Case Study ESTIMATING THE COST OF SERVICE FOR AN ELECTRIC UTILITY Regulated industries must pay particular attention to their cost structure. estimates of their operating costs must be presented to the authorities to support of any request by the regulated firm for the rate increase. As a consequence, these industries rely on rate researchers to empirically estimate the cost of providing their services. As one would expect, the estimated cost of service has many components. Economic theory states that the short run cost of providing a good or service consist of both variable and fixed costs. From a practical standpoint, the rate the researcher attempts to operationalize these classifications. First there are explicit variable costs of providing the product. These include all expenses directly related to the production of the good or service. such as labor , energy, and raw materials expenditures. Second there are fixed costs, including depreciation expenses, taxes, and capital investment expenditures. The standard formula for cost of service (COS) can be represented by the following: COS = TVC + DEP + TAXES + R * BASE Where: TVC= total variable costs, DEP=depreciation expenses, TAXES=all appropriate tax expenditure, R= allowed rate of return, and BASE=capital investment expenditures required to produce the service The electric utility industry has been the subject of intense investigation regarding its cost of service. Recall from introductory economics that electric utilities are natural monopolies. As such, an unregulated price of electricity would be detrimental to society. The utility will earn economic profits at the expense of consumers, and the presence extensive economic of scale would prohibit entry by potential competitors. The solution to this problem is for the government to regulate the price such that the natural monopolist earns just a normal rate of return. That is revenue of providing the service are controlled to be exactly equal to the cost of providing the service. To illustrate how the rate researcher might estimate the cost of service for a proposed utility in the new area, you collect the following data on thirteen regional plants for existing utilities. To hold technology constant, you restrict the data to include only fueled electric plants. For simplicity, the proposed utility will operate in the same region and will produce the average amount of output, incur the average amount of depreciation expense ($10 million) and taxes ($7 million), and undertake the amount of capital investment ($250 million). The firm will allow to earn a 10% return on its investment.The only component of the cost-of-service formula not known is the amount of Variable Cost that will be incurred. To estimate the Variable Costs of providing the good or service, you specify the Average Variable Cost equation as a quadratic function of output, given as follow: AVC = do + a,Q+ a2Q2 Where; AVC is the Average Variable costs and is the sum of labor and fuel expenditures divided by output. Estimate the preceding AVC function with the plant level data given below using least square regression analysis. Use your results to answer the questions. ## Plant Output Labor Expenditure Fuel Expenditure ## 1 A 1881 6350 88596 ## 2 2636 13431 131806 ## 3 C 2616 6239 123242 ## 4 26 717 1087 ## 5 E 2030 11688 107477 ## 6 F 4148 23056 190474 ## 7 G 3513 20744 158973 ## 8 H 192 700 14807 ## 9 I 118 2696 7355 ## 10 U 9203 21922 250350 ## 11 K 3754 22735 141368 ## 12 284 3063 13455 ## 13 M 3273 8698 65390 Output = power generation (million kilowatt hours). Labor expenditure = total production expense, exclusive of fuel ($000). Fuel expenditure = fuel production expense ($000). QUESTIONS 1. Does your estimated AVC function confirm to economic theory? Explain. 2. Use the parameter estimates to obtain estimates of Total Variable Cost (TVC). 3. Given your total variable cost estimation results, determine the estimated cost of service for the proposed utility. 4. Given the cost of service estimate and assuming that the utility sells the average amount of output, what is the price per kilowatt hour the authorities will allow this firm to charge? END OF CASE STUDY