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

The New Zealand Government’s objective in reforming the electricity supplyindustry has been economic efficiency. Policy actions specific to the powerdistribution sector have been based on the premise that electricity distribution is anatural monopoly, and a key desired outcome has been efficient and “fair” prices—those which allow electricity distributors to make a “fair return” on their networkinvestments, 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 thisquestion is the time dimension, since debates over pricing principles posit: staticversus dynamic efficiency; short run versus long run marginal cost;backward-looking versus forward-looking costs; historic cost versus replacement costvaluation; and back-loaded versus front-loaded depreciation. To address thisquestion, a deterministic two-good/two-period model of intertemporal subsidy-freeprices and economic depreciation is presented, by extending the model ofintertemporal unsustainability developed by the contestability theorists, WilliamBaumol, John Panzar and Robert Willig.This new model indicates that intertemporally subsidy-free prices areforward-looking, indexed to the hypothetical amortised opportunity costs incurred bya coalition of current and future consumers optimally constructing a greenfieldsnetwork to meet their own demand. Depending on the similarities between thisnotional asset configuration and the incumbent distributor’s actual network, suchprices may or may not reflect the distributor’s historic or replacement costs. Wherespare capacity is optimally built today, in anticipation of future demand, pricesshould cover the opportunity cost of the total capacity required to meet current andfuture demand. Where capacity does not require expansion or replacement untilsome later date, prices should initially cover the opportunity cost of the capacityrequired to meet current demand alone, then rise to the cost of total capacity at suchtime as it would become optimal for consumers to construct greenfields capacitysufficient to meet both current and anticipated demand. These results reaffirm MarcelBoiteux’s position that spare capacity has its own income, as well as Ralph Turvey’sview that the expectation of lower costs in future raises today’s prices, providing—insome cases—justification for accelerated depreciation. However, under NewZealand’s light-handed regulatory regime, electricity distributor prices and associateddepreciation schedules do not appear to have exhibited these characteristics.