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

Fortnightly Magazine - May 15 1997

15.49% 25.31%

Table 3 illustrates that the appropriate discount is a

function of the anticipated path of competition and the spread between tariff rates and market prices.

The Analytical Framework

The rate discount depends on the cumulative present value of gross margin.

MSD. The maximum supportable discount is defined as the percentage discount from tariff rates that would produce the same CPVGM (see below) with or without the contract extension. It represents a point of equivalent mathematical expectation. A discount greater than the MSD would produce a CPVGM that is lower than the expected value assuming no-discount. A discount below the MSD threshold level would yield a higher CPVGM compared to the no-discount case. The smaller the discount offered, all other factors remaining equal, the larger the expected benefit to the utility.

CPVGM. The cumulative present value of gross margin is derived by first calculating the expected (i.e., probability weighted) gross margin, assuming no contract extension, given forecast tariff rates, and market prices over the relevant period of analysis. The resulting value for CPVGM is dependent upon the probability of losing customer load through competition. This value is then used to determine the discounted price that would yield the same CPVGM over the contract period, assuming a long-term purchase commitment from the customer. The benchmark CPVGM represents the probability weighted gross margin, assuming that direct access is possible at any time over the relevant planning horizon. In other words, it is necessary to identify all the possible gross-margin outcomes and their associated probabilities, over the entire period of analysis.

1Given a cumulative probability of departure CP and I number of years in the planning horizon, the annual probability of departure P is determined by the following formula:

P = 1 - (1 - CP)1/I

The analysis is based on the assumption that the annual probability of departure is constant through time. However, the analysis can be easily modified to account for annual probabilities that vary through time.

2In our example, the MSD is expressed as a discount to the leveled tariff rate, and we have demonstrated that the new leveled price yields the same CPVGM. As a practical matter, there is no reason why the discount would have to be structured in this form. The utility could offer the same effective discount in a variety of ways (e.g., lump sum rebate, annual rebates, front-loaded or back-loaded rate discounts). Thus, the analytical results could be utilized in the context of various marketing programs.

3Our analysis implicitly assumes that once a customer has left the system, the utility absorbs the entire financial consequences of the reduced gross margins. To the extent that the utility is allowed to recover the otherwise lost gross margin through a non-bypassable charge, the MSD would be lower than the 18.59 percent figure derived above and for those set forth below, in the sensitivity analysis section. For example, if t he utility could recover 50 percent of the lost gross margin occasioned by customer departure, the MSD would fall from 18.59 percent to 9.29 percent for our base case result.