Marginal-cost pricing under uncertainty. Final report

The purpose of this study is to explain what marginal-cost pricing of electricity involves, how the rules change with the incorporation of demand and cost uncertainty and to illustrate these principles with an example. It is pointed out that marginal-cost-based rates and optimal investment plans have to be determined jointly. Thus, there are two rules to be followed: an optimal pricing rule and an optimal investment rule. The former sends proper signals to consumers and the latter sends proper signals to producers. The pricing rule says: Set price = short-run marginal cost if demand is less than capacity output, if demand is higher than capacity output, set the price at a level higher than marginal operating cost so that demand equals capacity output. Thus, contrary to popular belief, price is not always equal to marginal operating cost but it is marginal operating cost on the basis of which price is set. Further we need knowledge of demand elasticities to set prices. Finally, the pricing rule should be used in conjunction with an investment rule which says: Build new capacity when operating costs + marginal rationing costs are greater than marginal capacity costs. These pricing and investment rules have to bemore » changed suitably in the case of demand and cost uncertainty. The report illustrates these principles both with and without uncertainty and points out what data are needed to implement marginal cost pricing. It is also pointed out that some current regulations requiring utilities to report their marginal-costs ask only partial information and are not of much use. Without estimates of demand functions and the optimal investment plans, the marginal costs reported are useless for pricing purposes.« less