Understanding Costs and Their (Mis)Application to Electricity Pricing

John M. KellyDirector of Economics and ResearchAmerican Public Power Association

APPA Utility Education CourseTucson, ArizonaOctober 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?

actualadministrativecapacitycommoncontrollabledifferentialdirectdiscretionarydistributionfixedindirectjointmanaged

manufacturingmarketingnonmanufacturingopportunityperiodproductprogrammedsemifixedsemivariablestandardsunkvariable 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 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.”

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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 competition—the costs of operating an isolated plant—not the utility’s 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 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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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 $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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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 (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 Competitive wholesale power

market—realistic opportunities to sell and buy energy

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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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Why Economic Costs Are Important

Economic Efficiency—in Production and Pricing: Competition drives

prices to costs (and other good things)

Prices reflect cost to firms—and 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 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

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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), 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 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, “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).