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

Fortnightly Magazine - July 15 1996

utility that can cut costs will have even more flexibility to lower prices or increase profits. PBR assumes that even if utilities decide to lower prices mostly for large customers, small customers are still better off with a price cap, as long as the original cap is set sufficiently low.

A PBR plan that sets up specific price caps for different customer classes (as opposed to a single average price cap for all customers) is better designed to prevent cross-subsidization of costs between customer classes. If the price caps are set low enough to accurately represent the costs of serving each customer type, the utility will not have the ability to recover from one customer type the lost revenues created by price discounts to other customer types. Those lost revenues would have to be recouped by reducing operating costs or shareholder profits.

However, the job of accurately representing the costs of serving different customer types has historically proven extremely contentious in traditional ratemaking contexts. In addition, over time, the initial price cap for any given customer type may deviate from the costs of serving that customer type, obscuring whether and/or to what extent lost revenues are recovered from customers that do not receive discount rates. Therefore, as compared to other flexible pricing schemes, PBR mechanisms create a much greater risk that nonparticipating customers will pay the lost revenues created by price discounts. Further, they may allow utilities to offer discounted rates beyond those that would be necessary to maintain or attract customer load.

Recovering Strandable Costs

In the transition to a fully competitive retail generation market, utilities will increasingly employ flexible pricing schemes to retain large customer loads, and PBR will likely become the preferred mechanism for offering discount prices.

Discounting in General. It is important to recognize that any revenues lost because of flexible pricing essentially represent a portion of a utility's strandable costs. In general, strandable costs occur when a utility's embedded costs exceed "market" prices. The primary rationale for a utility to offer a discount rate is that its embedded cost (i.e., nondiscounted price) exceeds what a customer could get elsewhere in "the market." In effect, the difference between prices based on embedded costs and discounted rates will represent a portion of a utility's strandable costs. Therefore, customers with discounted rates avoid paying a portion of, or all of, their share of strandable costs, while customers that do not receive discounted rates pay their full share.

A further inequity is created if nonparticipating customers also pay for some or all of the lost

revenues caused by the discount rates. In this case, nondiscounted customers pay not only their share of strandable costs, but also a share (or all) of the discounted customers' strandable costs.

Such an outcome is inconsistent with the principles of stranded-cost recovery under development by many PUCs around the country. While recent restructuring debates present drastically different views about the magnitude of strandable costs and the extent to which ratepayers or shareholders should be responsible for paying these costs, there is widespread agreement that the utility