Transcript Economic Costs & Pricing Electricity Services

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.
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
1
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
2
Theory and Practice
3
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
4
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
5
Know Your Costs!
Which Costs?
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 … ?
— Sidney Davidson, Ph.D., CPA, et al.,
“Managerial Accounting,” An Introduction
to Concepts, Methods, and Uses.
6
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 forwardlooking, 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).
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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.”
8
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.”
9
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.”
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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
11
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
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Allocating Common Costs
Wool
Mutton
Total
$400
$400
$800
100
300
400
$500
$700
$1,200
Cost:
Sheep
Processing
Total
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Allocating Common Costs
(cont.)
Wool
Mutton
Total
Cost:
Sheep
???
???
$400
Processing
100
300
400
Total
???
???
$800
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Allocating Common Costs
(continued)
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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 cost
of supply.
16
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
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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
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Two Implications of
Effective Competition

Price Taker

Pressure on Prices
to Reflect Costs
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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.
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Cost/Price Structures and
Economic Efficiency
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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
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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
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Economic Costs: Defined for
Electric Power Generation

Short-Run Marginal Cost to
Utility:



Replacement cost of fossil fuels
Usage of equipment (wear
and tear)
Short-Run Marginal Social
Cost to Society:*

Replacement cost of fossil fuels
 Usage of equipment (wear
and tear)
 Environmental cost
 Marginal increment in
loss of load probability
* Caveat: Competitive wholesale power
market—realistic opportunities
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to sell and buy energy
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
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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?
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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.
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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
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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
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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).
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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 DistributionRelated Services (1997).
Jerry R. McKenzie, Costing Electricity Generation in
a 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).
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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).
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