A new report from the Department of Energy may confirm what many in the electric industry have said all along: That while stranded costs could dissolve some short-term gains from competition, in...

## Distribution Utilities: Forgotten Orphans of Electric Restructuring

already have recommended approaches, usually by extending the concept of avoided costs to determine cost-effective distribution investments.fn2 Applied to distribution investment, the avoided cost approach begins with a "base case" distribution investment plan and then determines whether specific investments, such as a new substation or distribution circuit, can be deferred by distributed resources like DSM and local generation. The deferral benefit is simply the present value savings associated with deferring an investment for a given amount of time.

For example, suppose that constructing a new substation will cost $11 million. If the utility's weighted cost of capital is 10 percent, then the deferral benefit from delaying construction of the substation exactly one year will equal $1 million, based on a simple present-value analysis: $11 million - ($11 million/1.10) = $1 million. Now suppose further that peak loads will increase exactly 1 megawatt during the year. Then the "avoided distribution cost" will be just $1,000 per kilowatt (or $1 million/MW). Using avoided costs, distributed generation and DSM costing less than $1,000/kW would be a cost-effective alternative. This reasoning is straightforward, compelling and, unfortunately, completely wrong.

If this method is used, alternative investments will be chosen to defer traditional transmission and distribution investments for as long as possible without adding additional costs. That is the fundamental flaw in the avoided-cost approach: What is cost-effective is not necessarily least-cost, unless the objective is to maximize the amount of deferral provided by the alternative investments, or what is the same thing, to maximize the penetration of alternative distribution system investments (DSM, distributed generation, etc.) beyond the point at which they are part of the optimal solution.

The avoided-cost approach makes the wrong marginal comparisons for distribution investment; it may defer traditional distribution capacity investments for too long or too little, but never the correct amount. Most importantly, the method does not incorporate future uncertainties, particularly uncertainty about future local distribution capacity demand. Thus, as a method for determining appropriate investments in new local area capacity, the avoided cost approach will lead to higher than necessary costs for consumers. This mistake reduces the overall economic benefits of restructuring and may lead to additional conflicts between retailers, customers and regulators.

So how should local distribution capacity planning be performed? First, utilities and regulators must recognize that uncertainties at the local level are likely to be magnified relative to overall system load uncertainties. The effects of one industrial customer's expansion plans are likely to be far greater in a specific local area than over a disco's entire service territory. Ignoring uncertainty, which most avoided cost methods do, will result in higher than necessary costs.

But if utilities and regulators address uncertainty, they need to do so correctly. The local area distribution capacity investment problem is strategic, in that the investments are long-lived, and dynamic, in that decisions and outcomes are interrelated. Addressing the problem with an avoided cost approach, however, treats the problem as a tactical, short-term exercise with deterministic solutions.

The economic benefits of new technologies such as microturbines and fuel cells, as well as targeted local DSM