Homework Ch 12 Electricity Regulation

1. Explain why economists advocate that regulators use marginal-cost and not average-cost pricing. Also explain why regulators favor average cost pricing. Marginal cost reflects opportunity cost. In order to give correct signals about how much electricity to use, and when to expand generation, transmission, and distribution, we must use marginal cost. Regulators favor average cost to insure that the electric utility covers its production costs. Marginal cost pricing results in a deficit when MC is below AC, requiring the regulator to find a way to make up the deficit. Consumers might not understand why they are paying an additional amount in addition to price.

2. Describe an advantage and a disadvantage of the 1978 Public Utilities Regulatory Policy Act (PURPA) legislation that required electric utilities to purchase electricity from qualifying facilities at avoided cost. An advantage is that PURPA demonstrated the feasibility of non-utility generation. A disadvantage is that utilities were required to buy from qualified facilities at avoided cost, which exceeded the utility’s cost of generation if they still had available capacity.

Electricity growth has been slowing. 3. What is the trend in electricity demand growth in the U.S. and the underlying industrial, commercial, and residential demands? Electricity growth has been slowing. Industrial demand has actually turned negative as industry increases its energy efficiency and uses its own generation rather than the utility’s generation. Commercial demand is the fastest growing of the three sectors. Residential growth is positive, but its growth rate has slowed.

Rev. Req. = Rate Base × Rate of Return (RoR) + Operating Expenses 4. Provide the formula for how a Public Utility Commission determines the rate-of-return. Then relate it to the Averch-Johnson Effect. Rev. Req. = Rate Base × Rate of Return (RoR) + Operating Expenses The formula biases the utility in favor of growing the rate base so as to increase the absolute amount of profit.

5. If an economist were asked how to allocate the costs of a utility company headquarters among residential, commercial, and industrial customers, how do you think the economist would respond? How would an accountant respond? Economics has little to say about how to allocate common costs such as the company headquarters. An accountant would suggest allocating costs based on several possible criteria such as: Number of customers Energy use Peak demand

Strength (s) Weakness(es) 6. What is a strength and weakness of using construction-work-in progress (CWIP) to finance new nuclear construction? Strength (s) Risk is lower, so the utility will be able to finance the nuclear plant at a lower interest rate. Another possible advantage is gradualism, as rates will increase gradually rather than a big increase when the plant is completed. Weakness(es) A weakness is that the utility has more incentive to build the plant even if it is not needed. It also has less incentive to complete the plant, if costs will be covered for construction work even if the plant never operates.

Rate of return = (0.6 × 0.1) + (0.4 × 0.05) = 0.08 (8%) 7. Suppose a utility uses 60% common stock and 40% long-term bonds to finance its expenditures. The target return to stockholders is 10% and the interest rate on the bonds is 5%. What is the minimum rate-of-return that will allow the utility to pay its stock- and bond-holders the anticipated returns? Rate of return = (0.6 × 0.1) + (0.4 × 0.05) = 0.08 (8%)

8. A consumer pays a fixed customer charge of $10 per month, and an energy charge of $0.15 for the 1st 100 kWh, $0.10 for the next 500 kWh, and $0.07/kWh beyond 600 kWhs. What is the customer’s monthly bill if she uses 1000 kWhs? What is the justification for including both a fixed component and a variable component in the bill? 𝐵𝑖𝑙𝑙=$10+ $0.15×100 + $0.10×500 + $0.07 ×400 =$103 Justification for a fixed component is that some costs, such as buying new office furniture, do not depend on energy sales. Justification for variable component is that some costs such as fuel costs, do depend on energy sales.

Peak SW Gain Off-Peak SW Gain P1 Pf P2 Quantity Price Dp Q2 MC Q2’ Q1 Q2’ Q1 Q1’ Do Peak SW Gain Off-Peak SW Gain

Utilities get money for selling more electricity, not less. 10. Why is it a challenge to utilities to promote energy efficiency? How might decoupling reduce the challenge? Utilities get money for selling more electricity, not less. Known as a volumetric rate. Decoupling pays the utility an amount independent of the actual amount sold. If the utility sells less than anticipated, the rates are adjusted after the fact. The utility still gets the same revenue.