When economic reformers in the old Soviet Union searched for a metaphor to describe their move to a market economy, they a spoke of a horseman jumping a ditch. The true test of a strategy was that...
Incremental-Cost Pricing: What Efficiency Requires
In thinking about transmission pricing for a competitive electric industry, we should remember that the fundamental objective of competition is to increase economic efficiency. Improved economic efficiency, after all, leads to better use of resources, lower costs, and long-term benefits for consumers. Competition in the sale of capacity and energy is just a means of fostering efficiency by driving prices to marginal costs.
But getting the right price for power at the generator is not enough. We also need reformed transmission prices that provide economically efficient prices for delivered capacity and energy. That in turn requires transmission prices based on marginal or incremental costs.1
As Alfred Kahn says in his classic text: "The central policy prescription of microeconomics is the equation of price and marginal cost."2 The fact that transmission service remains a natural monopoly neither requires nor justifies a departure from this fundamental principle. Furthermore, building a brave new world of competition that deliberately combines capacity and energy prices based on marginal costs, with transmission prices based on embedded costs, would be incongruous as well as inefficient.
Not Contract Paths
Efficient transmission prices based on incremental costs are possible. But first they require a new understanding about what must be priced.
What must be priced is the changes that occur in transmission system conditions, or that would occur, from the use or reservation of the transmission system for each incremental power transaction. In other words, prices need to be set for the real transmission services that are provided based on the actual flows resulting from each transaction. Those flows, although they are analyzed separately and incrementally, will "stack up" to match actual system use or, in the case of reservations for firm service, the potential demand on system capacity at the annual system peak.
Accordingly, the crucial first step toward more rational transmission pricing is to move from contract-path pricing to actual-flow pricing. Without considering the lines actually used, there is no hope of getting transmission prices right. Worse yet, continued contract-path pricing with a growing volume and variety of transactions will surely prove to be simply unworkable.
Duplication Costs Adjusted
for Line Loadings
Assuming a decision to price actual rather than fictitious uses of the system, the incremental cost principle can be applied in a sound and practical way. In its "Impacted Megawatt-Mile" pricing method, Dominion Resources proposes to price the megawatt-miles that flow over each line segment based on the duplication costs of each line, adjusted by the line's loading when the transmission service is committed.
Line loadings provide a good measure of how near or far the transmission owner is from incurring the costs of duplicating the line. When a line is fully loaded, its duplication cost is the incremental cost of new capacity. When a line is only partly loaded, its incremental cost is a fraction of the duplication cost. Duplication costs adjusted by line loading thus provide a practical measure of the current incremental cost of transmission capacity (em which represents the largest part of total transmission costs. Other elements of transmission costs (em