Ahmad Faruqui and Robert Earle are economists with CRA International located in Oakland and Los Angeles. They would like to acknowledge many helpful discussions with their colleague, Stephen S. George. Contact Faruqui at email@example.com.
A new wave of rate cases is sweeping through the electric industry, as rate freezes of the mid- to late-1990s come to an end, and as utilities sense the need to modernize their electric grid. In addition, the Energy Policy Act of 2005 calls for an evaluation of time-based tariffs.
Staff turnover means that, since the last big wave of rate cases in the mid- to late-1970s, much of the organizational capability for ratemaking and rate design has disappeared in both utilities and commissions.
To remedy this gap in knowledge, this article provides an overview of ratemaking and rate-design principles to ease the myriad tasks awaiting new rate analysts and attorneys. It assumes no prior knowledge of ratemaking and is written primarily for the novice. It may trigger nostalgia in some of the “old salts” that are still manning the ratemaking stations, but it is our hope that even they may pick up a few new pointers.
Ratemaking Through the Years
For decades, the electric industry around the globe was characterized as a natural monopoly with declining average cost curves. Economic theory suggests that the best way to maximize economic efficiency under such conditions is to have a single provider who is regulated. In competitive markets, the most efficient pricing algorithm is to base prices on marginal costs. However, in a declining-cost industry, marginal-cost prices would not recover the full costs of production and create financial difficulties for the sole provider. In such situations, the best rule has to give way to the second-best rule, which is to set prices to average costs. To illustrate the choices and tradeoffs implicit in these pricing rules, it is useful to briefly review the economic theory of pricing regulated services.
We can illustrate the main tenets of this theory by using a demand-supply diagram (see Figure 1) . Prices and marginal costs are shown on the vertical axis and quantity consumed is shown on the horizontal axis. The declining cost curves show that the industry is a natural monopoly. The marginal cost (MC) curve lies below the average cost (AC) curve, causing the average cost curve to decline continuously. The best solution is to set price equal to marginal cost, as that would be the outcome in a perfectly competitive market. This case corresponds to point C on the demand curve (labeled AR for average revenue), with a price of P1 and quantity of Q1. While this position would yield the highest level of consumer surplus, it would result in losses to the utility, since average costs at Q1 are higher than P1. So the first-best option is not feasible.
The second-best option, shown by point B, involves average cost pricing. The utility earns zero economic profits, but that includes a return on capital. Prices are set at P2 as they would be under cost-of-service