Efficient and "fair" pricing under New Zealand’s power distribution sector reforms : a model of intertemporal cross subsidies and economic depreciation

Abstract

The New Zealand Government’s objective in reforming the electricity supply industry has been economic efficiency. Policy actions specific to the power distribution sector have been based on the premise that electricity distribution is a natural monopoly, and a key desired outcome has been efficient and “fair” prices— those which allow electricity distributors to make a “fair return” on their network investments, while ensuring that consumers face prices which are “subsidy-free”. This thesis poses the question: what are the characteristics of efficient and “fair” prices for power distribution network services? Of crucial significance to this question is the time dimension, since debates over pricing principles posit: static versus dynamic efficiency; short run versus long run marginal cost; backward-looking versus forward-looking costs; historic cost versus replacement cost valuation; and back-loaded versus front-loaded depreciation. To address this question, a deterministic two-good/two-period model of intertemporal subsidy-free prices and economic depreciation is presented, by extending the model of intertemporal unsustainability developed by the contestability theorists, William Baumol, John Panzar and Robert Willig. This new model indicates that intertemporally subsidy-free prices are forward-looking, indexed to the hypothetical amortised opportunity costs incurred by a coalition of current and future consumers optimally constructing a greenfields network to meet their own demand. Depending on the similarities between this notional asset configuration and the incumbent distributor’s actual network, such prices may or may not reflect the distributor’s historic or replacement costs. Where spare capacity is optimally built today, in anticipation of future demand, prices should cover the opportunity cost of the total capacity required to meet current and future demand. Where capacity does not require expansion or replacement until some later date, prices should initially cover the opportunity cost of the capacity required to meet current demand alone, then rise to the cost of total capacity at such time as it would become optimal for consumers to construct greenfields capacity sufficient to meet both current and anticipated demand. These results reaffirm Marcel Boiteux’s position that spare capacity has its own income, as well as Ralph Turvey’s view that the expectation of lower costs in future raises today’s prices, providing—in some cases—justification for accelerated depreciation. However, under New Zealand’s light-handed regulatory regime, electricity distributor prices and associated depreciation schedules do not appear to have exhibited these characteristics.