Principles of modern electricity pricing

Abstract

This paper presents a framework for electric power pricing, reviews the basic theory of marginal cost pricing applicable to the power sector, and summarizes recent developments. The adaptation of the theory for practical application in relation to the objectives of power pricing policy results in a two stage procedure for tariff setting. First, the detailed structure of the strict long-run marginal costs (LRMC) of supply which meet the economic efficiency criterion are computed. Second, the strict LRMC is adjusted to arrive at an appropriate realistic tariff schedule which satisfies other constraints, including economic second best and social lifeline rate considerations, financial needs, simplicity of metering and billing, etc. The results obtained through past applications of modern pricing structures internationally are reviewed, and the U.S. situation is discussed with respect to the Public Utility Regulatory Policies Act (PURPA) of 1978.