Mitigating Transition Costs: The Utility's Role
How a sample electric company could reduce risk of loss by upgrading performance to industry benchmarks. Competition in electric generation will expose utility costs that exceed those of alternative suppliers. Roughly speaking, these above-market ("transition") costs should track the difference between the new market price and the embedded cost set by traditional cost-of-service regulation.
The problem has attracted no shortage of proposals. They range from opening retail markets immediately (and letting utility shareholders pay all transition costs) to delaying competition (and assigning the bulk of costs to ratepayers). But what's missing in the debate is how specific proposals will affect transition costs.
For instance, if a utility looks for expenses to cut, where should it begin? With generation, operating and maintenance (O&M), or administrative and general (A&G) costs? Or perhaps customer service or purchased power?
To examine the potential of cost reductions, we studied various mitigation strategies designed largely to raise company performance to industry benchmarks in certain cost categories. We tested real-world numbers taken from an actual utility. For activities other than generation, we found that A&G offered the greatest potential to mitigate transition costs, followed by customer service. O&M for distribution and transmission lagged a bit in potential for our sample utility. For utility-owned generation, nuclear (O&M) costs held substantial opportunities for mitigation (em and not by closing plants, but by reducing expenses to industry benchmarks. Coal (O&M) showed some limited potential, but not oil, natural gas, or hydroelectric generation.
Finally, our sample utility also showed significant opportunities for mitigating transition costs by reducing expenses for power purchased under "must-take" contracts with qualifying cogeneration or small power production facilities (QFs). These QF opportunities proved greatest in strategies designed to cut energy costs or gain control over QF dispatch. %n1%n
Model and Method
To examine the role that utility cost reductions might play in mitigating transition costs, we used data for the years 1993-94 for an actual utility that faced substantial transition costs in generation, power-purchase contracts, and regulatory assets. We multiplied key data by a fraction to preserve anonymity.
To test each individual strategy we created a base case, computed nominal income losses under a scenario for retail wheeling, and then incorporated each cost-reduction strategy into utility operations and estimated the consequences for shareholders. We calculated the effect of each strategy as the estimated difference in transition costs between the retail wheeling scenario with and without the strategy.
For non-generation costs, we estimated benchmarks for each cost category representing "excellent" performance levels (90th percentile (em achieved by only 10 percent of industry firms). Table 2 displays the base-case values and performance benchmarks for each of the cost variables. (In every instance, our base-case utility fell short of the benchmarks, both for generation and non-generation costs.)
Of course, a cost incurred cannot strictly speaking be mitigated. A utility cannot reduce the cost of a plant already built any more than a consumer can save money on electricity already consumed. Most options simply shift costs from industry to consumers, or from today's ratepayers to those of tomorrow.
Current costs are different. Any