MARGINAL COST PRICING FOR UTILITIES: A DIGEST OF THE CALIFORNIA EXPERIENCE

I. INTRODUCTION California has been a bellweather state in inaugurating regulatory pricing techniques,(1) and the California Public Utilities Commission (CPUC) has moved marginal cost pricing from crude to refined. The dollars at stake have been huge by any standard. Electric revenues for the state's "big three" companies total about $16.8 billion annually (1995 data). The dollars are proportionally as large for major companies in other states. In California, after two decades, procedures for marginal cost pricing have reached an advanced stage of maturity. However, by reason of California legislative action imposing a rate freeze, further steps are now at an abrupt stop until the year 2002. So there is opportunity now, in this hiatus, to pause and to rethink the basic question: can microeconomic marginal cost theory, as expressed in the doctrine, in actuality be put into operation without major debilitating deviations so as to achieve the goal of economic efficiency by transmitting accurate price signals to consumers? The time is ripe for a reexamination of the efficacy of the marginal cost pricing doctrine for other states that have adopted it, as well as for California. The entire electric industry stands at the crossroads of restructuring. Will the doctrine become an anachronism or continue as a guide for regulated pricing? Energy professionals and academicians alike will contribute to the answer. The California experience is instructive both historically and prospectively. Historically, a brief-summarization of the CPUC's tortuous steps to cross the bridge from theory to practice - virtual tour de force in economic improvisation provides an overview of the raw data for a reexamination. Prospectively, the pricing issue is even more intriguing. In California, will the CPUC continue marginal cost pricing for utility services that will remain regulated after the rate freeze expires (local transmission, distribution and its several subfunctions, and QF payments)? Will free market prices for the deregulated electric generation sector - as they emerge from restructuring - conform to the microeconomic model of perfect competition as this model has been interpreted by the CPUC for fixing prices at the generating plant, either short-run or long-run? Nationally, given the divorce of generation from price regulation, will marginal cost pricing be relegated to the role of "just another" cost allocation method? Whatever the answers to these questions may turn out to be, the ventures of the CPUC provide useful background for the general microeconomist as well as for the specialist in micro theory applied to energy pricing. A. The Marginal Cost Pricing Doctrine The "marginal cost pricing doctrine" is shorthand for the proposition that utility rates should be predicated upon marginal costs for the purpose of attaining economic efficiency by means of accurate price signals. The doctrine stems from Professor Alfred E. Kahn's hugely influential two-volume book, The Economics of Regulation, (1970 and 1971). Kahn espoused marginal cost pricing as a means of bringing "economic efficiency" to regulated utilities. This pricing would result in "price signals" to consumers of sufficient accuracy so that they could evaluate the appropriate economic level and timing of their use of utility services. Thus, the buying decisions of consumers would be the means by which the end purpose of economic efficiency would be reached. B. The Theory(2) Quoting Professor Kahn, normative/welfare microeconomics concludes that "under pure competition, price will be set at marginal cost" (the price will equal the marginal cost of production), and this results in "the use of society's limited resources in such a way as to maximize consumer satisfactions" (economic efficiency) (I, pp. 16-17). The basis for the theory is clearcut: since productive resources are limited, making the most effective use of these limited resources is a logical goal. …