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Revenue Caps or Price Caps? Robust Competition Later Means Healthy Choices New

Fortnightly Magazine - May 1 1996

a perversion that runs counter to sound economics and regulatory policy.

A Second Opinion

Under revenue caps, energy efficiency comes at a high potential cost to consumers and society as a whole (em at the cost of serious economic distortions. The price is clearly too high. Less perverse mechanisms are available if policymakers approach energy efficiency from both sides of the meter. Price caps offer such a mechanism.

Price caps have been wrongly criticized for deemphasizing energy efficiency. In fact, price caps give utilities a strong incentive to innovate and to deploy supply-side facilities with greater energy efficiency. Improved energy efficiency means lower costs; price caps reward lower costs by allowing a utility higher profits for a number of years. Competitive markets provide a similar incentive.

On the demand side of the meter, price caps encourage market-based energy efficiency by allowing a utility to price services as low as its marginal cost. This flexibility, limited by the condition that prices cannot fall below marginal cost, ensures correct price signals.

Price caps promote energy efficiency in a way that corresponds to market realities. Revenue caps create incentives that are incompatible with both a competitive marketplace and generally accepted regulatory objectives. As the electric power industry proceeds on a procompetitive path toward unbundled service and customer choice, revenue caps will prove increasingly inappropriate. A competitive market has no use for a mechanism that shifts the risks of lost sales to consumers, distorts price signals, promotes inefficient technologies, and produces excessive prices. Indeed, a mechanism that fails to recognize the true barometer of consumer welfare (price) is fundamentally at odds with a market in which competition is for the consumer.

Kenneth Costello is associate director of the National Regulatory Research Institute in Columbus, OH. The views and opinions of the author do not necessarily reflect those of NRRI, the National Association of Regulatory Utility Commissioners (NARUC), or NARUC member commissions. This article is adapted from material the author presented in a 1995 debate before the NARUC Committee on Energy Conservation. The opposing viewpoint in that debate was presented by Ralph Cavanagh of the Natural Resources Defense Council.

Tying Caps to Rate of Return: No Better

Assume that the cap constraints revenues at their prior value (i.e., R = Q(m) x P(ror).* Under rate-of-return regulation, the firm would price at average cost (P(ror) = AC), produce at Q(ror) and earn a normal profit. As in Figure 1, equilibrium lies at e(rc).

Outcomes:

. Consumers are worse off (by area C + A)

. Total economic welfare declines (by area A + E)

. Prices move farther from marginal cost

. Average cost rises

. Utilities profit by the amount of the reduced costs (area B).

These adverse outcomes generally apply even when consumers pay lower bills and the utility incurs lower total costs.

*This assumes that the price elasticity of demand between the relevant points on the demand curve equals one. In figure 1, because revenues decline in moving from point e(1) to point e(re), the price elasticity of demand between these two points exceeds one.