Energy Pricing

This chapter adopts the mundane activities of a lowly baker to portray one of the most fundamental functions of the economy—the determination of cost and price. The baker computes his costs as the sum of the prices he pays for his ingredients and other inputs. He sets his prices to recover these costs plus a profit. This is simple in broad concept, but becomes elusive in the real world. The baker produces a variety of products—doughnuts, pies, and cakes, as well as bread—to each of which he must assign a portion of his costs, a process called cost allocation. This process in most cases is involved and subjective. And, finally, the baker may be faced with competition. He must then adjust his several prices to meet the prices of his competitors, either directly or by distinguishing his product from theirs (product differentiation).

Two elements enter into the determination of the price of every component exchanged in the economy: the costs of producing, transporting, and delivering it, on the one hand, and its value to the buyer, on the other hand. Under price regulation, these two individual elements are the subject of highly developed formal processes and strictures, particularly as to costs. Chapters 2, 3, and 4 explore the economics of various aspects of the cost approach. Chapter 2 emphasizes one central principle–that prices tend to follow the direction of costs. To determine this direction, costs are examined from their fundamental role as either fixed or variable, and whether in combination they lead to decreasing, constant, or increasing per-unit costs. For capital-intensive industries, such as the energy utilities, the direction of unit costs is downward as plant is utilized more extensively with growth. Comparative scenarios are presented which analyze growth in its several stages, even or erratic, constant or interrupted, with resulting changes in the firm’s prognosis.

You are the manager of a large manufacturing plant located on the plains of Kansas, and you have just been informed that your company is being sued for selling one of its several products (product A) below cost in order to meet competition. All products manufactured at the plant use the same structure, the same machinery, and the same labor force. Your lawyer advises that your best defense is to prove that your price for product A meets or exceeds the cost of producing it. In other words, you must compute the cost of product A. What will you do? You might reread Chap.​ 3, leading you to divide total plant costs into those costs directly assignable to product A and those incurred jointly by product A and the other products. You might then functionalize the joint costs, to the greater-than-normal degree utilized by Southern California Edison Company, thus increasing the direct costs assignable to the individual products and decreasing the joint costs to be allocated among them. The remaining joint costs could then be allocated by the relative number of product units involved. Or, if you were an energy utility, you could follow Chap.​ 3 directly.

Chapter 4 has two parts. The first discusses why and when fixed and variable costs should be assigned to the demand charges of multi-part rates. Each of the four famous methods is covered: the Atlantic Seaboard method, the United method, the modified fixed–variable method, and the straight fixed–variable method. Two other issues are included as well: the demand charge and zoning. The second part of the chapter covers the entirety of the accounting involved in a full rate case before the responsible US regulatory commission, starting with the aggregation of the pipeline’s total costs of service stated pursuant to the commission’s uniform system of accounts, and ending with the allocation of these total costs to the demand and commodity charges of the pipeline’s individual rate schedules.

In this chapter we reverse direction, turning away from cost-influenced supply to value-influenced demand. The market, which reflects consumer preferences, gauges demand. Demand for energy is both direct and derived. Natural gas, for example, is desired for its heating ability alone, a direct demand, and also for its use as a fuel in industrial processing, an indirect demand depending upon the market for the product being processed. Important to the forecasting of energy demand is price elasticity, the responsiveness of the market to changes in price. Ignoring the impact of price changes can have a disastrous affect upon the quantities of energy required. Price differences between products having the same or similar costs can encourage price differentiation, a permissible result, or monopoly pricing, prohibited under the anti-trust statues. The theory of class price establishes reasonable distinctions.

This chapter instructs on how to prepare a load forecast for both the short-run and long-range. The latter involves conforming the forecast to a strategic plan and accommodating it to the limits of available supply. Often the difficult issue of market share must be faced. Procedural issues are encountered: should the forecast indicate a single trend or include a range of trends? Availability of the product, the reliability of supply, and the anticipated impact of public-awareness programs, such as conservation, must each be considered. The higher importance of forecasts involving public-policy issues is emphasized.

The five preceding chapters are normative, addressing pricing in an orderly fashion. Chap.​ 7 departs from this course, covering a diverse array of subjects alike only in that they result from public policies or social engineering or both. Six different subjects are explored: California’s lifeline/baseline rate, designed to provide cheaper energy for the minimum essential amount of energy used; price consciousness, with the public wanting detail about the functions financed by their energy payments; timed pricing, with prices varying with the time of use in accord with the changing costs of the service provider; the color GREEN, with pricing adjusted for conservation measures, on the one hand, and non-conventional methods of energy production, on the other hand; a venture by an important regulatory commission into marginal cost as a basis for regulation; and, finally, how wind power is accommodated by a large-integrated electric grid.

Chapter 8 introduces the environment surrounding utility prices (or rates, in utility jargon) by outlining the viewpoints brought to bear on the subject by customers, utility managements, and the public. The chapter also includes some pertinent definitions.

Chapter 9 introduces the non-price clauses which frequently are inserted into the rate to modify its price statements. Minimum charges are an example. The chapter also introduces the non-price features of the basic rate design. These design features include, for example, whether the prices are blocked or not (i.e., whether or not different prices are applicable as the volumes taken change) and whether the prices are applicable throughout the system (a “postage stamp” pattern) or vary in different locations in the system (a zone pattern). Finally, the chapter mentions the generalized “fine print” provisions which ordinarily are included in the package of rates as a routine matter.

Chapter 10 covers the types of rate forms for the energy industries which have been developed and tested throughout the past century and which are widely used today. Distinctions are made as to whether the rate incorporates only a single price (a single-part rate), or two or more prices, which in combination comprise the total charge (a two- or three-part rate). The single-part rate is the most common for a large customer group with relatively small usages per customer, such as the residential customer class. The two-part rate is almost universally applicable to customers with greater usages, where their takes can be divided, and priced separately, for total volumes taken (the commodity or energy charge) and for the highest amount required at any one time (the demand charge). By far the most popular rate form for larger electric customers is the two-part Hopkinson rate, which combines a commodity charge per kilowatt-hour for total volumes taken, with a demand charge per kilowatt for the greatest amount taken at any one time. All rate forms are discussed in Chap.​ 10.

Chapter 11 is aptly termed “Tools of the Trade.” It opens the door to measures that are essential for an understanding of the economics of all industries, particularly capital-intensive industries as are the energy utilities. The factors of measurement are fully explained for the beginner, and their implications are developed for the practitioner. Load factor gauges whether facilities are heavily or lightly loaded, and gives insight into the impact of these conditions upon the economics of operations of the concerned firm. Diversity factor, the second most important measure, assesses the variety of uses to which a facility can be put simultaneously, the greater the number, the greater the efficiency. Other factors—capacity factor, utilization factor, demand factor, and for the electric technician, power factor—are also covered in Chap.​ 11.

Preceding sections introduce the process of pricing energy delivered by the electric and natural gas utilities. Guidelines and opinions are directed toward executive decisions governing internal operations. Decisions governing external relationships are for the most part left unexplored, leaving a gap between internal utility decision-making and external decisions applicable to other sectors of the economy. But even the most meticulous internal operations fall short if a company’s external relationships are deficient. There is a gap between internal and external in the earlier chapters. To narrow this gap, Chap.​ 12 addresses an often overlooked phase of management’s responsibilities: its decisions on outside issues. Chapter 12 is not intended for technical readers only. It is written to be read by a wider audience, by those who are affected by business or governmental micro-economic decisions, which means all of us. Chapter 12 has three distinct parts. The first addresses those who, directly or indirectly, contribute to the preparation of the company’s published business reports, particularly those of a financial nature. It points to frequent loose or inaccurate statements often found in these reports which are misleading and should be avoided. These are basic guidelines, intended to be instructive for those who originate the reports as well as for those who read them. The second part goes beyond basics. It aims at the top executives of businesses of all sizes who fashion the policies of their companies. Here good judgment in decision-making is of vital importance to the operations they control. As a prime example of a failed policy in the utility sector, this part cites the California energy crisis, where ill-fated decisions by executives of two major utilities led to the disastrous bankruptcy of one of the companies and the near-bankruptcy of the other. The third part is directed toward upper-level government executives who are responsible for the nation’s macro- and micro-economic policies. It reviews the 2008–2009 recession, and highlights the short-sighted decisions of the nation’s financial heads whose leadership (or lack thereof) permitted the recession to develop. The message for all three addressees is the same: be judicious in your decision-making, for its results may be greater and more far reaching than you realize.