A Marginal-Cost Pricing Model for Gas Distribution Utilities

FOREWORD The bylaws of The National Regulatory Research Instit~te state that among the purposes of the Institute is: • • • to carry out research and related activities directed to the needs of state-regulatory commissioners, to assist the state commissions with developing innovative solutions to state regulatory problems, and to address regulatory issues of national concern. This report-the fifth in our series of Occasional Papers-helps meet that purpose, since the subject matter presented here is believed to be of timely interes!_ to ___ ~_~g_~l~tory agencies and to others concerned with gas utility regulation. PREFACE In contrast to the case of electric utilities, there has been relatively little research in recent years on the application of marginal cost pricing principles to gas utilities, and most gas pricing studies have focused on the marginal cost of gas supply, discarding the marginal capacity cost as irrelevant because of an alleged excess capacity. However, several state regulatory agencies have recently expressed an interest in implementing marginal cost pricing-for gas distribution utilities. that .the marginal cost of gas is a relevant consideration in gas rate cases, and requested estimates of the commodity and capacity marginal costs at different times, recognizing the effects of contract provisions with suppliers, of storage co~ts, 'and of plans for transmission, distribution and storage. It is the purpose of this report to present a modeling methodology for the calculat'ion of gas marginal costs at the distribution level, with particular emphasis on capacity costs. A partial eq~ilibrium pricing model, including the optimization of supply mix and capacity expansio'n, the financial analysis of r€!venue requirements, and the design of marginal-.cost-based rates that achieve the revenue requirement constraint, is developed and applied with data characterizing the East Ohio Gas Company. Average and marginal cost pricing policies are compared in terms of their respective impacts on total gas consumption, load factor, new plant investments, and consumers' surpluses. The marginal cost pricing policy is shown to significantly improve the utility's load factor, to require smaller investments in new plant, and to yield higher surpluses for both gas consumers and the utility.