Economic Costs and Pricing Electricity Services

1. Economic Costs and Pricing Electricity Services APPA Spring Education Institute Crowne Plaza San Diego, Calif. May 5, 2008 Instructor: John M. Kelly Director of Economics and Research American Public Power Association Washington, D.C.

2. The Aims of Education and Other Essays “Whatever be the detail with which you cram your students, the chance of their meeting in after-life exactly that detail is almost infinitesimal; and if they do meet it, they will probably have forgotten what you taught them about it.” —Alfred North Whitehead

3. The Aims of Education and Other Essays (continued) “The really useful training yields a comprehension of a few general principles with a thorough grounding in the way they apply to a variety of concrete details. In subsequent practice the students will have forgotten your particular details; but they will remember by an unconscious common sense how to apply principles to immediate circumstances.” —Alfred North Whitehead

4. Theory and Practice

5. The Role of Economic Theory “Economic theory bears somewhat the same relation to other branches of economics, such as economic history or the study of economic institutions, as geometry does to surveying: it provides a logical framework or skeleton in relation to which the necessarily inexact and incomplete observations of the real world can be apprehended with greater insight.” —William Vickrey

6. 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, 1955

7. actual administrative capacity common controllable differential direct discretionary distribution fixed indirect joint managed manufacturing marketing nonmanufacturing opportunity period product programmed semifixed semivariable standard sunk variable or … ? Know Your Costs! Which Costs? — Sidney Davidson, Ph.D., CPA, et al., “Managerial Accounting,” An Introduction to Concepts, Methods, and Uses.

8. Accounting Costs v. Economic 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).

9. Fully Allocated Cost Pricing v. Marginal Cost Pricing • Fully Allocated Cost View: • Prices must reflect the full cost of service. Selling prices should reflect all costs, both fixed and variable, of production, administration, and sales, as well as provide for a reasonable return on investment. • “If a utility can not compete based on full cost then it should not compete.” • Marginal Cost View: • “The principle of marginal cost pricing must play a major or even dominant role in the elaboration of any scheme of rates or prices that seriously pretends to have as a major motive the efficient utilization of available resources and facilities.”

10. Costs that Confound … • Overhead Cost—“Any cost not associated directly with the production or sale of identifiable goods and services.” • 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…” • 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.”

11. Costs that Confound … (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.”

12. 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, January-February 1990

13. Opposing Views on Problem of Common Costs (continued) • 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

14. Allocating Common Costs WoolMuttonTotal Cost: Sheep $400 $400 $800 Processing 100 300 400 Total $500 $700 $1,200

15. Allocating Common Costs(cont.) WoolMuttonTotal Cost: Sheep ??? ??? $400 Processing 100 300 400 Total ??? ??? $800

16. Allocating Common Costs (continued)

17. Demand Charges • Demand charges are a form of fully allocated cost and a method to allocate common costs and price discriminate: • Demand charges were adopted as “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 costof supply.

18. Economic Concepts Related to Costing & Pricing Electricity • Implications of Competition • Opportunity Costs • Common Costs • Economic Efficiency • Inherent Costs v. Decision Costs • Investment Costs v. Operating Costs • Short-Run Costs v. Long-Run Costs v. Decision Costs • Economic Goods and Commodities

19. Competition Defined “[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

20. Two Implications of Effective Competition • Price Taker • Pressure on Prices to Reflect Costs

21. Opportunity Costs • “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 an 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.

22. Cost/Price Structures and Economic Efficiency

23. 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 million, rooms at $55–$65 per night • Doubletree: 25,000 rooms converted to Club Hotels, rooms at $50–$70 per night —USA Today, January 26, 1996

24. Economic Goods and 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

25. Economic Costs: Defined for Electric Power Generation • Short-Run Marginal Cost to Utility: • Replacement cost of fossil fuels • Usage of equipment (wearand tear) • Short-Run Marginal Social Cost to Society:* • Replacement cost of fossil fuels • Usage of equipment (wearand tear) • Environmental cost • Marginal increment in loss of load probability * Caveat: Competitive wholesale power market—realistic opportunities to sell and buy energy

26. Marginal Costs • “Short-Run Marginal Cost”—Cost of utility producing another kilowatthour (KWh) • “Short-Run Marginal Social Cost”—Wholesale price in markets that are effectively competitive

27. Objections to Pricing Electric Services Based on Economic Costs • Under-Recovery of Revenues • Over-Recovery of Revenues • Annoyance of Having to Monitor Real-Time Prices • Volatility • Does Not Affect Consumption • Unfair • Costly to Implement • Others?

28. Under-Recovery of Revenues 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 • If 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.

29. Cross-Class Subsidies and Economic Costs • Consistent framework that guards against contradictory rate policies • Proper understanding of related cost and price issues: • Demand-responsive pricing • Misplaced emphasis on RTP rather than RTC • Cross-class subsidies • Price discrimination • Demand-side management programs • Innovative rate programs • Costing and pricing other utility services

30. Benefits of Using Economic Costs to Price Electric Services • Charge consumers at least marginal cost of service • Efficiency: lower costs and prices • Efficient use of utility resources—personnel, time, effort, and consulting projects • Consistent with public power’s goals • Sound understanding of issues—local and national • Need to understand before changes can begin/effectively communicate to customers

31. References Roland Andersson and Mats Bohman, “Short- and Long-Run Marginal Cost Pricing: On their Alleged Equivalence,” Energy Economics (October 1985), 279–288. William J. Baumol and Alfred G. Walton, “Full Costing, Competition, and Regulatory Practice,” The Yale Law Journal (March 1973). Sanford V. Berg and John Tschirhart, Natural Monopoly Regulation (1989). R.R. Braeutigam, “An Analysis of Fully Distributed Cost Pricing in Regulated Industries,” Bell Journal of Economics 11, 182–196 (1980). J.M. Buchanan and G.F. Thirlby, ed., L.S.E., Essays on Cost (1973). J. Maurice Clark, Studies in the Economics of Overhead Costs (1923). J. Maurice Clark, “Toward a Concept of Workable Competition,” The American Economic Review 30, Issue 2 (June 1940), 242. Reavis Cox, “Non-price Competition and the Measurement of Prices,” The Journal of Marketing,Vol. X (April 1946).

32. References (continued) Sidney Davidson, Michael W. Maher, Clyde P. Stickney, and Roman L. Weil, Managerial Accounting: An Introduction to Concepts, Methods, and Uses (1985). Joel Demski, Managerial Uses of Accounting Information. Peter Lazare, “The Smoke and Mirrors of Marginal Costs,” The Electricity Journal (October 1998). Peter Lazare, “Why Embedded Costs Beat Marginal Costs in the Real World,” The Electricity Journal(June 1999). Jerry R. McKenzie, Unbundling Electric Distribution-Related Services (1997). Jerry R. McKenzie, Costing Electricity Generation ina Competitive Environment: Principles and Procedures (1999). Kent B. Monroe, Pricing: Making Profitable Decisions, second edition (1990). Thomas T. Nagle and Reed K. Holden, The Strategy and Tactics of Pricing (1995).

33. References (continued) John L. Neufeld, “Price Discrimination and the Adoption of the Electricity Demand Charge,” Journal of Economic History (1987). Gerald B. Ostroski, “Embedded-Cost Pricing: What Fairness Demands,” Public Utilities Fortnightly (January 1, 1996). Hethie Parmesano and Amy McCarthy, “Argument for Embedded Costs Has Basic Flaws,” The Electricity Journal (March 1999). Dave Rosenbaum, Cross-Subsidy-Free Pricing: Upper and Lower Boundaries for Utility Pricing (1997). F.M. Scherer, Industrial Market Structure and Economic Performance, second edition (1980). Hermann Simon, Price Management (1989). S. Sunder, “Simpson’s Reversal Paradox and Cost Allocation,” Journal of Accounting Research(Spring 1983). William Vickrey, “Efficient Pricing of Electric Power Service,” Resources and Energy (1992).