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Pricing Reform for the Local Disco: Setting Rates That Will Support Distributed Generation

The Proposed Distribution Tariff
Fortnightly Magazine - July 1 2000

owner of DG, no matter how much power that user takes in any month. 1 If designed properly, such a tariff would maximize welfare and boost incentives for both customers and the wires company in an environment marked by increasing deployment of DG by retail customers.

Of course, the distribution pricing issue is made more difficult because everyone seems to have a different idea as to what it is that an independent utility distribution company (UDC) will do. Should a UDC be permitted to own both local wires assets and generation resources? Does it make a difference whether the generation sells output in competitive markets or is operated simply to augment the stability and functions of the grid itself?

These questions are important. Before regulators can expect to resolve the issue of UDC pricing for distribution service, they should address and develop a set of "Roles, Rules, and Responsibilities" for the UDC, analogous to federal requirements defining the nature of regional transmission operators. A draft set of eleven such principles is offered here for consideration.

In fact, regulators probably should establish the regulatory regime immediately, because it no doubt affects a UDC's financial viability, profitability, and shareholder value. The choice of regulatory regime influences the UDC's long-term incentives to invest, maintain, and enhance the system, and to provide new products and services for its customers.

One possible choice is a traditional cost-of-service (COS) regime. It features the benefit of familiarity for many managers and regulators. Cash flows and risks are relatively transparent. COS emphasizes fairness at the expense of efficiency-it provides only weak incentives for cost minimization (through regulatory lag) and efficient rate design. COS may in fact maximize UDC shareholder value under certain restrictive cases, such as those marked by technological stasis, small expected gains in productivity, or high expected risk.

That is not the scheme developed in this article, however. Though this new tariff design can be implemented under COS, it is intended for use under price-cap regulation (PCR). PCR de-couples the price level from costs. PCR may maximize UDC shareholder value in a different kind of case-where investment in new technology can be expected to yield disproportionate cost reductions, or where the risks are low or better known to the UDC than to the regulator.

Pure price-cap regulation allows the firm to retain the fruits of its success, though that result can prove problematic if the firm is highly profitable. Such "excess profits" may lead to a failure of commitment on the part of regulators. To avoid that problem, PCR can be modified initially into some form of performance-based regulation (PBR), with profit/cost sharing to mitigate risk for regulators and the UDC. In general, this article argues that PCR or some related form of PBR is essential to provide the UDC with appropriate economic incentives and the pricing flexibility that will be needed in what is certain to be a dynamic environment marked by rapid technological, institutional, and pricing changes.

The Proposed Distribution Tariff

I propose a model UDC tariff structure, under a PCR or PBR regime, that promotes