serving the region in which the QF is located. Transmission access has been quite limited, so QFs have very little ability to seek buyers other than the monopsony utility. Wholesale transactions have been generally limited to inter-utility exchanges, up to the passage of the Energy Policy Act of 1992 (see Part 3 below). Therefore, since the utility is a monopsony buyer, and can potentially limit or manipulate over time a revisable QF tariff price, the seller needs a long term contract with fixed prices to limit opportunism. The alternative would be to finance relying only on a tariff. This approach would require much more equity than has been typical of project finance supported by long term contracts. Since equity is much more expensive than debt, such projects would be less profitable.

PURPA defined the pricing rule in both the long and short run using the notion of avoided cost. The fundamental idea underlying the avoided cost concept was that ratepayers should be indifferent to QF purchases. This meant that any economic rent accruing from QF efficiency would flow to the private producers, not utility ratepayers. State implementation of the avoided cost concept focused on the substantial practical problems of estimating what constituted ratepayer indifference.

The distinction between avoided energy and avoided capacity costs is basic. The former is appropriately measured considering the operations and dispatch of the power system (see, for example, Jabbour, 1986). The latter is essentially a reliability issue; capacity costs are incurred to reduce the probability that shortages will occur. Where utilities had excess capacity, avoided costs were predominantly associated with energy. Where utilities had capacity requirements, both terms had to be considered, commonly in a framework that examined a wide range of generation technology options. In practice, utilities and state commissions negotiated estimates of avoided cost. The boundaries of these negotiations could be broad, requiring compromises between precision and ease of estimations.

Seen broadly, the avoided cost dialogue is part of the “cost unbundling” process in which the underlying cost structure of the firm gets examined with increasing sophistication and depth. Cost unbundling is common in regulated industries under competitive pressure (Bailey, 1986). What is different in this case is that a competitive fringe of firms audits the costs of the incumbent by litigation in regulatory proceedings. The advantage of this arrangement is that the regulatory process can compel disclosure that otherwise would not occur. The disadvantage is that the competitors are seeking economic rents in their use of the regulatory process, so their auditing function is not necessarily unbiased. This process, in both its positive and negative aspects, is illustrated by the litigation in California over short-run avoided energy cost payments (Kahn, 1995).

### I II. Competitive Bidding for Private Power

Competitive bidding for long term contracts emerged as a successor to the “first-come/first served” rationing mechanism associated with standard offers. The bid evaluation process requires complex trade-offs. Proposed projects differ by their fuel type, level of