Regulatory Preferences and Two-Part Tariffs: The Case of Electricity

1. Regulatory Preferences and Two-Part Tariffs: The Case of Electricity Paper by Michael C. Naughton

2. Introduction • Purpose: • To develop and demonstrate a method for deriving and testing regulatory preferences within and across customer classes. • To assess the impact of these preferences on price structures and regulatory effectiveness in the electric utility industry.

3. The Regulator’s Constituents Regulators’ constituents consist of: • The regulated firm • Three classes of consumers: • Residential • Commercial • Industrial • Assumption: consumers within each class are heterogeneous (they differ in demand)the number of potential buyers who make the decision to consume depends on prices charged • LR Choices:

4. The Regulator’s Constituents Surplus = utility consuming q1 – utility from being excluded from the market for q1 *For an individual P1 = per-unit price for kilowatt hour output L1 = connection charge Y(h1) = prepurchace income of consumer type h1 Membership: Aggregate Output: Producer Surplus for regulated firm:

5. The Regulators’ Optimal Prices • The regulators are assumed to maximize social surplus (W) where the surplus of each customer in class i is weighted by zi(hi) and the producer surplus of the regulated firm is weighted by zM. • When maximizing this weighted social surplus function, regulators may be maximizing political support as suggested by the economic theory of regulation. Weighted social surplus for customer class i: Given that regulators are assumed to maximize the sum of weighted consumer and producer surplus, prices are the solution to:

6. Ramsey Numbers and Price Structures Ramsey Number based on Output: Ramsey Number based on Membership: These equations indicate that for given output-weighted and membership-weighted Ramsey numbers, prices differ from their marginal costs so as to minimize the change in kWh output and membership from their first-best level. If regulators have constant preferences across and within customer classes then = for all i and optimal pricing then requires that the proportionate change in kWh output and customer connection be equal across all customer classes.

7. Model Specifications: From Theory to Estimation • We develop a demand model that is used to derive estimates of kWh output and connection demand elasticities with respect to the per-unit and fixed prices for each customer class. These estimates are used to generate regulators’ Ramsey numbers and to develop second-best efficient and monopoly price structures (Demand equations found on table in slide 9). Elasticities derived from the demand models Output elasticities: Membership elasticities:

8. The Sample and Data • Sample: • 1980 cross section of privately-owned electric utilities • Only utilities whose service areas are contained within one state • Data Sources: • Department of Energy • Department of Commerce

9. Demand Equations and Estimates

10. Demand Elasticities and Price-Marginal Cost Differentials and Ramsey Numbers

11. Estimation Results • All coefficients in the estimated demand equations have the expected signs. • Ratio of consumption level of marginal consumer to consumption level of average consumer is significantly less than one in all three classes. • This implies that demand curves do not intersect because consumers with the lower consumer surplus have lower demand. • All estimates of elasticity are significant with the exception of the residential class cross elasticities. • Membership elasticity of price per kWh is less elastic in the residential class as compared to the industrial and commercial classes. • kWh output and customer connection demand are far less sensitive to the fixed charge than to the per-unit price.

12. Regulatory Preferences and Price Structure • All Ramsey numbers are significantly different from zero at the 5 percent level except for the membership weighted Ramsey number in the residential class • For Ramsey Numbers:

13. Regulatory Preferences and Price Structure • Intraclass Preferences: • The hypothesis of constant intraclass preferences can be rejected for the residential and commercial classes. • Results indicate that regulators favor small consumers in these classes. • Interclass Preferences: • Results indicate that the commercial class is the least favored.

14. Alternative Price Structure • Things to note: • Actual average prices in residential and industrial classes are very close to second-best average prices. • Actual average price is higher than the monopoly average price in the commercial class.

15. Conclusions • The results indicate that we can reject: • Monopoly pricing • First-best efficient pricing • Second-best efficient pricing • Regulation is effective in reducing monopoly power (esp. in residential & industrial classes) • Price structures tend to favor residential & industrial classes over commercial classes and favor small users within residential and commercial classes • Not surprising that low preference is given to commercial class  the great diversity of users in this class provides little political cohesiveness