The application of marginal cost pricing principles to a hydro-electric system: The case of hydro-Québec

Abstract

This paper develops a marginal cost pricing methodology for electricity generated almost entirely from hydro sites. We apply this methodology to the case of Hydro-Quebec, a large hydro-electric utility. Cost minimizing rules for the choice of generating equipment while taking into account the limited availability of water power are derived, and these form the basis for the estimation of the marginal cost of delivering power. Here are the main findings. First, prices based on the marginal cost of delivering power to final users would stand in a ratio of 15:l for the peak period versus the off-peak period. Second, prices established under the marginal cost principle would exceed current uniform prices in the peak period for all classes of users and they would decrease in the off-peak period for residential and commercial users. Third, such price changes could generate additional profits to Hydro-Quebec of more than one billion dollars a year even if the change in overall output is rather small. Finally, the welfare gain resulting from the application of marginal cost pricing would range from $270.0 to $530.0 millions a year, without taking into account the added metering expenses required to implement such a pricing scheme.