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Flexible Pricing and PBR: Making Rate Discounts Fair for Core Customers

Fortnightly Magazine - July 15 1996

utility to be cautious about handing out price discounts is to require that the utility absorb all, or a portion of, the revenues lost from the reduced rate. Not only does this requirement directly reduce or eliminate the amount of funds recovered from nonparticipating customers, it also gives incentives to the utility to

(a) limit the number of discount rates, and (b) keep the size of the discount to the minimum necessary. Requiring the utility to absorb lost revenues from price discounts aligns the utility's interests with those of all ratepayers, including those that do not participate in the discounted rates. In addition, retaining load, or attracting new load, works to the benefit of utility shareholders as well as customers. Therefore, utility shareholders should bear some responsibility for the costs necessary to achieve those benefits.

Requiring utility stockholders to absorb a portion of the lost revenues from discounted rates is not uncommon. As indicated in Table 1, five states require utility stockholders to absorb all of the lost revenues from load retention or economic development rates; six states require stockholders and ratepayers to share these lost revenues.4 Recent legislation in New Jersey requires utilities to absorb at least 50 percent of lost revenues from flexrates; the New York Public Service Commission requires 30 percent; and the California Public Utilities Commission recently made Pacific Gas & Electric stockholders responsible for 35 percent of revenue losses due to economic development rates, and 50 percent of revenue losses from load retention rates. Detroit Edison recently established discount rate contracts with its three big automobile industry customers, and the Michigan Public Service Commission required the company to absorb 100 percent of the revenue losses.5

However, the extent to which regulators can require utilities to absorb a portion of lost revenues will depend upon the type of flexible pricing practice allowed. With load retention rates and economic development rates, a PUC can explicitly determine the amount of lost revenues that should be absorbed by utility shareholders based on the specific conditions associated with each customer that receives a discount rate. As regards flexrates, where a PUC has less oversight over each individual discount rate, regulators can establish a generic policy mandating that a certain amount of lost revenues should be absorbed by utility shareholders as a means of aligning ratepayers' and shareholders' interests.

Price Caps. PBR mechanisms make it much harder for regulators to ensure that shareholders take responsibility for revenues lost to discounts. In theory, regulators could design PBR mechanisms to prevent utilities from collecting the lost revenues of price discounts from nonparticipating customers; in practice this goal proves difficult to achieve.

A well-designed price-cap scheme must set the initial rates for each customer class fairly, based upon an appropriate allocation of costs. The price cap may then increase from year to year to allow for inflation, but must also decline over time to encourage increased productivity. Once a price cap is set, the utility can offer prices below the cap, enabling management to choose between lowering prices to compete for customers and increasing profits. A