On the Pricing of Independently-Generated Electricity

Abstract

Independent power production represents one of the most rapidly-growing sources of electric power supply. Cogeneration and small power production currently accounts for approximately 3 percent of total energy output, and the Department of Energy has predicted that independent power production will quintuple by the year 2000 [6, 258]. Underlying these aggregate figures is a high degree of geographic dispersion. Some states have no independent power producers (IPPs) on line, whereas other states have become heavily dependent on independent power production. For example, California has in production or on plan IPP capacity equivalent to eighteen nuclear power plants [6, 258]. There is widespread concern that some of this growth is uneconomic and has been encouraged by inefficient pricing methods. Section 210 of the Public Utility Regulatory Policies Act of 1978 established a framework for regulatory oversight of electricity sales from independent power producers to electric utilities. The Federal Energy Regulatory Commission (FERC) promulgated rules implementing this legislation, requiring that IPPs be compensated at a rate reflecting the utility's full avoided cost. The FERC rejected approaches to pricing that would transfer some of the cost savings to utilities, acknowledging that, . . under the full avoided cost standard, the utilities' customers are kept whole, and pay the same rates as they would have paid had the utility not purchased energy and capacity from a qualifying facility [4, 12222]. The specific pricing methods employed in the implementation of the FERC guidelines are the objects of growing concern. The literature in economics has not provided a fully-developed model of the pricing of independently-generated electricity. The absence of such a framework precludes a critical evaluation of pricing practices. Our objective here is to develop a model for the analysis of the pricing of independently-generated electricity. This model is applied in a critique of an important existing pricing method, and is used to develop an efficient pricing scheme. The most prominent avoided-cost pricing method is to price energy provided by IPPs at a