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Recovering Local Distribution Costs

Fortnightly Magazine - November 15 1995

cost allocation among the customer's activities and cost allocation for the service provider (em is critical to a sound understanding of utility costs.

The Elasticity Trap. Spill-over or cross-elastic revenue effects and utility costs represent separate economic phenomena. Revenues are a function of customer demand and service prices, while producers' costs are determined largely by input prices. Certainly, in telecommunications, end-user subscriber access service, local usage, and long-distance usage are likely to be cross-elastic to some degree on the revenue/demand side. However, this observation does nothing to change the fundamental nature of the costs of providing the services. Local distribution costs are not common production costs to the LEC simply because customers consider these services to be complements to one another. Consumers may consider bread and jam to be complements, but that does not make the cost of growing wheat a common cost to a company that produces jam.



Some of the traditional methods of thinking about local distribution costs and recovering them may not be sustainable as utility industries become increasingly competitive. How then, should these costs be recovered?

Three types of charges are possible: a one-time charge; a monthly recurring customer charge; or recovery through increases in usage charges. A one-time service connection charge to the customer could provide recovery of local distribution costs at the time costs are incurred. A monthly recurring charge can be thought of as an annuity payment sufficient to recover the initial one-time expenditure by the utility for local distribution facilities. If local distribution costs are recovered through "usage" charges, the rate per kilowatt-hour, gallon, minute, message, Btu or Mcf must exceed its marginal cost by an amount sufficient to ensure full recovery over time.

The Usage-based Charge. Generally, increases in usage charges represent the least desirable method for recovery of local distribution costs. As noted earlier, local distribution costs are largely insensitive to usage. As a general principle, the structure of prices for services should reflect the structure of costs; usage-insensitive costs should generally not be recovered through usage-sensitive charges.

Recovering local distribution costs through increases in usage-sensitive charges distorts the economic incentives that customers face. In telecommunications, a

significant portion of local distribution costs are recovered through long-distance calling charges (both intraLATA long distance and switched-access charges). These charges climb well above the marginal cost of usage (e.g., long-distance calling) and customers therefore use the system less than the optimal level; i.e., high long-distance rates discourage customers from making calls that carry a higher value than the marginal cost of providing such calls.

A usage-based charge also violates the principle of considering access to a network or system as a service in its own right. In some sense, that method expects that each customer's usage will prove sufficient to recover the cost of providing that customer with access to the system. However, when attempting to recover the local distribution costs of an electric power provider (for example) through an increase in kilowatt-hour charges, one cannot guarantee that the customer will use enough energy to allow cost recovery. Customers with