Peak Load Pricing in the Electric Utility Industry

Author(s): John T. Wenders

Source: The Bell Journal of Economics , Spring, 1976, Vol. 7, No. 1 (Spring, 1976), pp.
232-241
Published by: RAND Corporation

Stable URL: https://www.jstor.org/stable/3003198

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 Peak load prcing in the electric
utility industry
John T. Wenders
Associate Professor of Economics
University of Arizona

In the electric utility industry cost minimization requires that

heterogeneous electric generation technologies be used to produce
electricity demands of different durations. In contrast to the conclu-
sions of traditional peak-load pricing theory, the existence of a
heterogeneous capital stock mneans that off-peak marginal cost prices
almost always should include some marginal capacity costs, and that
the profit maximizing regulated electric utility may set peak price
above marginal cost and off-peak price below marginal cost in order
to encourage the expansion of capital-intensive base load generating
capacity.

1. Introduction * The traditional theory of peak-load pricing1 argues that peak

period users should bear marginal operating costs and all of the
marginal capital costs, and off-peak users should be charged prices
which cover only marginal operating costs. These results appear
prominently in the Berlin, Cicchetti, and Gillen report (1974, espe-
cially Chapter 3) to the Energy Policy Project of the Ford Founda-
tion, and have recently been emphasized by the well-known
economist-regulator, Alfred E. Kahn (1975, p. 32). In addition,
economists have extended peak load pricing theory to include the
effect of a regulatory constraint (Bailey and White, 1974), with the
conclusion that the regulated utility will set off-peak prices at the
same level as an unconstrained monopolist and set peak prices below
the level that would be set by an unconstrained monopolist. The

John Wenders received the A.B. in economics from Amherst College in 1958, the
M.A. from the University of Hawaii in 1960, and the Ph. D. from Northwestern
University in 1967. Currently he is doing research on the problems of electricity pricing
with emphasis on a benefit-cost analysis of peak load residential electricity pricing.
This article is a revision and extension of part of a paper (with Lester D. Taylor)
presented at the Regulatory Information Systems Conference in St. Louis during
September 1974. The author is grateful to Lester D. Taylor, John Panzar, and James
Boyd for useful comments on earlier versions of the analysis and to the Division of
Economic and Business Research of the University of Arizona and the Iowa Com-
merce Commission for financial support.
After this paper was completed, the papers by Panzar (1975) and Crew and
Kleindorfer (1975, 1976) were brought to my attention. The interested reader should
consult these for related approaches to the peak load pricing problem. The present
paper can be regarded as an extension of the Crew and Kleindorfer papers to allow for
pricing periods of unequal duration. The Panzar paper is a generalization of the analysis
THE BELL JOURNAL presented below.
232 / OF ECONOMICS 1 See Bailey and White (1974) for an excellent bibliography on peak load pr

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implication of this analysis is that the regulated firm will, therefore,
expand productive capacity beyond the level that would be set by the
unconstrained monopolist, possibly even beyond the level that would
maximize social welfare.2 This is a logical variant of the well-known
A-J-W theory of overcapitalization.3
The purpose of this paper is to urge caution in the application of
peak load pricing theory to the electric utility industry. Cost minimi-
zation in this industry requires that heterogeneous electric generation
technologies be used to produce demands of different duration, and
this modifies the usual conclusions of peak load pricing theory. In
particular, I shall show that off-peak marginal cost prices almost
always should include some marginal capacity costs and that the
profit maximizing regulated electric utility may set price above margi-
nal cost at the peak and below marginal cost during the off-peak in
order to encourage the expansion of capital-intensive base load
generating capacity.
The analysis presented below is concerned with only the fixed
peak pricing problem-the possibility that marginal cost pricing may
shift the peak is explicitly excluded. In addition, it is assumed that the
objective is to maximize economic welfare in the market for electric-
ity, and this assumption is implemented formally by maximizing the
sum of consumer and producer surpluses.

* Since electricity can be produced by using different technology or 2. Long-run

capacity mixes, it is important that the electric utility adopt that capacity
combination of capacities which will meet its pattern of demand at adjustments
minimum cost. Assume that three generation technologies are avail-
able to the utility-base, intermediate, and peak load-all of which
have different annual capacity and energy costs per KW. For notation
the subscript 1 will be used for peak load capacity, 2 for intermediate
load capacity, and 3 for base load capacity. The symbol Bi will be
used to designate the annual marginal and average capital cost for
each technology, and it is assumed that B3> B2 > B1. The symbol bi
will be used to designate the marginal and average energy cost of
producing a KW of electricity for one year, and it is assumed that b,
> b2 > b3. Thus, base load capacity has high capital costs and low
energy costs, while peak capacity has low capacity costs and high
energy costs. Intermediate capacity lies somewhere in between these
extremes. In addition, it is assumed that b, + B1 > b2 + B2> b3 +
B3. Table 1 gives a rough estimate of the magnitudes involved from
data supplied by Tucson Gas and Electric Company.
The optimal mix of these three capacities depends on the pattern
of load demand experienced by the utility. Figure 1 shows a load
duration curve. This curve is a descending arrangement of the hourly
demand for electricity during a year. Thus, at least KW3 amount of
capacity is needed for t2 hours the year, while at least KW2 is needed
for only t1 hours. t* represents the number of hours in a year = 8760.
t1 and t2 divide the year into three periods, each of which make up a
fraction of tne year defined by w1 = t1/t*, w2 = (t2 - t1)/t*, W3 = (t*
- t2)/t*.

2 See Hanke (1975, pp. 79-81) for an analysis that concludes that the regulated
electric utility will set peak prices below marginal cost and off-peak prices above
marginal cost.
I See Baumol and Klevorick (1970) for a review of this literature. WENDERS / 233

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 TABLE 1

ANNUALIZED CAPITAL AND ENERGY COSTS BY PLANT TYPE

TYPE OF LOAD TYPE OF PLANT Bbi

BASE COAL STEAM $100.00 $ 20.81

INTERMEDIATE OI L STEAM $ 40.00 $175.20

PEAK INTERNAL COMBUSTION $ 20.00 $240.90

SOURCE: TUCSON GAS & ELECTRIC COMPANY.

FIGURE 1

ANNUAL LOAD DURATION CURVE

KW,

< KW2

<l KW3 l

C]

tl t2 t*

LOAD DURATION
(HOURS)

Suppose this utility has built KW3 units of base load capacity, and
is contemplating increasing this capacity by one KW. As an alterna-
tive, it must consider the cost of one additional unit of intermediate
capacity. Thus, the marginal cost of an additional unit of base load
capacity (MC3) must be weighed against the marginal cost of an
additional unit of intermediate load capacity (MC2), where the energy
cost of t2 kilowatt hours is included in these marginal costs. The
relevant marginal costs are

MC3 = B3 + (t2/t*)b3 (1)

MC2 = B2 + (t2/t*)b2. (2)

Clearly, if MC3 < MC2, base load rather than intermediate load
capacity should be added, and this should continue up to the point
where MC3 MC2, or

t2lt* = WI +b2W2
- b
B3 - B2 (3)

THE BELL JOURNAL A similar argument shows that intermediate load capacity should
234 / OF ECONOMICS then be added up to the point where MC2 = MC1, or,

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 tI1/t = WI = B2_ -l . (4)
And, since W1 + W2 + w3 = 1,

W3 =1 -(5)
If the t1 and t2 shown in Figure 1 are the same as those defined by
equations (3) and (4), then the utility should build KW3 units of base
load capacity and operate it on the margin for loads between t2 and
t*, KW2 - KW3 units of intermediate load capacity and operate it on
the margin for loads between t1 and t2, and KW1 - KW2 units of
peak load capacity and operate it only for loads between 0 and t1. At
these points, the energy saved by increasing base (intermediate) load
capacity at the expense of intermediate (peak) load capacity is exactly
offset by the increased capital cost associated with the increased base
(intermediate) load capacity.
One important conclusion can be drawn from equations (3)
through (5): w1, w2, and w3 depend only on the relative capital and
energy costs of the three alternative capacities and do not depend in
any way on the shape of the load duration curve. This curve could be
flatter or steeper without altering the size of the w's. But the amount
of each kind of capacity will vary with the load duration curve.4

* Having shown how capacity mix should be adjusted to any fixed 3. Marginal cost
load duration curve, the next problem is to define the optimal prices pricing with
which should be charged. The usual theory of peak load pricing homogeneous
assumes that all capacity is homogeneous. While this is at variance capacity
with the analysis of the previous section, it is useful for purposes of
comparison to expose the pricing problem by using this assumption.
Assume that the load duration curve is divided into three pricing
periods. During the first period, which lasts for z1 fraction of the year,
demand is at an annual rate of Q,; during the second period, which
lasts z2 fraction of the year, demand is at the annual rate of Q2; and so
on for the third period. By definition, Qi > Q2 > Q3. Since output is
quoted as annual rates, there is a one-to-one relationship between the
KWi needed to produce Qi units of output. It is assumed that the
markets in these three periods are separable and independent5 and
that the same capacity (with annual capital cost B) serves all three
periods.
The welfare optimum will be reached by maximizing the sum of

4 The reader should note that the t1 and t2 which divide capacity optimality among
the three alternative generation technologies are really points of indifference between
adjacent technologies. Thus, the long-run cost of generating KW2 for t1 hours of the
year would be the same if either peaking or intermediate capacity were used. For the
remainder of this paper, I shall assume that the loads for t1 and t2 hours of duration are
always produced using the next highest generation technology. Thus, peak load units
operate for loads from 0 through t1, intermediate load units operate for loads from (but
not including) t1 through t2, and base load units operate for loads from t2 through t* =
8760. This overcomes some of the difficulties associated with the discontinuous,
stepped, load duration curve used in Section 4 below.
5 Extension to the interdependent demand case is straightforward. See Pressman
(1970). WENDERS / 235

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 producer and consumer surpluses, given by the integrals of demand
curves less costs. The objective function is

3 fj3
W = zZ Jo PidQi - E zibiQi - BQ1, (6)

where the P's refer to annualized prices6 in each of the three pricing
periods. The differing subscripts on the b's indicate that the marginal
energy cost of serving each of these periods may be different even
when there is only one kind of generating capacity. The above
maximization yields the following set of optimal prices in the three
pricing periods:

P1 = b1 + B/z1 (7)

P2 = b2 (8)

P3= b3 (9)
These results show that only peak users bear any marginal capital
costs, and the off-peak users bear only the marginal energy costs of
their usage. This result is explained by the fact that only peak usage
presses against capacity, and, therefore, only these users should bear
the incremental capital costs of the system. This is the familiar result
demonstrated by Boiteux, Steiner, and Williamson, among others.

4. Marginal cost * Let us now pull together the analysis of the last two sections. In
pricing with Figure 2, the load duration curve is represented as a simple step
mixed capacity
FIGURE 2

SIMPLIFIED ANNUAL LOAD DURATION CURVE

Q, = KW,
01KW l I
l I
Q2 =KW2?- _

0 I I I
EQ3 =KW3 _

_ _ _ _ I I I ti' ti t2, t2 t*

LOAD DURATION
(HOURS)

function; the dashed vertical lines indicate the break points in load
duration among the three supply periods and correspond to the op
mal t1 and t2 derived in the first part of this paper.7 The peak pric
6 An annualized price is the price of one KW of electricity for one year. To find the
actual KWH price during each period the Pi should be divided by 8760.
7 Strictly speaking, the results derived in Section 2 are only applicable to a con-
THE BELL JOURNAL tinuous load duration curve. However, it is possible to approximate the curve in Figure
236 / OF ECONOMICS 2 with a continuous curve for which the results of Section 2 are applicable.

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period, when quantity Q, is demanded, lies wholly within the peak
supply period and will be served by peak load capacity on the margin;
the second pricing period is assumed to be served by intermediate
load capacity on the margin; and the third pricing period is served by
base load capacity on the margin. Peak capacity operates only during
the first or peak pricing period, intermediate load capacity operates
during both the first and second pricing periods, and base load capac-
ity operates during all three pricing periods. Thus, z1 = t'1/t*, z1 +
Z2 = t'2 /t*, z1 < w1 and z1 + Z2 < W1 + W2. These assumptions
make up only one of the many cases that can be enumerated. The
present case is used for illustrative purposes only, and it is not
intended that this case be considered as typical.
What prices should be charged during these three pricing periods?
Total energy costs are given by

Co = b3Q3 + (Z1 + Z2)(Q2 - Q3)b2 + ZI(Q1 - Q2)b

and total capital costs are

Ck = B3Q3 + B2(Q2 - Q3) + B1(Qj -Q2).

The equation for total welfare then becomes

3 (-i
W = W ziJ PidQi - Co - Cl

Maximizing W with respect to output then yields:

P1 = b, + Bl/zl (10)

P2 (Z1+z2)b2 - z1b1 + B2-B1 (11)

z2

p - b3-(zl+z2)b2 + B3 - B2 (12)

When contrasted with equations (7) through (9), these results show
that capital costs now appear in the prices for the off-peak periods.
This is easily explained in terms of marginal cost. For example, when
a user during the third pricing period, denoted by the subscript three,
increases his usage, this requires that more base load capacity be
added. But an increase in base load capacity to accommodate period
three users allows for a substitution of base load for intermediate
capacity, which can also be used by users during the first and second
pricing periods; thus, only the difference is that B3 - B2 appears as
an addition to capacity costs. Further, there is at least a partial offset
to this rise in capital costs, since lower base load operating costs (z1
+ z2)b3, are substituted for higher intermediate load operating costs
(z1 + z2)b2. However, we know from equation (3) that the increase in
capital costs (B3 - B2) will be exactly offset by the reduction in
energy costs (z1 + z2)(b2 - b3) only if z1 + Z2 = W1 + W2 . Since z,
+ Z2 < W1 + w2, then the offset is not complete and P3 will exceed
b3. The offset will be complete for both off-peak pricing periods if z,
= w1 and Z2 = w2. In this case, equations (3), (4), and (5) can be
appropriately substituted for the z's in equations ( 1) and (12) to yield
P2=b2 andP3 = b3.
The example analyzed above, and shown in Figure 2, is only one
of the possible alternative relationships between three supply and WENDERS / 237

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 pricing periods. However, the following generalizations can be
drawn.

(1) An off-peak price will have no marginal capital cost component

only when the supply and pricing periods are such that: (a) only one
kind of generating capacity should be built, e.g., when z1 > W2, (b)
the supply and pricing periods exactly coincide, as in the above case
when z1 = w1, or z1 + Z2 = W1 + V2, or (c) an off-peak pricing period
is wholly contained within one of the supply periods (e.g., when z1 >
rv1 and z1 + Z2 < WI + W2).
(2) In all other cases, off-peak prices will contain a marginal capital
cost component. In these cases the size of the off-peak price varies
inversely with the size of the next highest pricing period(s)-the
partial derivatives of P2 with respect to z1 and P3 with respect t
+ Z2) are both negative. This is due to the fact that the energy saving
off-set to marginal capital costs varies directly with z1 (for pricing
period two) and z1 + Z2 (for pricing period three) in the example
analyzed above.8

5. Peak load * Extension of the above analysis to the theory of the regulated firm
pricing and the is reasonably straightforward.9 I assume that the objective of the
regulated regulated firm is to maximize profits (rr) subject to a regulatory con-
firm straint governing its rate of return on total capital. Formally, the
objective is to

Maximize: T= TR - 0Co- Ck
subject to: TR - CO -CR = 0,
where

TR = z1PIQI + z2P2Q2 + Z3P3Q3

Co = b3Q3 + (Z1+Z2)(Q2-Q3)b2 + ZI(Q1-Q2)b1
Ck = rk3(Q3+X3) + rk2(Q2+X2- Q3-X3) + rk1(Q1+X1-Q2-X2)
CR = sk3(Q3+X3) + sk2(Q2+X2-Q3-X3) + sk1(Q1+X1-Q2-X2)
and

TR = total revenue
r = cost of capital
Xi excess capacity in units of output, Qi
s regulated rate of return (s > r)
ki= capital-output ratio for each kind of generating capacity
(Bi = rki).
This analysis assumes that z1 < w1, and z1 + Z2 < W1 + w2, and is
thus comparable to the case analyzed in detail in the previous section.
It is also assumed that the firm is able to operate off the production
frontier and carry excess generating canacitv of each kind (X.).

8 While off-peak prices can depend on marginal capital costs, thus raising their
value above marginal energy costs, it is not possible for either of the off-peak prices to
exceed the price charged in any higher demand period. In short, in all cases, the order
of price is P1 > P2 > P3-
9 The analysis of this section follows that of Bailey and White (1974), except t
is assumed that an optimal mix of different generating capacities is employed. It
THE BELL JOURNAL assumed that the relationship between the supply and pricing periods is the same as
238 / OF ECONOMICS that analyzed in the previous section (see Figure 2).

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TABLE 2

SUMMARY OF PEAK AND OFF-PEAK PRICES FOR WELFARE MAXIMUM, UNCONSTRAINED

AND REGULATED MONOPOLY

P1 P2 P3

(z1 + Z2)b
WELFARE
MELFAXIMUMbl + B1 /z1 = MC, /z1 Z2 Z3
MC2/Z2 = MC3/Z3

UNCONSTRAINED MC, MC2 MC3

MONOPOLY z1(1+1/E1) z2(1+1/E2) z3(1+1/E3)

REGULATED
MONOPOLY MC,-B1 MC2 + B1-B2 MC3 + B2-B3
(INDEPENDENT z1 (1+1/E1) Z2(1+1/E2) z3(1+1/E3)
DEMAND)

REGULATED
MONOPOLY MC, B1-11 MC2 + B1-B2-12 MC3 + B2-B3-13
(INTERDEPENDENT z1(1+1/E1) Z2 (1+1/E2) z3(1+1/E3)
DEMAND)

WHERE |1 =z2Q2 aP2 +z3 a aP3 12 z Ql1 + z3Q3 aP | 13 = ZI Q_a___ + z

I12Q8a+zQ aQ1 a2ZQ28Q+Z3Q3 Q3 8Q3

Table 2 shows the prices which will be charged during each of the
three pricing periods. Here, MCi is the unannualized marginal cost
and Ei is the elasticity of demand in the ith pricing period. The first
row repeats the welfare maximizing prices derived in the previous
section. The second row shows the prices which would be charged by
an unconstrained monopolist. The third row gives the profit maximiz-
ing prices which should be charged by the regulated monopoly under
the assumption that demand in each pricing period is independent of
the demand in the other two periods. The fourth row shows what
prices should be charged when these demands are interdependent.
It is useful to contrast these results with those of Bailey and White
(BW) who assume that a single capacity serves all users.

(1) When demands are independent, BW find that off-peak prices are
the same as for an unconstrained monopolist. The results of row three
in Table 3 show that both off-peak prices are reduced below those of
the unconstrained monopolist. Since constrained profits increase with
capacity-whether peak or off-peak-a lowering of off-peak prices
allows for an increase in base and/or intermediate load capacity unlike
BW's model, which assumes that all capacity is determined only by
peak demand. In addition, it can be shown that these off-peak prices
will be reduced below the welfare maximizing prices (Table 3, row
one) when

> MC2
2B2-B,
and/or
> MC3
B3-B2D_ WENDERS / 239

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 With the values for capital and energy costs presented in Table 1,
these critical values for the elasticity of demand are 0.74 and 0.21,10
respectively. This would indicate that off-peak prices which are below
the welfare maximizing prices are not improbable. This conclusion is
modified somewhat when interdependent demands are allowed (Table
2, row four), and where strong substitution relationships among the
three pricing periods1" serve to raise the regulated monopoly's off-
peak prices.

(2) BW emphasize that the regulatory constraint results in a lowering

of peak price below the unconstrained monopoly level and that peak
price might even be lowered below the welfare maximizing level. The
results in Table 2 show that BW's results may be obtained in our
model. However, since off-peak prices will be lower in our model-
and quite possibly below the welfare maximizing level-the necessity
for the lowering of peak prices is reduced. It can be shown that, with
independent demands, the peak price will be kept above the welfare
maximizing level when

-El < bz
B1 +1+

Again, with the capital and energy costs found in Table 1, this critical
value for the elasticity of demand is 4.7. In addition, allowing for
interdependent demands, strong substitution relationships among the
three demand periods serve to further modify the necessity of reduc-
ing peak prices by raising the peak price above what it would be with
independent demands.

(3) Finally, BW emphasize the possibility of a reversal between peak

and off-peak prices. Since our model has shown that off-peak prices
will be lower, and peak prices higher, than those obtained with BW's
model, the possibility of peak/off-peak price reversals is similarly
reduced.

6. Conclusion * The traditional theories of peak load pricing and the regulated firm
both assume homogeneous production capacity. The above analysis
has demonstrated that when it is optimal to employ capacities with
different capital and energy costs, the conclusions of both these
theories are modified considerably, and these modifications are par-
ticularly relevant to the application of these theories to the electric
power industry.12

References

BAILEY, E. E. AND WHITE, L. J. "Reversals in Peak and Off-Peak Prices." The Bell
Journal of Economics and Management Science, Vol. 5, No. 1 (Spring 1974), pp.
75-92.

10 In these and the following elasticity calculations, it is assumed that z1 = w1 a

Z2 = W2-

II Electricity consumed during one demand period will be a substitute for electric-
ity consumed during another period when aPi/aQj is negative.
12 One additional conclusion will be mentioned, even though it will not be pursued
further here. One of the arguments frequently raised in support of peak load pricing is
that it will reduce the demand for capital by the electric utility industry (see Berlin et
al., 1974, p. 29). However, if peak load pricing succeeds in reducing the demand for
THE BELL JOURNAL energy intensive peaking capacity, but increases the demand for capital intensive base
240 / OF ECONOMICS load capacity, then peak load pricing may actually increase the demand for capital.

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BAUMOL, W. J. AND KLEVORICK, A. K. "Input Choices and Rate of Return Regula-
tion: An Overview of the Discussion." The Bell Journal of Economics and Man-
agement Science, Vol. 1, No. 2 (Autumn 1970), pp. 162-190.
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Ballinger Publishing Company, 1974.
CREW, M. A. AND KLEINDORFER, P. R. "On Off-Peak Pricing: An Alternative
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"Peak Load Pricing with a Diverse Technology." The Bell Journal of
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HANKE, S. H. "An Assessment of Some Policy Issues in the Pricing and Forecasting
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Electric Utility Regulation, Cambridge: Ballinger Publishing Company, 1975, pp.
73-88.
KAHN, A. E. "Between Theory and Practice: Reflections of a Neophyte Public Utility
Regulator." Public Utilities Fortnightly (January 2, 1975), pp. 29-33.
PANZAR, J. C. "A Neoclassical Approach to Peak-Load Pricing." Bell Laboratories
Discussion Paper, July 1975.
PRESSMAN, I. "A Mathematical Formulation of the Peak-Load Pricing Problem." The
Bell Journal of Economics and Management Science, Vol. 1, No. 2 (Autumn
1970), pp. 304-326.

WEN DERS / 241

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