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Incremental Pricing - Fixed and Variable O&M Cost Analysis

A key question all utilities are now facing is that of pricing incremental O&M costs for use in determining prices for off-system sales. Previous methodologies, which addressed energy versus capacity pricing, do not meet today’s needs of defining variable costs.

Issue Background

One of the key components in determining incremental costs of power production is variable O&M. The issues surrounding variable O&M have become very important in the utility industry as competition increases and more and more utilities try to improve their earnings or margins through increased off-system sales. Historically, fixed and variable O&M calculations were established primarily to determine demand and energy charges for long-term sales. Under these circumstances, the concern was proper cost accounting and allocations between the two types of rate charges. Today, as margins for off-system sales become smaller and competition becomes greater, it is important for a utility to know, as closely as possible, its incremental costs of producing electricity so that it can be assured that sales are being made which cover production costs.

At many utilities, a "fixed percent" method , i.e. 70% fixed/30% variable has been used for a number of years. This method was developed in the early 1980’s and was based on estimates of the appropriate variable and fixed costs needed to operate a power plant. Other methods that have been accepted include the Federal Energy Regulatory Commission (FERC) procedure, which classifies expenses as pro-rated to demand or energy related; the National Association of Regulated Utility Commissions (NARUC) method, which uses a similar classification of demand in energy related expenses; and the EPRI method of classification.

The evaluation of production O&M expenses is generally the responsibility of the Rates Department for most utilities, in conjunction with Power Production, Engineering, and System Operation Department to provide input and utilize the O&M expense information for off-system sales.

The impact of decisions regarding variable cost on fuel procurement are somewhat indirect, but extremely important. The pricing structure that is utilized by system operations for off-system sales will dictate the level of system sales and the result in fuel consumption. Some utilities use spot coal in its pricing for off-system sales. By using the spot price of coal for the production of off-system sales, the short-term procurement policies must be capable of changing very quickly, as sales opportunities rise or diminish.

Vantage Implementation Approach

Our consultants will work directly with power supply, rates, cost accounting, engineering and system operations management to determine both the corporate philosophy and specific costs needed for the evaluation. The typical steps would be to:

Determine if management has developed specific objectives regarding off-system sales and develop if necessary.

Review the current methodology for determining fixed/variable mix.

Establish a proposed sales strategy for each unit in the system.

Establish a work team for each station/unit to identify specific activities.

Review and allocate all cost elements into variable/fixed categories.

Develop algorithms for converting current cost accounting information to incremental pricing activity.

Prepare pricing policy for dispatch and sales personnel.

 

The benefits of a system that provides accurate and current information regarding incremental costs provide an array of benefits:

At any time, power sales personnel will know, with some assurance, the actual incremental cost of power production. This will help in maximizing profits and avoiding sales at below cost.

An increase in sales is also likely as a result of better definition of mission and clearer cost estimates. For example, a 500 MW coal fired unit with a capacity factor of 60% might see an increase in capacity factor of 1% to 3%. With a 5 mill margin between incremental cost and sales level, the annual net revenue would be approximately $219,000 for each 1% increase in capacity factor.

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