Appropriateness of marginal-cost-based electricity prices in deregulated markets

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This thesis examines the appropriateness of marginal-cost-based principles for pricing electricity in deregulated markets. This examination is prompted by the rising concerns about the incessant increases in electricity prices; disconnects between costs and prices; social equity and justness of prices; and – more broadly – increasing disparity between expected and actual outcomes of electricity market reform. While it is true that these outcomes are a result of a complex array of factors, this thesis is however premised on the argument that electricity pricing practices, based on marginal-cost principles, is a dominant factor in affecting the above noted market outcomes. In view of multi-dimensional foci of this research, recourse is made to the body of knowledge residing in several academic disciplines (e.g., engineering, economics, and public policy) and research methodologies (e.g., historic review, empirical research, inferential analysis, and econometrics). The case-examples for this thesis are provided by the electricity industries in the developed world (primarily, the US, UK and Australia, but – more broadly – Germany and France). The analysis reveals that pricing philosophies of the earlier times (from the Aristotelian, to the medieval times) – that are precursors to the modern-day pricing practices – quintessentially emphasized considerations of social justice and fairness in pricing; profit, rather profiteering, was generally viewed unfavourably in those times. The coincidental births (in the mid-to-late 1880s) of the electricity industry and neo-classical ideology however appears to have imparted a profit-seeking ethos to the foundations of the electricity industry. Assisted by rapidly rising (and highly, inelastic) electricity demand, technology-innovation-induced economies-of-scale, and mutually-symbiotic ‘understanding’ between diverse industry interest (namely, utilities, customers, equipment manufacturers, fuel suppliers, regulators, investors, governments), the electricity industry – up until the 1960s- continued to earn super-normal profits, while maintaining lowering cost and price trends for electricity. These trends however reversed in the 1970s, turning the electricity industry into a rising-cost, even faster-rising-prices, and a shrinking profit industry. Concomitant with the rise of neo-liberal thinking in the eighties, the electricity industry began to be deregulated – in accord with neo-liberal principles. A key element of this reform was the re-enforcement of faith in market-discovered, marginal-cost-based electricity prices – as the best means to achieve allocative efficiency, lower electricity costs and prices, and investment-attractive returns (profits). In view however of the plateauing of technological advancements in the 1970s and 1980s, availability of alternative technologies (e.g., low-capital-high-operation-cost gas turbines, renewables), systems (e.g., decentralized), and structural and governance arrangements (completion, choice, light-handed incentive regulation), marginal cost-based prices failed to deliver on the expectations. The only course of action for the industry to recoup capital costs (in this high-capital cost industry) was to ‘game’ the system, through the abuse of market power, taking advantage of the indispensability of electricity. Cost (euphemism for profit) considerations became the motor of all major decisions. This sent the system into a disarray – costs became disconnected from prices, households bore the brunt of price increases, and the technical integrity of the system was compromised. In addition to empirical validation, this research has substantiated these claims through econometric analyses. This research further makes a case for developing alternative pricing paradigms, underscored by considerations, for example, of continual efficiency improvements, incentivizing technology innovations, benchmarking costs to improved efficiencies, and - above all – ensuring that social justice and fairness are central to the pricing strategies for various segments of society.
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