Fortnightly

Incremental-Cost Pricing: What Efficiency Requires January 01, 1996

By Alfred F. Mistr, Jr. In thinking about transmission pricing for a competitive electric industry, we should remember that the fundamental objective of competition is to increase economic efficiency. Improved economic efficiency, after all, leads to better use of resources, lower costs, and long-term benefits for consumers. Competition in the sale of capacity and energy is just a means of fostering efficiency by driving prices to marginal costs. But getting the right price for power at the generator is not enough. We also need reformed transmission prices that provide economically efficient prices for delivered capacity and energy. That in turn requires transmission prices based on marginal or incremental costs. As Alfred Kahn says in his classic text: "The central policy prescription of microeconomics is the equation of price and marginal cost." The fact that transmission service remains a natural monopoly neither requires nor justifies a departure from this fundamental principle. Furthermore, building a brave new world of competition that deliberately combines capacity and energy prices based on marginal costs, with transmission prices based on embedded costs, would be incongruous as well as inefficient. Actual Flows, Not Contract Paths Efficient transmission prices based on incremental costs are possible. But first they require a new understanding about what must be priced. What must be priced are the changes that occur in transmission system conditions, or that would occur, from the use or reservation of the transmission system for each incremental power transaction. In other words, prices need to be set for the real transmission services that are provided based on the actual flows resulting from each transaction. Those flows, although they are analyzed separately and incrementally, will "stack up" to match actual system use or, in the case of reservations for firm service, the potential demand on system capacity at the annual system peak. Accordingly, the crucial first step toward more rational transmission pricing is to move from contract-path pricing to actual-flow pricing. Without considering the lines actually used, there is no hope of getting transmission prices right. Worse yet, continued contract-path pricing with a growing volume and variety of transactions will surely prove to be simply unworkable.

Duplication Costs Adjusted for Line Loadings Assuming a decision to price actual rather than fictitious uses of the system, the incremental cost principle can be applied in a sound and practical way. In its "Impacted Megawatt-Mile" pricing method, Dominion Resources proposes to price the megawatt-miles that flow over each line segment based on the duplication costs of each line, adjusted by the line's loading when the transmission service is committed. Line loadings provide a good measure of how near or far the transmission owner is from incurring the costs of duplicating the line. When a line is fully loaded, its duplication cost is the incremental cost of new capacity. When a line is only partly loaded, its incremental cost is a fraction of the duplication cost. Duplication costs adjusted by line loading thus provide a practical measure of the current incremental cost of transmission capacity, which represents the largest part of total transmission costs. Other elements of transmission costs include incremental real and reactive losses, and ancillary services would be measured and priced separately. Line loadings also provide a good measure of value added, because the most heavily loaded lines are those that connect areas with low generating costs to areas with higher costs. The greater the difference in regional generating costs, the more valuable the use of the transmission system and the greater the loadings on the connecting lines. When lines are fully loaded, Impacted Megawatt-Mile pricing provides for opportunity bidding by users and generators able to free up capacity for a new transaction. Through this mechanism, fully loaded transmission capacity can always be used for the most valuable transactions. Prices That Make Sense Incremental pricing makes basic economic sense. Incremental cost pricing under the Impacted Megawatt-Mile proposal creates strong incentives for efficient use of the existing transmission system and efficient additions to transmission capacity. In addition, transmission prices that reflect incremental transmission costs promote efficient decisions on the location of new generating capacity. By contrast, prices based on embedded costs would improperly reflect past costs. Moreover, they would vary capriciously. In a flowbased system with embedded-cost pricing, the cost of using an identical transmission line providing identical service would change, perhaps drastically, depending on the embedded costs of the system it belongs to. Besides its important features encouraging efficiency, Impacted Megawatt-Mile pricing offers other advantages for both users and owners. Because pricing is based on a formula and considers the same flows in pricing that are examined in reliability (i.e., availability) evaluations, Impacted Megawatt-Mile pricing allows almost instantaneous determinations of availability and price in real-time information networks (RINs). Impacted Megawatt-Mile pricing provides a transparent and predictable pricing system that would apply equally to all competitive users, including transmission owners. Users would pay only for the lines their transactions actually used, not for slices of entire systems. They would pay based on distance, but not be subject to pancaked prices.

For owners, Impacted Megawatt-Mile pricing provides proper payment for the services each owner's system actually provides, eliminating uncompensated loop flows. Native customers would be protected, and owners would have incentives to add needed new transmission capacity. Impacted Megawatt-Mile pricing is also well suited to provide regional transmission service without the need to alter existing transmission ownership. Impacted Megawatt-Mile pricing can be applied to bilateral transactions, in pools or in a mixed setting. It applies to firm and nonfirm service as well as point-to-point and network service. Objections are Invalid The objections often raised against incremental-cost pricing are not valid in the case of the Impacted Megawatt-Mile proposal. First, Impacted Megawatt-Mile pricing does not lead to a substantial increase in average transmission prices. The prices for specific transactions would differ sharply from traditional pricing, as they must to give efficient price signals. But the variations above and below traditional prices would tend to balance out, with no sharp change in overall price levels. This balancing reflects the fact that much of the system is not heavily loaded. Second, Impacted Megawatt-Mile pricing does not require forecasts or speculation about future uses of the system. Prices are based solely on knowable facts about current system use and current line duplication costs. Third, since Impacted Megawatt-Mile pricing produces the lowest prices consistent with economic efficiency and applies them without discrimination to all competitive users, the prices set under this system can be approved by the Federal Energy Regulatory Commission (FERC) as just and reasonable, even though they will not produce revenues that match a traditional embedded-cost revenue requirement in any particular year. The time has come to abandon traditional thinking and recognize that if transmission prices are set properly, the revenue they provide is the revenue requirement for regulatory purposes. Adjusting prices based on incremental costs to match each year's embedded-cost revenue requirement would unnecessarily undermine the pricing system's incentives for efficiency. Over time, Impacted Megawatt-Mile pricing should allow owners making average decisions on capacity additions to recover their investment costs for both existing and new capacity, including their allowed return on capital. Owners wise enough or lucky enough to build lines that experience high usage growth should realize above average returns. Let's remember that if the transmission system is viewed in terms of actual flows, rather than contract paths, a number of different investments can relieve heavy loadings on a particular line or lines. Impacted Megawatt-Mile pricing provides market-like incentives rather than central planning to encourage the best choices of new lines. In sum, Impacted Megawatt-Mile Pricing provides a practical way to reflect incremental costs. In that way, it will help achieve increased efficiency that marks the true objective of electric restructuring. Alfred F. Mistr, Jr. is director of planning analysis for Dominion Resources, Inc., chairman of the Interconnection Dynamics Working Group of the North American Reliability Council, and a charter member of the General Agreement on Parallel Paths Committee. A licensed professional engineer in the State of Virginia, Mr. Mistr holds a BS in electrical engineering from Virginia Polytechnic Institute.