Understanding Costs and Their (Mis)Application to Electricity Pricing

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Understanding Costs and Their (Mis)Application to
Electricity Pricing

• John M. Kelly
• Director of Economics and Research
• American Public Power Association
• APPA Utility Education Course
• Tucson, Arizona
• October 4, 2006

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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

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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.
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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).

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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.

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A Few Special Types of Costs

• Overhead CostAny cost not associated directly
  with the production or sale of identifiable goods
  and services.
• Common CostCost 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 CostsCosts 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.

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A Few Special Costs Further Defined

• 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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Allocating Common Costs

• Wool Mutton Total
• Cost
• Sheep 400 400 800
• Processing 100 300 400
• Total 500 700 1,200

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Allocating Common Costs (continued)

• 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 competitionthe costs of
  operating an isolated plantnot the utilitys
  marginal costof supply.

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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 experienceno
  choicethere 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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A Few Important, Related Economic Concepts

• Implications of Competition
• Economic Efficiency
• Common Costs
• 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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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

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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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Investment Costs v. Operating Costs

• Investments in, and Forecasted Prices of,
  Mid-Range Hotels
• Hilton 100 Garden Inns, 50,000 rooms at 6585
  per night
• Choice 10 Mainstay Suites costing 100 million,
  rooms at 5565 per night
• Doubletree 25,000 rooms converted to Club
  Hotels, rooms at 5070 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 characteristicswhich
  are the real subjects of demand
• Examples From coal shipments to restaurant meals

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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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Economic Costs Defined for Electric Power
Generation

• Short-Run Marginal Cost to Firm
• 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
• Competitive wholesale power marketrealistic
  opportunities to sell and buy energy

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Marginal Costs

• Short-Run Marginal CostCost of utility
  producing another kilowatthour (KWh)
• Short-Run Marginal Social CostWholesale price
  in markets that are effectively competitive

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Why Economic Costs Are Important

• Economic Efficiencyin Production and Pricing
• Competition drives prices to costs (and other
  good things)
• Prices reflect cost to firmsand to society
• Results in good use and allocation of resources

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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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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 resourcespersonnel,
  time, effort, and consulting projects
• Consistent with public powers goals
• Sound understanding of issueslocal and national
• Need to understand before changes can begin

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Benefits of Using Economic Costs to Price
Electric Services (continued)

• 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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References

• Roland Andersson and Mats Bohman, Short- and
  Long-Run Marginal Cost Pricing On their Alleged
  Equivalence, Energy Economics (October 1985),
  279288.
• 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,
  182196 (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
  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).

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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, Simpsons Reversal Paradox and Cost
  Allocation, Journal of Accounting Research
  (Spring 1983).
• William Vickrey, Efficient Pricing of Electric
  Power Service, Resources and Energy (1992).