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Pricing Off the Tariff: How to Figure the Maximum Supportable Electric Rate Discount

Fortnightly Magazine - May 15 1997

be obliged to cut rates for its generation component. In either case, expected revenues and margins will be reduced from those produced by sales at existing tariff levels.

Assume a utility attempts to forecast total revenues and margins over the next five years from an existing customer who consumes 1 million kilowatt-hours per year at a tariff rate of 5¢/kWh. Assume further that the forecast tariff rate remains constant over the five-year period and that the utility's marginal cost of production is equivalent to the market price of power, or 2¢/kWh for each of the next five years. (Some may question whether the utility's marginal production cost or the market price of power is the appropriate variable to use when calculating gross margin. In this example, we assume they are equivalent, so the question is moot.) Finally, assume the utility's cost of capital is 10 percent.

If the customer has a predictable load, and no possibility exists of lost sales from competition, it is a relatively simple matter to forecast revenue and gross margin values annually and over time. Total annual revenues, marginal costs and gross margins would total $50,000, $20,000 and $30,000, respectively, producing cumulative present value revenues and gross margins of $189,539 and $113,724, respectively. While tariff rates can be forecast with a high degree of certainty, marginal costs are likely to be somewhat more difficult to project, making the calculated gross margins sensitive to this parameter. For example, if marginal costs were forecast to be 3¢/kWh instead of 2¢/kWh, annual margins would fall to $20,000, all other factors remaining equal.

In our example, if the customer switches all of his load to another supplier, the utility loses all revenues and margins at existing tariffs. In the alternative, if the utility attempts to retain the customer by reducing rates to market prices, revenues will decline to $20,000 per year, and margins will fall to zero. In either case, the effect on gross margin is the same (em full loss of gross margin. Facing this prospect, the utility might be willing to reduce its tariff rate in advance of retail wheeling, in exchange for purchase commitments that enable it to preserve some portion of its current expected gross margin. But how much should the utility discount the price?

Factoring the Probability of Competition

For a given forecast of market prices, the magnitude of the preemptive rate reduction will depend upon the perceived likelihood and timing of retail access. For example, if the utility manager was absolutely certain that retail access would be implemented immediately, the MSD would be 3¢/kilowatt-hour since it would stand to lose this much without the discount. (However, if the utility believes that for some reason the customer would choose an alternative supply, the MSD would have to be adjusted to reflect this expectation.) If, on the other hand, the utility manager assigned a relatively low probability to the advent of direct access, expected revenues and margins would decline by lesser amounts, and thus the appropriate discount would be correspondingly smaller.

To complete the picture, the utility has