Energy Pricing and Taxation

Abstract

This chapter introduces the economic concepts related to pricing of energy in different market conditions. The chapter starts with the basic competitive market model and discusses the extensions required to analyse specific features (such as indivisibility of capital , specificity of assets, capital intensiveness, etc.) of the energy sector. The chapter also covers the issue of market failure and presents the commonly used market interventions in such situations. The concept of cost-benefit analysis is used as the framework for most of the analysis. The principles of energy pricing are then introduced and the economic rationale behind energy taxation is considered.

Annex 9.1: Peak Load Pricing Principle

In what follows, we use a simple example to illustrate the pricing principle for peak and off-peak periods. This follows Munasinghe and Warford (1982, Appendix C).

Suppose that the annual load duration curve of the electric utility is composed of two distinct periods (see Fig. 9.25):

• An off-peak period during which the base load plants (using coal, nuclear, etc.) are used to supply the power. For simplicity it is assumed that the cost characteristics of these plants are uniform. The fixed cost per kW of capacity is a and the variable cost per hour is f. Assume also that the base capacity is given by X kW.

• A peak-period during which peaking plants are called to supplement power supply from the base load plants. The fixed cost per kW of capacity is b and the running cost per hour is g. Total load is Y kW, which implies that Y-X is the peak load capacity.

Fig. 9.25

Load duration curve for the example

It is assumed as usual that a > b but f < g. It is also assumed that the entire capacity is fully utilised.

For any duration, h, the cost of using 1 kW of capacity of base plant is given by

$$ {\text{y}} = {\text{a}} + {\text{f}}\,*\,{\text{h}}, $$

(9.21)

whereas for the peak plant the cost is given by

$$ {\text{z}} = {\text{b}} + {\text{g}}\,*\,{\text{h}} $$

(9.22)

Given the cost characteristics, there exists a point where the costs of using the two types of plants are equal, i.e. y = z. This point indicates a number of hours during which the peaking plant shall be operated. By equating 9.21 and 9.2, this duration is obtained as follows:

$$ {\text{H}} = \left( {{\text{a}} - {\text{b}}} \right)/\left( {{\text{g}} - {\text{f}}} \right) = {\text{difference in fixed costs}}/{\text{difference in variable costs}}. $$

(9.23)

This is shown in Fig. 9.26.

Fig. 9.26

Screening curve

The cost of supplying the load as shown in Fig. 9.26 can be written as:

$$ {\text{C}} = {\text{X}}\left( {{\text{a}} + {\text{f}} \cdot {\text{T}}} \right) + \left( {{\text{Y}} - {\text{X}}} \right)\left( {{\text{b}} + {\text{g}} \cdot {\text{H}}} \right) $$

(9.24)

where T is the total hours in a year (8760).

We are now going to analyse how the cost changes due to changes in peak and off-peak demand.

Case 1: Peak load demand changes by 1 kW

As the installed capacity is fully used, when the peak load demand increases by 1 kW, the utility has to install an additional peak capacity of 1 kW. This is shown by the coloured rectangle above Y. The new cost of production is given by:

$$ {\text{C}}1 = {\text{X}}\left( {{\text{a}} + {\text{f}} \cdot {\text{T}}} \right) + \left( {{\text{Y}} + 1 - {\text{X}}} \right)\left( {{\text{b}} + {\text{g}} \cdot {\text{H}}} \right) $$

(9.25)

$$ {\text{The incremental cost is}}\,\Delta {\text{C}}1 = {\text{C}}1 - {\text{C}} = {\text{b}} + {\text{g}} \cdot {\text{H}} $$

(9.26)

This suggests that an additional demand during the peak period leads to two types of costs: the fixed cost and the running cost and the consumers should bear these costs if the tariff has to be cost-reflective.

Case 2: Demand increases during off-peak period

As the off-peak capacity is fully used, the utility has to install 1 kW of off-peak capacity. As the off-peak capacity will be available for peak load as well, the peak capacity will be reduced by 1 kW. The cost of supply can be written as:

$$ {\text{C}}2 = \left( {{\text{X}} + 1} \right)\left( {{\text{a}} + {\text{f}} \cdot {\text{T}}} \right) + \left[ {Y - \left( {X + 1} \right)} \right]\left( {b + g \cdot H} \right) $$

(9.27)

The incremental cost is given by

$$ \Delta {\text{C}}2 \, = {\text{ C}}2 \, {-}{\text{C}} = \left( {{\text{a}} + {\text{f}} \cdot {\text{T}}} \right){-}\left( {{\text{b}} + {\text{g}}.{\text{H}}} \right) = \left( {{\text{a}} - {\text{b}}} \right) + \left( {{\text{f}} \cdot {\text{T}}{-}{\text{ g}} \cdot {\text{H}}} \right) $$

(9.28)

From Eq. 9.27, (a − b) = (g − f).H

Replacing Eq. 9.27 in Eq. 9.28, we get

$$ \Delta {\text{C}}2 = {\text{f}} \cdot \left( {{\text{T}} - {\text{H}}} \right) $$

(9.29)

The supplementary cost is equal to the cost of running the off-peak capacity during the off-peak hours (T − H). There is no fixed cost attached here and hence consumers coming to the grid during off-peak hours should pay only the running cost.

Case 3: Demand increases during the entire period

In this case, the total demand increases by 1 kW throughout. The total cost of supply is given by:

$$ {\text{C}}3 = \left( {{\text{X}} + 1} \right)\left( {{\text{a}} + {\text{f}} \cdot {\text{T}}} \right) + \left( {{\text{Y}} - {\text{X}}} \right)\left( {{\text{b}} + {\text{g}} \cdot {\text{H}}} \right) $$

(9.30)

Hence, the incremental cost is given by

$$ \Delta {\text{C}}3 = {\text{a}} + {\text{f}} \cdot {\text{T}} . $$

(9.31)

This suggests that the total incremental cost of supply has to be borne by the consumers in this case.