An investor-owned electric utility subject to rate-of-return regulation currently generates 5 million Mwh per year from a single hydroelectric dam, with an operating cost of $5 per Mwh.
The regulator allows the company to include the replacement cost of its plant and equipment in the rate base. The dam has a replacement cost of $5 billion.
The company also has transmission and distribution assets, of $1.5 billion, and has of $100 million annually in addition to the operating cost of the generating plant, so the total operating cost is $125 million and the rate base is $6.5 billion.
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Generating station
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Capacity (Mw)
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Annual generation (Mwh)
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Replacement capital cost ($millions)
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Operating cost ($/Mwh)
|
|
Period 1
|
|
|
|
|
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Hydroelectric dam
|
1,000
|
5,000,000
|
$5,000
|
$5.00
|
|
Period 2
|
|
|
|
|
|
Hydroelectric dam
|
1,000
|
3,600,000
|
$5,000
|
$5.00
|
|
Coal-fired steam power plant
|
600
|
2,400,000
|
$3,000
|
$30.00
|
If utility investors need to earn 10 percent on the investment in the coal plant, what is the marginal cost of electricity, assuming that the coal plant is the lowest cost option for increasing generation? What can you infer from your answer about incentives for conservation under rate-of-return regulation?
What are some strategies that the utility might use to avoid having to build the coal plant and still avoid a situation where it cannot supply enough power to meet demand?