1. Chapter 12 Traditional Electricity Regulation: The Calm Before the Storm Part B

2. Rate-of-Return Regulation
Why not set price equal to marginal cost?
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Demand
LRMC
LRATC
PAC
PMC QM
QAC
QMC
DWL PM
Existence of a natural monopoly, due to economies of scale creates a scenario where regulation may be required
Average cost pricing is used to ensure a “normal” rate-of- return
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3. Chasing Efficiency
The case for regulation depends upon two imperfect alternatives
Limited competition
Firms restrict output leading to
increased prices
Government Failures
Averch-Johnson Effect
Firms purposely use more capital than
is necessary
Regulatory Capture
Politicians acting on behalf of producers
rather than consumers
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LRMC
LRATC
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QAC
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LRATC’
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4. Determining the Revenue Requirement
The revenue requirement is the amount of revenue a utility needs to take in to remain profitable
Rev. Req. = Rate Base x Rate of Return +Operating Expenses
Rate Base = Net Investment = Investment – Accumulated Depreciation
Used and Useful
Smyth v Ames (1898)
Construction Work in Progress (CWIP)
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5. Calculating Required Rate-of-Return
Must be sufficient to allow the utility to attract additional capital
Benchmark is “zero economic profit”
Includes returns on equity (shareholders) and debt (bondholders)
Discounts future earnings
𝐷𝐶𝐹= 𝑡=1 𝑛 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑠 𝑡 (1+𝑟) 𝑡
Incorporates risk
Capital Asset Pricing Model (CAPM)
𝑅 𝑐 = 𝑅 𝑓 + 𝛽×( 𝑅 𝑚 − 𝑅 𝑓 )
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6. Rate Classes
Utilities set different rates for residential, commercial, and industrial customers
Industrial customers face the lowest costs, residential the highest, and commercial in between
This is determined based on the marginal costs of supplying electricity
Rules for allocating capacity costs (fixed costs) is arbitrary
Based on population, % peak energy demand, or % energy sold
Residential customers prefer when determined by % energy sold
Industry uses a higher percentage of electricity
Industrial customers prefer when determined by population
Basing rates off population size will often decrease the share of fixed costs paid by industrial customers
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7. Peak Load Pricing
Efficient pricing calls for higher prices during peak periods
Takes advantage of merit order: running generation facilities from least to most expensive depending on the level of demand
Baseload units:
Generally have high capital costs and low operating costs
Peak units:
Generally have lower capital costs but higher operating costs
Peak load pricing is an incentive to decrease quantity demanded while generation facilities with higher variable costs are in use
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8. Peak Pricing Efficiency Gains
Flat rate:
Too much is consumed when demand is high
Too little is consumed when demand is low
Consumers should use more when marginal costs are low and less when marginal costs are high
No incentive to do so with flat rate pricing
Quantity
Price Dp Pf P2 Q2 P1 MC
Q2’ Q1
Q1’ Do
Peak SW Gain
Off-Peak SW Gain
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9. Peak Pricing: Continued
Shifting Peaks
Simply having peak and off-peak pricing could result in a situation where, in order to take advantage of lower prices, consumers all delay their energy use until peak pricing is over
If enough consumers behave in this manner, peak energy use may not have decreased, but simply moved to a different time
Shoulder Price
An intermediate price between peak and off-peak meant to decrease the likelihood of shifting peaks
May be more theoretically efficient, but a more complex tariff would also be more difficult for consumers to understand
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10. Demand Reduction (DR)
Subsidizes customers for reducing demand during peak hours
Consumers can be reluctant to accept peak pricing formats
Customers fear that their bill might increase although the average consumer would likely pay less
Demand reduction is a second-best option
Compensates consumers for using less peak power than their baseline
May cause consumers to artificially inflate their baseline if they are expecting any demand reduction programs in the future
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11. Energy Efficiency Programs
Utilities may encourage customers to consume less energy
Complimentary energy saving bulbs
Rebates for reducing energy use
Not generally in the best interest of the utility
Often mandated by state regulatory commissions
What is the difference between demand reduction and energy efficiency programs?
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12. Decoupling Concept where utility revenue no longer depends on sales
If sales decrease due to energy efficiency, rates will shift upward so that revenue remains constant
May be difficult to determine the cause of decreased sales
Could result in load control
Consumers face a reduced rate for shutting down certain appliances
Rebound effect results in increased energy use in other areas, offsetting savings due to the decreased use of energy intensive appliances
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13. Incentive Regulation
Traditional RoR regulation often produces an incentive to inflate costs
Incentive regulation is designed to encourage utilities to accurately reveal costs
Price under incentive regulation is determined according to:
𝑃 𝑡 = 𝐶 𝑡 +𝑠 𝐶 𝑡 − 𝐶 𝑒
𝑃 𝑡 : Regulated price at time “t”
𝐶 𝑡 : Actual cost at time “t”
𝐶 𝑒 : Estimated cost for time “t”
𝑠: Sharing Parameter
Cost cutting is then beneficial for both the utility and the customer
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