Workshop I

Game Plan for the Course

Workshop 1: Marginal Cost Estimation

ƒ Benefits of Using Marginal Costs

ƒ NERA’s Marginal Cost Framework

─ Marginal Generation Costs
─ Marginal Transmission Costs
─ Marginal Distribution Costs
─ Customer Expenses
─ Economic Carrying Charges
─ Administration and General Expenses

─ Marginal Losses

ƒ Exercises to compute marginal costs

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 Workshop I

Definition

Marginal Cost: Change in Total Cost from a

Small Change in Load

Because the cost of additional usage may differ by hour, it

is key to estimate marginal costs of electricity by time of
use and for each element of service

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 Workshop I

PURPA Required Looking at Marginal

Costs in 1978

Public Utility Regulatory Policies Act

Purposes: Conservation

Efficiency

Equity

ƒ Regulators were required to determine how marginal

cost-based rates would help achieve these purposes.

ƒ Utilities were required to purchase energy and

capacity from cogenerators and small power
producers at “avoided cost.”

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 Workshop I

Additional PURPA Ratemaking Standards

Standards Added in 2005:

▪ Net Metering
▪ Interconnection with generation on customers’
premises

And in 2007:

▪ Energy Independence and Security Act (EISA)

requires regulators and utilities to evaluate time-
varying rates that promote energy efficiency

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 Workshop I

Hourly Market Prices can now be

Signaled to Consumers with Smart Grid
Technologies

▪ “Smart Grid” includes:

▫ Advanced Metering Infrastructure (AMI) and

Real-Time Communications

▫ Home Area Network (HAN)

▫ High-performance grid sensors

▫ Integration of energy storage devices

Marginal cost information is essential

to assess the potential cost savings
from adopting these technologies

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 Workshop I

Basic Framework for Marginal

Cost Study

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 Workshop I

Components of Electric System

Transmission
Grid

Sub-transmission
Lines

Line
Primary Lines
Transformer

UG Service
(primary)

OH Service

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 Workshop I

Electric Marginal Cost Components

• Marginal Generation Costs – Energy and

Capacity (approach varies with industry
structure)

• Marginal Transmission Costs – (approach varies

with industry structure)

• Marginal Distribution Substation & Trunkline

Primary Feeder Costs

• Marginal Local Distribution Facility Costs

(including Radial Primary, Transformer, and
Secondary)

• Marginal Customer Costs (including Meter,

Service Drop and customer-related expenses)

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 Workshop I

Marginal Costing Analysis

ƒ Analyze forward-looking market conditions and

anticipate the response of system planners,
operators budgets, and system dispatchers to
changes in load

ƒ Identify which cost components change with time

of use, and compute hourly marginal costs

ƒ Group hourly marginal costs by time-of-day periods

and seasons, for pricing purposes

ƒ Estimate short-run marginal costs over several

years (and average them, if appropriate, for rate
purposes)

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 Workshop I

Marginal Cost Under Alternative

Industry Structures

Simplest - Vertically integrated utility

No competition
No customer choice

Utility
T

c c c c

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 Workshop I

Industry Restructuring
Requires More Complex Cost Analysis
▪ Competitive generation
▪ ISO/RTO
▪ Regulated delivery company
▪ Customer choice

G G G

ISO
Regulated
Regulated transmission
transmission tariff
and Wholesale
distribution
tariff
Aggregator

Regulated “Default
D Service” tariff
D D

Retailer Retailer c

c c
c c c
Arrows represent
electricity supply
arrangements

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 Workshop I

Marginal Cost Pricing – A Review of

Economic Welfare Concepts

Price

Consumer Surplus

Marginal
P0
Cost

Demand

Quantity

Consumer surplus is the difference between what

buyers are willing to pay and what they have to pay.

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 Workshop I

Pricing Above Marginal Costs Results

in “Deadweight Loss”

Price
and
Cost Loss of Consumer
Surplus (Deadweight
Loss)

P
1
Marginal
Cost

Demand

Q1 Q0 Quantity

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 Workshop I

Pricing Below Marginal Costs results in

Wasted Resources
Price
and
Cost
Loss to Society

Marginal
Cost
P
2

Demand

Q0 Q Quantity
1

The cost of producing the additional units exceeds their

value to consumers.

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 Workshop I

Marginal Cost Notions

ƒ Long-Run: Cost of hypothetical optimal

system (all inputs are variable – no
specific time horizon)

ƒ Short-Run: Costs of existing situation, reflecting sub-

optimality (capacity is fixed, but shortage-
related costs are included)

ƒ Long-Term: Stream of short-run costs over

some specific time period
(includes cost of adding capacity)

LRMC = SRMC in Equilibrium

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 Workshop I

How can revenue requirement allocations

reflect marginal costs?

ƒ Revenue from Tariffs set at MC levels will produce

above or below than actual Revenue Requirement

ƒ The revenue gap (positive or negative) can be

allocated to classes efficiently to minimize
distortions in efficient use

ƒ If “cross-subsidy” is defined on the basis of

marginal costs, every class should pay no more and
no less than its MC of service plus the ‘efficient’
share of the gap

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 Workshop I

Overview of NERA’s Approach

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 Workshop I

NERA Marginal Cost Framework

Annual Marginal Customer Costs
by Customer Class and Voltage Level
Investment
Meter and Service Drop Investment

General Plant Loading

Annualization
Annual Economic Charge

A&G Loading for Plant

Expenses
Meter and Service O&M Expenses
Customer Accounts Expenses

Customer Service & Informational Expenses

A&G Loading for Expenses

Revenue Requirement for Working Capital

Materials & Supplies

Prepayments
Cash Working Capital

Total

Total Annual Marginal Customer Cost

Monthly Marginal Customer Cost

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 Workshop I

NERA Marginal Cost Framework

Marginal Distribution Facilities Costs

Investment by Customer Category

Investment per kVa
General Plant Loading

Annualization
Annual Economic Charge
A&G Loading for Plant

Expenses
Distribution Facilities O&M Expenses
A&G Loading for Expenses

Revenue Requirement for Working Capital

Materials & Supplies
Prepayments
Cash Working Capital

Total

Annual Marginal Distribution

Facilities Cost per kVa

Conversion
Annual Marginal Distribution Facilities Cost
Per Customer for Residential Categories

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 Workshop I

NERA Marginal Cost Framework

Hourly Marginal
Transmission and Distribution Substation Costs

Investment
Investment per kW
General Plant Loading

Annualization
Annual Economic Charge
A&G Loading for Plant

Expenses
Demand-Related O&M Expenses
A&G Loading for Expenses

Revenue Requirement for Working Capital

Materials & Supplies
Prepayments
Cash Working Capital

Total Annual Marginal Cost

Time Differentiation
Assign annual costs to hours based on
relative likelihood of exceeding capacity

Loss Adjustment
Apply Demand Loss Factors

Hourly Marginal Costs By Voltage Level

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 Workshop I

NERA Marginal Cost Framework

Hourly Marginal Energy Costs
(Two Hours are Shown for Illustrative Purposes)

Competitive market — for Traditional utility — for each

each hour hour

Spot Price* / kWh Marginal Running Costs (system lambda)

+
A&G Loading for Nonfuel
O&M Expenses

+ +
Revenue Requirement for Working Capital

Fuel Inventory
Cash Working Capital
Cash Working Capital for Fuel

Cash Working Capital for

Nonfuel O&M Expenses

x x
Marginal Losses

Marginal Energy Loss Factor Marginal Energy Loss Factor

for the hour for the hour

Marginal Energy Cost per kWh Marginal Energy Cost per kWh
by Voltage Level of Service by Voltage Level of Service

* If there is no separate capacity market, the spot price will include

a capacity component sufficient to clear the market when supplies are tight.

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 Workshop I

NERA Marginal Cost Framework

Short-Run Hourly Marginal Generation Capacity Costs

In competitive situation with a With no competitive market:

separate market for capacity:
Market Price per kW in Period Investment Cost per kW of Least-Cost Option
OR
General Plant Loading

Annualization
Annual Economic Charge
A&G Loading for Plant

Expenses
Fixed O&M on Least-Cost Option
A&G Loading for Expenses

Revenue Requirement for Working Capital Revenue Requirement for Working Capital
Cash Working Capital Materials & Supplies
Prepayments
Cash Working Capital

Total Annual Cost Per KW

Reliability Adjustment
Divide by 1 minus effective forced outage rate

Calculate Cost of Unserved Energy

Divide annual cost of reserves by target LOLH
Compute Hourly Cost Compute Hourly Shortage Cost
Relative likelihood of having to buy Multiply costs of unserved
capacity in each hour of the period energy by LOLH in hour

Loss Adjustment Loss Adjustment

Apply energy loss factor Apply demand loss factor

Hourly Short-Run Marginal Capacity Cost By Voltage Level

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