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Recovering Local Distribution Costs

Fortnightly Magazine - November 15 1995

high levels of system usage provide high levels of contribution (revenues in excess of the marginal costs of providing access) and/or subsidy, while low-usage customers may provide no contribution at all (they receive a subsidy). The typical result is that not only do usage services subsidize access service, but high-usage customers subsidize low-usage customers.

Even if one mistakenly believed that all local distribution costs represented common production costs, usage charges should not bear the bulk of the recovery burden. The most efficient method of recovering costs that are truly common to multiple utility services is by obtaining the greatest degree of contribution (price exceeds marginal cost to the greatest extent) from services that are the least elastically demanded (those that are the least responsive to price changes). This method is sometimes called Ramsey pricing. It minimizes the degree to which customers substitute away from the efficient quantities of services because prices rise above what is efficient. Ramsey prices are also more likely to be sustainable in the face of competitive pressures. Utility customers are relatively sensitive to usage-based charges (the demand elasticity for usage is generally higher than for recurring monthly access or one-time charges). Recovering distribution costs largely through usage-based charges would prove relatively inefficient.

The Recurring Customer Charge. A second method of recovering the costs of local distribution is through a monthly recurring charge to customers simply for the option to obtain service and use the system. Such a charge offers the major advantage of standing completely independent of system usage. Usage charges can be set to more accurately reflect the marginal costs of usage. This approach will improve economic efficiency and consumer welfare. As a general principle, the most appropriate price structure or recovery mechanism is one that mirrors the structure of costs. Since the costs of local distribution facilities are generally not sensitive to usage, a monthly recurring customer charge (which is not sensitive to usage) is superior to recovering such costs through usage-based charges.

The One-time Connection Charge. A third method involves a one-time assessment for the capital costs of installing local distribution facilities. This method recognizes the franchise obligation as a cost causer and may well prove the most efficient for recovery of local distribution costs.

The costs of local distribution facilities may become largely sunk once facilities are placed; i.e., the facilities have no alternate value if customers choose not to use them. In particular, local distribution costs may be unaffected by the number of customers who actually sign up for service. These costs appear to be caused largely by the provider's franchise obligation to offer service to all potential customers within the service territory on a timely basis. To meet this obligation, utilities must place local distribution facilities well in advance of the time at which customers actually demand service. In some sense, the cost causer is the developer that initially plans and begins construction of homes and businesses. A one-time charge, assessed to the developer for the capital costs of placing local distribution facilities within that development, is probably the most efficient system