduction/Overview A. The Central Issue “The dominant issue is one of whether the pattern of [electric]rates should be based on tradition, inertia, and happenstance, or whether it is to be developed by careful weighing of the relevant factors with a view of guiding consumers to make efficient use of the facilities that are available.” Professor William Vickrey

4. I. (cont.) • Inconsistencies Inherent in Traditional Costing Practices • What Signals will Smart (Broadbanded) Homes Need to Work? • Costs “Actually” Impact Net Income • Theory v. Practice -- and the Circumference of the Earth • Insight v. Organization

5. A Few Important Economic Concepts • Competition, Effective Competition and Imperfect Markets • Economic Efficiency • Economic/Opportunity Costs • Inherent Costs v. Decision Costs • Investment Costs v. Operating Costs • From Short-Run and Long-Run Costs versus Decision Costs • Economic Goods & Commodities

6. (cont.) • Competition, Effective Competition and Imperfect Markets Some Formal Assumptions: • Large number of firms, each producing the same product; • Each firm attempts to maximize profits; • Each firm is a price taker; and • Transactions are costless, etc.

7. (cont.)Assumptions More Directly, Simply and Meaningfully Put: “… The central elements of competition [are] the freedom of traders to use their resources where they will, and exchange them for prices they wish…” George Stigler “[It] is rivalry in selling goods, in which each selling unit normally seeks maximum net revenue, under conditions such that the price or prices each seller can charge are effectively limited by the free option of the buyer to buy from a rival seller or sellers of what we think of ‘the same’ product, necessitating an effort by each seller to equal or exceed the attractiveness of the others’ offerings to a sufficient number of sellers to accomplish the end in view.” J.M. Clark

8. (cont.)Two Implications of Effective Competition • Price Taker • Pressure on Prices to Reflect Costs

9. (cont.) Competitive (good things) v. Imperfect Markets (& bad…)

10. (cont.) B. Economic Efficiency -- In Production & Pricing • Competition Drives Prices to Costs (& other good things) • Prices reflect Cost to Firms – and to Society • Result is Good Allocation of Resources

11. (cont.) • Economic/Opportunity Costs  1. Definitions of: • "The simple though far-reaching, observation that the true cost of any action can be measured by the value of the best alternative that must be foregone when the action is taken;" • The market value of the displaced product; • The expected value of the alternative product at the moment of decision, as estimated by the chooser; • Any one of a range of possibilities that must be foregone in order to select a preferred but mutually excluding alternative; • The value placed on the most attractive of several alternatives is the cost of a particular action (i.e., decision/choice); • The cost of any alternative chosen is the alternative that has been given up; where there is not alternative to a given experience – no choice – there is not economic problem; • The cost of doing anything consists of the [net] receipts which would have been obtained if that particular decision had not been taken.

12. (cont.) • Contrasted with Accounting Costs • Accounting costs typically reflect "out of pocket" expenses, historical costs, depreciation and other bookkeeping entries and are frequently averaged. • Economic costs are forward-looking, reflecting "variations that will result if a particular decision is taken, and the variations that are relevant to business decisions are those" that affect net income. (e.g., respective estimates of the cost of fossil fuels used to produce electricity.)

13. (cont.) D. Inherent Costs v. Decision Costs E. Investment Costs v. Operating Costs Investments in, and Forecasted “Prices” of, Mid-Range Hotels Hilton: 100 Garden Inns, 50,000 rooms at $65-$85 per night Choice: 10 Mainstay Suites costing $100 millions, rooms at $55-$65 per night Doubletree: 25,000 rooms converted to Club Hotels, rooms at $50-$70 per night USA Today, 26 Jan 96

14. (cont.) • From Short-Run and Long-Run Costs to Decision Costs • Economic Goods & Commodities Question: What is it in the nature of things that are daily exchanged on markets that gives rise to exchangeable value? • Consumers demand not just physical objects, but the qualities with which they are endowed; • It is the characteristics of the goods that potential purchasers first turn their attention; • Such characteristics form a gap between the ‘actual things’ which are exchanged in markets and their “want-satisfying” characteristics – which are the real subjects of demand. (Examples, from coal shipments to restaurant meals)

15. Allocating Common Costs and Problems with Doing So • Some Definitions: Common Cost: “Cost resulting from the use of raw materials, a facility (for example, plant or machines), or a service (for example, fire insurance), that benefits several products or department …” Overhead Cost: “Any cost not associated directly with the production or sale of identifiable goods and services.” Joint Costs : “Costs of simultaneously producing or otherwise acquiring two or more products … that must, by the nature of the process, be produced or acquired together, such as the cost of beef and hides of cattle.”

16. (cont.) Costs that "cannot be traced home and attributed to particular units of business in the same direct and obvious way in which, for example, leather can be traced to the shoes that are made from it." "Most of the real problems [of common cost] stem from the fact that an increase or decrease in output does not involve a proportionate increase or decrease in cost."

17. (cont.) • Some Problems: Wool Co. Mutton Total Cost: Sheep $400 $400 $800 Processing 100 300 400 Total $500 $700 $1,200

18. (cont.) Wool Co. Mutton Total Cost: Sheep ??? ??? $400 Processing 100 300 400  Total ??? ??? $800

19. (cont.) Method for Allocating Common CostFully Allocated CostProfit Wool MuttonWoolMutton Even Split $300 $500 $280 $280 Proportional PC 200 600 380 180 Proportional LC 180 620 400 160 Proportional Rev. 270 530 310 250

20. (cont.) Production Plan 1 Variable Output Cost AllocationAllocation Product A $26.13 $22.50 Product B $ 2.61 $13.50

21. (cont.) Production Plan 2 Variable Output Cost AllocationAllocation Product A $30.00 $21.00 Product B $ 3.00 $12.00

22. (cont.) Variable Cost Allocation Production Plan 1 Production Plan 2 Product A 26.13 30.00 Product B 2.61 3.00 Output Allocation Production Plan 1 Production Plan 2 Product A 22.50 21.00 Product B 13.50 12.00

23. (cont.) Box(es) 1 2 3 4 1+3 2+4 Black Chips 5 3 6 9 11 12 White Chips 6 4 3 5 9 9

24. (cont.) • Opposing Views on Problem of Common Costs Accounting Perspective: • “…General management must ensure that … data are reordered along the lines necessary for intelligent product/market management. • “Shared costs are a particularly difficult problem for most companies and difficult to attack as a lump sum. • “You must break [shared costs] down and assign them to discrete business units or product lines, even if it means being ‘arbitrary’ by some standard. • “Allocating all costs is the only way to know what is really going on.” C. Ames and J. Hlavacek Harvard Business Review, Jan.-Feb. 1990

25. (cont.) Economic Perspective: “Not all costs are relevant for every pricing decision.” Relevant costs are “those that actually determine the profit impact of the pricing decision.” “[Relevant costs] are … costs that are incremental (not average), avoidable (not sunk).” T. Nagle and R. Holden, The Strategy and Tactics of Pricing: A Guide To Profitable Decision Making, 1994

26. Application to Electric Utility Industry • Efficiency—Capacity Utilization • Each 8760 kWh a Different Economic Good • Do kWhs have Inherent Costs? • Investment Decisions Versus Operating Decisions

27. IV. (cont.) • Demand Charges: A Form of Fully Allocated Cost -- a Method to Allocate Common Costs and Price Discriminate Demand Charges were Adopted as a “Price-Discrimination” Mechanism in Order to Avoid Competition from “Isolated Plants” and Maximize Profits The “Profit-Maximizing” Rate Structure had to Track the Costs of the Competition – the Costs of Operating an Isolated Plant – Not the Utility’s Marginal Cost of Supply

28. (cont.) • Marginal Cost Pricing – A Working Definition • Short-Run Marginal Cost • Replacement Cost of Fossil Fuels • Usage of Equipment (Wear and Tear) • Short-Run Marginal Social Cost • Environmental Cost • Marginal Increment in Loss of Load Probability

29. V. Recovery of Common Costs • In Industries Subject to Some Competitive Pressures, Common Costs are Recovered through Proper Pricing -- Note: Public Power Systems Entering Broadband Markets • Distinguish – again – Investment versus Operating Decision

30. (cont.) • Relevant Marginal Cost is Market Price -- the "Short-Run Marginal Social Cost" -- in Markets that are Effectively Competitive In contrast, SRMC of firm is used for firm output decisions, for deciding whether it should be producing additional output to sell on market, and to be sure firm is at least charging its marginal cost. •  Measurement: Firm SRMC: Cost of last unit of output is the minimum price that would be charged for all units of output;  Society SRMSC: Market price as described above

31. (cont.) • If a utility is seriously worried about the recovery of all costs then this suggests the initial investment decisions, or decision to stay in industry, were imprudent in the first place. (Again, consider type of analyses made by public power systems that have decided to provide broadband services.)

32. (cont.) Finally, to the extent: • Utility has some monopoly power over price, it can simply mark up the prices of all kWhs by some percentage sufficient to recover all costs; and … • It does not have such power (i.e., there is significant competitive pressure on prices), then it will be forced to reflect market prices (which are reflective of short-run marginal social costs) in its rates.

33. So What? • Getting the Issues and Problems Straight • Public Enterprise as a Substitute for Competition

34. (cont.) • MCP would effect a significant change in the pattern of electric rates that can be expected to significantly improve the utilization of existing facilities and lower prices. Equity v. Efficiency • Precedence? • Largely a False Dilemma

35. (cont.) • Why aren’t Economic Costs More Widely Used? Know-How and Cost (Conceptual & Administrative) -- or “Political Will,” et al.?

36. (cont.) • Benefits of Focusing on, and Systematically Measuring Economic Costs -- Even if Constraints Reflecting Such Costs in Prices • Sound Understanding of Issues, Local and National • Efficient use of utility resources -- personnel, time, effort, and consulting projects • Need to understand before changes can begin

37. (cont.) • Proper Understanding and Assessment of Related Issues such as: Demand Responsive Pricing Misplaced Emphasis on RTC rather than RTP Cross-class Subsidies Price Discrimination Demand Side Management Programs Innovative Rate Programs

38. References • Full Costing, Competition and Regulatory Practice, William J. Baumol and Alfred G. Walton, The Yale Law Journal, (March 1973) • Simpson’s Reversal Paradox and Cost Allocation, S. Sunder, Journal of Accounting Research (Spring, 1983) • Efficient Pricing of Electric Power Service, William Vickrey, Resources and Energy (1992) • Embedded-Cost Pricing: What Fairness Demands, Gerald B. Ostroski, Public Utilities Fortnightly, (January 1, 1996) • An Analysis of Fully Distributed Cost Pricing in Regulated Industries, R. R. Braeutigam, Bell Journal of Economics, 11, 182-96 (1980) • The Smoke and Mirrors of Marginal Costs, Peter Lazare, The Electricity Journal, (October 1998) • Argument for Embedded Costs Has Basic Flaws, Hethie Parmesano and Amy McCarthy, The Electricity Journal, March 1999)

39. References (cont.) • Why Embedded Costs Beat Marginal Costs in the Real World, Peter Lazare, The Electricity Journal, (June 1999) • Non-price Competition and the Measurement of Prices, Reavis Cox, The Journal of Marketing, vol. x (April 1946) • L.S.E., Essays on Cost, edited by J.M. Buchanan and G. F. Thirlby (1973) • Industrial Market Structure and Economic Performance, Second Edition, F. M. Scherer (1980) • Managerial Accounting, An Introduction to Concepts, Methods, and Uses, Sidney Davidson, Michael W. Maher, Clyde P. Stickney, Roman L. Weil (1985) • Price Management, Hermann Simon, (1989) • Natural Monopoly Regulation, Sanford V. Berg and John Tschirhart (1989)

40. References (cont.) • Pricing: Making Profitable Decisions, Kent B. Monroe, Second Edition (1990) • The Strategy and Tactics of Pricing, Thomas T. Nagle and Reed K. Holden (1995) • Studies in the Economics of Overhead Costs, J. Maurice Clark (1923) • Cross-Subsidy-Free Pricing: Upper and Lower Boundaries for Utility Pricing, Dave Rosenbaum (1997) • Unbundling Electric Distribution-Related Services, Jerry R. McKenzie (1997) • Costing Electricity Generation in a Competitive Environment: Principles & Procedures, Jerry R. McKenzie (1999) • Price Discrimination and the Adoption of the Electricity Demand Charge, John L. Neufeld, Journal of Economic History (1987) • Managerial Uses of Accounting Information, Joel Demski