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

Fortnightly Magazine - May 1 1996

a well-functioning electric power market.

Fourth, revenue caps deemphasize the role of prices in utility markets. Competitively motivated, efficient utilities do not attempt to directly minimize a consumer's bill; market forces compel them to set prices at marginal cost or some other profit-maximizing level. The other component of total bill, consumption, depends on consumer response to the price, as well as the quality of service.

Fifth, revenue caps encourage utilities to reduce total rather than unit (average) costs. Additional sales under a revenue-cap regime tend to cause total costs to increase by more than total revenues.8 Thus, utilities gravitate toward practices that reduce rather than improve sales. They tend to operate to the left of the minimum point on their average-cost curves, because of the distorted price signals provided to consumers. Over time, technological change would suffer, since productivity

improvements are largely driven by a company's expectation of selling more products or services as it reduces its average cost. Revenue caps negate this motivation.

Sixth, revenue caps can cause volatile price changes. Utilities can vary their prices according to changes in consumption. Competitive markets do not permit a company to increase its price when demand falls. In efficient markets, declining demand translates into declining prices. Since utility sales could fluctuate widely from year to year in a more competitive market, revenue caps will likely result in more unstable and unpredictable prices.

Seventh, revenue caps induce excessive energy conservation on the basis of a market test. Competitive markets rely on a market test to evaluate the need for energy conservation; revenue caps, however, rely on a cost-effectiveness test.9 A market test offers utilities no incentive to promote energy conservation unless marginal cost exceeds price.10 The cost-effectiveness test, according to some analysts, provokes excessive energy conservation that cannot be sustained in a competitive environment.11

Although revenue caps promote cost-effective DSM,12 their built-in bias elicits too much utility-funded DSM. Their misplaced emphasis on minimizing DSM costs for a targeted level of energy conservation ignores the larger question: How much DSM should a utility stimulate? Whereas revenue caps give utilities an incentive to overspend on energy conservation, price caps encourage utilities to produce at the level where marginal revenue equals marginal cost. Where marginal revenue equals price, utilities are correctly motivated to sell more when price exceeds marginal cost, and sell less when marginal cost exceeds price.

Eighth, revenue caps reduce a utility's incentive to maintain service quality. Unlike price caps (em which fall short in this regard, nonetheless (em revenue caps enable utilities to increase price to compensate for lost sales due to poor service quality. Utilities can do this as long as revenues do not rise above their previous level. To a large extent, companies maintain service quality to avoid sales and revenue losses. Revenue caps, however, enable utilities to increase price to compensate for lost sales due to poor service quality. More disturbing, some utilities may even discover an incentive to offer lower-quality service. If declining service translates into reduced output and costs, a utility could increase its profit by increasing price (em