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Marginal Cost Prices: A Methodological Exercise

Marginal cost methods have be.en used for power sector

analysj_s in (a) electricity pricing and (b) investment

planning for long-term optimisation of system expansion.

Although its use for long term capacity expansion plan has

been less prominent, marginal cost can be a handy yardstick

to resolve planning problems at the margin of the least-cost

program. However, the focus in this study is on estimation of

marginal costs for pricing electricity.

I Basic Principles

Marginal cost of power supply refers to the change in

total cost of service resulting from unit change in demand.

Total cost function C(Y,P) may be defined as the minimum cost

of producing certain level of output (Y) at a given set .of

prices(P). Marginal cost function is a derived cost function

and is defined as a first order partial derivative of the

total cost function with respect to output. Marginal cost

may change according to the place and time of use. Prices

that are equal to marginal cost provide the appropriate

signals to decision makers that should result in market

equilibrium at a volume of supply that optimizes economic


A distinction here is between marginal cost within

a given capacity of the system, and that allowing for

capacity expansion:

1 6L:4
A cost function is called short-run cost function

if in the production process some of the factors

are assumed to be fixed. In the short run, the

installed capacities of the system are given: an

increase in demand modifies the operating policy

and translates into additional fuel costs.

In the long run, investments can be made to

minimize total costs: an increase in demand leads

to expansion in capacity through large and

sometimes bulk additional investment. The major new

costs are therefore those arising out of new

investment although higher capacity also. The cost

function is called long-run cost function if all

the factors are taken to be variable.

Corresponding to short-run and long-run cost functions,

short run marginal cost ( SRMC) and long-run marginal cqst

(LRMC) may be defined. At the operational level, given an

installed capacity, short-run marginal cost becomes an

increment in total variable cost per unit increase in output.

An increment in the total variable cost is the increase in

the operation and maintenance cost brought about by the

increase in the output. For electric power system this may

be called energy cost. The long-run marginal cost will be

equal to the short-run marginal cost plus cost of installing

an additional unit of plant capacity which may be termed as

marginal capacity cost(MCC).

The difference is not so much in the time frame as in

the choice of variables. The results of a short run analysis

carried out for a few last years (some of them in a distant

future), would provide the right framework for pricing and

planning decisions if outage costs were accurately

determined. In practice, a smoothing of short-run

fluctuations can be obtained by calculating LRMCs and

averaging them overtime. This average can be defined as the

incremental cost of all adjustments in the system expansion

plan and system operations, attributable to an incremental

increase in demand that is sustained into the future. The

sustained nature of the demand increment is important, as

more short-run considerations could apply in the case of

temporary demand changes. 1

It has been observed in Chapter II that the theory of

peak load pricing suggests that during off-peak periods when

there is excess capacity, price should be related to the

short-run marginal cost. However, when there is full p~ak

load without any excess capacity, price should be related to

th~ long-run marginal cost.

While defining marginal cost, it is assumed that all the

factors of production are perfectly divisible. But some of

the factors like capital are lumpy and are not perfectly

divisible. This leads to lots of problems in the

operationalisation of the concept of marginal cost. In fact,

most of the ambiguities in the actual estimation have stemmed

from the different ways in which the economists have tried to

handle the problem of capital indivisibility.

1. World Bank Energy Department, "Guidelines for Margional-
Cost Analysis of Power Systems" Energy Department Paper
No.18 (June 1984) p.3.
II. Alternate Methods of Measuring Marginal Cost

Three alternate methods of estimating marginal cost have

generally been advocated~ 2

These are (a) Long-Run Incremental

Cost ( LRIC) Method, (b) Present Worth of Incremental System

Cost (PWISC) Method, (c) Average Incremental Cost (AIC)

Method. For electricity pricing separate estimates of short-

run marginal cost and marginal capacity costs are needed.

The methods of computing SRMC and MCC based on three

alternate definitions of marginal cost 3 are given in Table

4.1 The definitions are similar in that they are forward

looking, that is, they consider only future costs and future


It is obvious from the table that the methods differ

primarily in the way marginal capacity cost has been

computed. The difference lies in the extent to which they

stress the importance of short-run as opposed to long-:r;un

costs' operation or as opposed to Investment Costs.

Long-run Incremental Cost (LRIC) Method

11.] 1<.
In this method long-run MCC= I -
in which I
& 1<-tl

stands for the next investment in the year 'k'. In fact 'k'

denotes the year in which the very next major investment

expenditure is completed. During the year 't' through 'k'

2. Robert J. Saunders, Jeremy J. Warford, Patrick C. Mann,

Alternate Concepts of "Harginal Cost for Public Utility
Pricing: Problems of Application in the Water Supply
Sector", IBRD Staff Working Paper No. 259 (May 1977)
3. Mark W. Gallerson, "Marginal Cost-Based Electricity
Tariff: Theory and Case Study of India", Indian Economic
Review Vol. S IV(New Series) No.2(0ctober, 1979) pp.163-

, I •·

marginal capacity cost remains constant. This Marginal

Capacity Cost (MCC) is the annual equivalent of the marginal

capacity cost for the next lump of investment. At year k,

the capacity cost may be redefined in terms of the next



Method Marginal Energy Marginal Capacity
Cost Cost

Incremental Rt+t- Rt
Cost(LRIC ) G.-ttl - ~-t c/ 1<+1 - Q 1u
U( 1"\

Present Worth of
Incremental System
Cost (PWISC )

1:" -I
)_ It-!-~-~ I (1-+~)
Average Incremental 'f.: I
Cost (AIC ) T

"L ~::I


t = year for which marginal cost is being calculated

R = Operation and maintenance Cost in year 't'
I = Investment in the year 'k'
I = Investment/Capital expenditure in year 't'
Q = Quantity of energy generated (in kWh) in the year
, t,
Q = Installed Capacity (kW) in the year 't'
i = Opportunity cost of capital = interest rate
r = Capital recovery factor or the annual payment that
will repay one unit capital cost over the useful
life of the capital invested with compound interest
(equal to the opportunity cost of capital) on the
unpaid balance. If ' i ' is the rate of interest
(equal to the opportunity cost of Capital then:
. . "'
r=-~~~-~--where 'n' is the useful length of the life
( 1+-i>Yt-1
of capital stock.

capital investment to be made. The marginal cost estimate by

LRIC method, is very close to the actual marginal cost. This

method has been extensiv.ely used in literature. 4 The method,

however, suffers from certain serious defects. If the

investment takes place every year, MCC will vary with new

investments. Thus, the estimates of marginal cost will

fluctuate. Such estimates cannot be used for price policy as

one of the desirable characteristic of pricing policy is that

the price should not be subject to frequent changes. So

there is a need to search for a relatively stable measure of

incremental capacity cost.

Present Worth of Incremental System Cost Method

This method, proposed by Turvey 5 , defines marginal cost

as the present worth of the increment of system costs

resulting from a permanent increment in output I consumption

at the beginning of year minus the present worth of the

increment of system costs resulting from the same permanent

increment in output starting at the beginning of year t+1.

Algebraic expression of it is given in table 4. 1 where the

notations are similar to those used for LRIC and where the

useful life of investment is assumed to be thirty years. If

amortisation rate is assumed to be equal every year, PWISC

method reduces to the traditional method of calculating

4. (i) Ralph Turvey and Dennis Anderson, Electricity

Economics: Essays and Case Studies (The John Hopkins
University Press, Baltimore and London,1977).
( ii) Dennis Anderson, Ralph Turvey and Charles Taylor,
Study of Electricity Tariff in Andhra Pradesh, (IDA
Report No.851,1975), Mimeograph
5. Ralph Turvey, Optimal Pricing and Investment in
Electricity Supply) (George Allen and Unwin, London,
1968), p.55.

Average Incremental Cost Method (AIC)

Both LRIC and PWisc· methods may not be in a position to

capture the effects of economies of scale and technological

change as they take into account only next investment. This

defect is overcome by the Average Incremental Cost ( AIC)

method that takes a longer view of costs, looking beyond the

next increment in capacity. It includes all future investment

costs during a specific time period for which reliable data

would be available. AIC assumes that when investment is

lumpy, marginal capacity cost (MCC) can be estimated as:

Present worth of the least cost investment stream

Present worth of the stream of incremental capacity/
output resulting from the investment.

Average Incremental Cost (AIC) is however calculated by

discounting all incremental costs that will be incurred in

the future for creating additional capacities required for

meeting the demand and dividing that by the discounted value

of incremental output (kWh) over the period. As this ratio

accounts for changes in capacity it is also known as the Long

Run Average Incremental Cost (LRAIC)

6. National Economic Research Associates, U.S.A. A
Framework for Marginal Cost Based, Time Differentiated
Pricing in the United States reproduced in Electri-
icity Design Study Book No.1, Commercial Directorate,
C.E.A. Delhi, Nov. 1979, Mimeo.
In the formula for calculating AIC given above in table

4.1 notation is similar to that used for other two formulae

except that T is the number of years or the time horizon for

which capital investments and attributale generation in kWh

are forecast. Theoretically the interest rate i in the

numerator of AIC should be equal to opportunity cost of

capital and in the denominator it should be equal to time

preference rate for consumption.

AIC takes into account several future investments and

so, gives a relatively stable estimate of marginal cost.

Average Incremental Cost (defined as 'a cost when multiplied

by discounted value of additions to capacity will equal the

present value of the investment stream in the period for

which investment or capacity addition plan has been taken

into consideration) may be computed for the following:

for production with respect to volume (kWh)

including losses at high, medium and low


for transmission with respect to system peak

kW(HV level);

for distribution with respect to coincident

peak at LV level.

AIC method has been used by Gellerson 7 and the

World Bank study of Kenya's Power system. 8 In their

7. Ge 11 e r son, op . cit .
8. World Bank, Kenya:Electricity Tariff Study, 1977 in
Electricity Utility Rate Design Study, Book No.5.
Commercial Directorate, C.E.A., Delhi, March, 1980,

respective studies Iyer and Kumar also used this method. 9

Iyer in his study discounted only the investment stream and

did not discount the· addition to the future capacity


In addition to the Average Incremental Cost method World

Bank has also been using the following two calculation

methods to approximate the Long-Run Marginal Cost (LRMC).

(a) Rough estimates of fuel costs and per - kW cost of

peaking capacity, combined with AIC based capacity cost of

transmission and distribution.

(b) Estimates of the structure of relevant LRMCs,

consisting of the marginal costs of peaking capacity,

transmission and distribution capacity, peak and off-peak

energy costs.

However, both these methods are less accurate and less

sophisticated. Therefore, it is proposed to apply AIC method

in this study.

III. Electric System Marginal Cost

In this section, it is proposed to develop a framework

for the estimation of electric system marginal costs. The

main components of the LRMC structure are:

(i) marginal energy cost;

(ii) marginal capacity cost of generation;

(iii) marginal capacity cost of transmission;

9.(i)S.Chidambara Iyer, Costing and Pricing of Electricity in

India: Current Practices and Possible Alternatives,
(Unpublished Ph.D thesis, I.T.M., Bangalore, 1980)
(ii)S. Kumar, Pricing in Public Utilities: A study of
electricity undertakings in Punjab and Haryana,
(Unpublished Ph.D thesis, JNU, 1984)
(iv) marginal capacity cost of distribution; and

(v) marginal consumer costs.

A methodology needs to be evolved that would compute

each component of LRMC. As power is supplied at various

voltage levels, these costs shall be computed separately at

each voltage level. According to the theory of peak load

pricing, capacity cost is to be charged from peak load

consumers whereas only energy cost is to be charged from the

off-peak consumers. This requires determination of various

costing and pricing periods as well.

A simple system with thermal and run-of-river hydro

capacity may be illustrated. The presence of hydro storage

capacity in the system complicates the analysis somewhat, but

the considerations are similar.

Capacity cost is straight forwardly related to a peaker

plant, and the opportunity cost of incremental use ·of

optimally stored water is likely to be the increased use of a

thermal plant. However, both peaker and marginal plant off-

peak may differ from one period to the next.

Marginal Energy Costs:

Marginal energy costs are the fuel and operating costs

of providing additional energy (kWh). For every hour of

system operation, the marginal energy cost of the system is

the incremental running cost of the plant best sui ted to

accomodate demand variations. In an electric power system

consisting of a number of generating plants, this marginal

plant is usually the thermo-electric unit with the highest

running costs among those operated above their technical


In a hydro-thermal mixed system, the power system is run

to meet the energy demand directly or ultimately in such a

way that run-of-river type hydro plant is operated at the

base load as its cost of generation is negligible. As cost of

variations in the level of operation of thermal plant is much

higher in comparison with the reservoir type hydro plants,

the thermal plant is operated at the intermediate level and

the reservoir type hydro-plant is used for peaking

purposes. 1 0 The reservoir type hydro-thermal system is

operated in such a way that by the end of the dry season

whole of the hydro-energy potential is exhausted. The level

of demarid beyond which hydro-plant is used is known as

critical level of demand. 11 The total energy potential of the

reservoir type of hydro-plant is determined by the amount of

water in the reservoir which cannot be increased at will. If

in the hydro plant of reservoir type, water is spilled at

at that moment, and it is operated as a marginal plant, then

marginal energy cost is zero.

Generally any increase in demand has ultimately to be

met by additional energy generation from the thermal power

plant. If there are more than one thermal plants, they are

operated in the ascending order of their marginal costs of

generation. Hence, marginal plant needs to be determined at

a given point of time to calculate marginal energy cost,

10. Ralph Turvey and Dennis Anderson, op., cit pp.317-32

11. A Harberger and N. Anreatta, "A Note on the Economic
Principles of Electricity Pricing," in P.N. Rosenstein
Rodan, ed. (Pricing and Fiscal Policies) George Allen
and Unwin, London, 1964), pp.147-64.
which may be taken to be the average cost of energy

generation of the marginal plant. From the generation plants

to be added in future and their operational characteristics,

It may be determined how the resultant system will be

operated and th~s estimate the marginal plant and also, the
marginal energy cost at various points of time.

In the following example, a simple system with thermal

and run-of-river hydro capacity is taken to determine

marginal energy cost. For practical purposes, all hours per

ye'3.r are grouped in two categories, "peak" and "off-peak", to

reflect periods with and without capacity constraint.

Units demanded and

supplied in TWh during

Peak Off-Peak
:Qeriod :12eriod
Energy Demand(Twh) 4.7 14.9

Run-of-river generation 0.5 2.5

Balance (TWh) 4.2 12.4
Met with ( 1) Coal fired units 3.3 12.4

( 2 ) Gas turbines 0.9

If the running cost of coal-fired units is Re 0.90/kWh,

and that of gas turbines is Rs. 1.75/kWh, the marginal energy

cost of generation during the peak period is Rs. 1. 7 5, and

during off-peak periods Re. 0.90, as the marginal kWh off-

peak can be supplied by cheaper coal-fired capacity. The

availability of the cheaper coal fired energy at peak,

however, is only 3.3 TWh, and the marginal kWh has to be

supplied from combustion (gas) turbines.

As plants use various fuels with different efficiencies,

marginal energy cost differences are usually found for:

-Peak vs. off-peak· hours in ·thermo-electric systems

- wet vs. dry periods in hydro-electric systems.

- winter vs. summer months in industrialised temperate


Given the marginal energy cost of generation, the

marginal energy cost can be estimated at various voltage

levels as follows:
x------- --------

= Marginal energy cost per kWh demanded at

the supplying end of the transmission
line at a particular voltage.

= Marginal cost of supplying energy at

bus bar

%L = Per cent cumulative losses up to the

voltage of supply.

(1-%L)- 1 = Loss factors

As energy flows through transmission and distribution

network, a part of it is lost due to copper losses which is

equal to r 2 R where I is the current passing through

transmission lines and R their resistance and a part is lost

due to transformation to the supply voltage. Therefore, the

cost of supplying energy increases to the extent of cost of

energy losses involved on the way to the supply end.

is the cost of one unit of energy at the generation plant

supply terminal, then the cost at lower supply voltage (EgV)

1 M C.
will be =---------------~ J
1-% T&D losses
where % T & D loss-~ is the percentage of energy lost upto

the supply voltage.

For the sake of s~mplicity in calculation and easy

understanding some studies 12 start from the marginal energy

cost at generation level (e.g. Rs.1.75 and Re 0.90/kWh) and

increase the fuel cost simply by the forecasted system loss

rate of the hour considered to arrive at the marginal energy

cost at each delivery point. Only system losses upstream of

the delivery point are considered and are calculated as a

percentage of energy delivered by the appropriate network

component above (transmission or distribution), rather than

as cumulative percent of energy sent out.

To illustrate:
Off peak
Loss rate ill13

Transmission 6 4

Distribution 12 8

Marginal energy cost (Rs/kWh)

At generation 1.75 0.90

At Medium voltage 1.06x1.75=1.86 1.04x0.9=0.94


At Low voltage level 1.12x1.75=1.96 1. 08x0. 9=0. 97

If the system is being operated at full capacity, a

further increase in electricity demand will require an

increase in the generation, transmission and distribution

12. World Bank Energy Department Paper No.18 op.cit p.4.

13. For off peak hours,year round average loss rate is used.
The loss rate at peak is equal to the year round average
divided by the ratio of loss factor to load factor (in
most systems this ratio can be taken as 0.15+0.85 x load
capacities. The marginal capacity cost consists of three


(i) Marginal Gener9tion Capacity Cost

(ii) Marginal Transmission Capacity Cost

(iiL) Marginal Distribution Capacity Cost

Thus marginal capacity costs are the investment costs of

generation, transmission and distribution facilities

associated with supplying additional capacity(kW).

Generation Capacity Cost

Marginal generation capacity costs are those expenses

the power utility is ready to incur in order to maintain

reliability of service, regardless of fuel costs. Usually,

in a predominantly thermal system, this reliability will be

required for provision of capacity (kW) during peak periods.

In systems with a large hydro component, generating capacity

expenditure may be required not only for purposes of ensuring

kW availability at peak, but also to ensure firm energy in

dry years. When capacity is constrained, an increment in

demand sustained indefinitely into the future will lead to

the necessity for system capacity expansion, not only with

respect to the new plant brought on line to meet the current

increment in demand, but for subsequent plants as well. The

exact form of this expansion depends on the nature of the

increment in demand i.e. whether it is an increase in peak or

off-peak demand, or both, since capacity expansion plans are

made within the context of a long-run plan, rather than just

the next plant to be brought on line.

To be in a position to estimate the marginal generation

capacity cost, it is essential to understand the production

(generation) planning process. The planners try to meet the

forecast peak capacity as well as energy demand by the least

cost cOmbination of existing equipment plus future additions

to the generation system. The least cost plan is defined to

be one which yields the lowest present worth of all costs to

be incurred over the life of the equipment to be used to

carry out the plan.

Given a least cost investment plan the marginal

generation capacity cost can be computed by any of the three

methods discussed in section 1 above. In the mainly thermal

system of the energy cost example given above in section 1,

the marginal kW during peak periods is provided by combustion

turbines. If the system capacity is just sufficient to

provide the maximum peak demand, any additional sma-ll

increment in demand is likely to be supplied by new

combustion turbine capacity. The marginal capacity cost,

expressed as annuitized investment costs of the peaking

capacity (Rs/kW/year), can therefore be calculated as


Investment Cost Rs 14500/kW

Discount rate 12%
Equipment life 15 years

Capital recovery factor: 14.5% of investment cost

Operations and Main- 1.5% of investment cost

tenance Cost

Annual charge Rs 14500 @ 16% Rs2320/kW

If a 20% derating of the unit is assumed to accomodate

risks of actual operating conditions and possible outages,

the marginal cost rises to 2320/0.8 Rs 2900/kW/year at


If system planning is carried out using a computerised

model, it is relatively easier to determine the change in

capacity cost by simulating the expansion path and system

operation with and without the demand increment. The theory

of peak load pricing suggests that for the optimal system,

revenue earned will be equal to total costs if price at peak

period is put equal to energy cost plus capacity cost of the

peaking plant and at off-peak periods price is equated to the

marginal cost of energy generation of the marginal plant at

the time . 14 Sometimes the least cost plan may require the

addition of a base or an intermediate plant which has lower

running costs and higher capacity cost in comparison with the

peaking plant. When a system is optimal, then:

Capacity cost of peaking plant is equal to the Capital

Cost of base load plant minus fuel savings from running base

load plant rather than the intermediate or the peaking plant,

of the capital cost of cycling (intermediate) plant minus

fuel saving from running the cycling plant rather than the


Thus the theory sugests that for the LRIC method, the

next plant to be added should be determined and it should

also be determined whether it is a peaking, intermediate or

14. Marcel Boiteux, "Peak Load Pricing", op., cit., pp.59-89

base load plant. If it is the base load or intermediate

plant, from the capacity cost substract fuel savings which

will be there if the base load or intermediate plant is

operated rather than peaking plant. If peaking capacity would

be provided by plant with longer construction periods, the

investment cost could be arrived at by discounting the stream

of annual investment expenditures for peaking plant.

Similarly, discounting would have an effect if temporary

excess capacity would require additional generating

investment to supply a sustained demand increment only in the

future. It is precisely this LRIC method which has been used

in a number of studies. 1 6 As the cost estimate of marginal

capacity cost by this method is not stable over

time,particularly in a fast expanding power system, Average

incremental cost ( AIC) method may be preferred. Given the

least cost capacity expansion plan, one can find the pres~nt

value of investment as well as capacities from which average

incremental cost may be computed. Gallerson and World Bank

study of Kenya's electric system used the AIC method. AIC for

peak generation capacity equals the present value of the cost

of the generation investment stream over the relevant period

divided by the present value of the incremental demand met.

15. Ralph Turvey,Optimal Pricing and Investment in Electri

city Supply System (London, George Allen and Unwin,
19 6 8 ) pp . 12 -19 .
16. i) Anderson Turvey and Taylor, Andhra Pradesh Study
op. cit.,
ii) Turvey and Anderson, op. cit.
iii) Mohan MunaSinghe "Electric Power Pricing Policy",
World Bank Staff Working Paper No.340, July, 1979.
iv) S.M. Tewari, "Marginal Cost Pricing for Power
Industry", Indian Journal of Power and
Industry & River Valley Development, Sep.1976.

AIC is used only when annual incremental investment and

demand streams are available.

Marginal cost estimate by the AIC method may not be

equal to the MCC of the peaking plant as the expansion plan

may inc'lude some base as well as intermediate plants. Still

the AIC estimate being average of the future expansion

programme, the cost may be taken as a marginal cost of the

system and being a stable estimate, it is preferred for the

pricing policy.

Given a social rate of discount and life of the capital,

it is possible to annuitize the marginal capacity cost.

Operation and maintenance costs associated with the

additional capacity are also to be estimated (section 5) .

Marginal capacity cost per month per kW demanded at the

busbar is estimated by the following formula.


Marginal generation capacity cost per kW

demanded at the busbar of the generating
station per month.

A = Annuity factor
Ck = Marginal Capacity Cost per kW (MCC)
O&M = Operation and Maintenance Cost/kW/year

Q = Reserve capacity margin

LfA = Loss factor due to Auxiliary consumption
is equal to 1/ ( 1-% Auxiliary consumption)

17. Gellerson, op. cit.
18. World Bank, Kenya:Electricity Tariff Study. op. cit.
In the above formulae, two corrections have been

applied: one for the auxiliary consumption and the other for

the reserve capacity ·margin. The cost of auxiliary

consumption would be paid by the consumer. Provision for the

reserve· capacity margin is provided because all the plants

cannot be run at full capacity all the times. Some times

they may be off for routine maintenance and sometimes due to

unforeseen contingencies or the forced outages. So to· take

care of uncertainty and ensure reliable supply certain

reserve margin may be provided for.

Marginal Capacity Cost of Generation at Various Voltage

As . electricity is transmitted from the generating

stations and supplied at various voltages to different

consumers, a part of the energy is lost in the process of

transmission and transformation from the one voltage to the

other. To meet the demand for one kW at a particular voltage,

supply at the busbar will have to be increased by the amount

of capacity losses involved on the way. As with marginal

energy cost, the marginal capacity cost derived for the

generating level needs to be increased by system losses at

peak, to yield the actual cost at the point of delivery. The

loss factor to be taken into account is the peak period loss

factor as it is the peak period, when the demand strains the

generation, transmission and distribution capacities and

provides signals for the capacity expansion. Thus the

generation capacity cost at various voltage level will

Cgv: Cgbb[l/(l-%L)]


: Marginal generation capacity cost per kW

demanded at the system peak period at a
given voltage per month.

cg bb' : Marginal generation Capacity Cost per kW

demanded at the busbar of the generating station
per month.

%L : Per cent peak period T & D losses involved

upto the supply end.

The marginal cost per kW obtained in this way needs to be

adjusted by including a desirable capacity margin, for peak

loss, and for diversity. The total marginal cost per

incremental kW is annuitized to arrive at an annual charge

suitable for tariff purposes.

Marginal Transmission Capacity Cost

In this section it is proposed to evolve methodology to

compute marginal transmission capacity cost. The

transmission capacity is determined by the level of peak

demand and the degree of reliability targetted to be

achieved. Given the level of reliability, transmission

investment will vary directly with the expected size of the

peak demand.

The transmission investment is lumpy. The investment

plan is designed in such a way as to meet the total

transmission network requirement at a minimum cost over a

given period of time. Therefore, while computing marginal

cost, one should take such a period into account so that

capacity investment plan and corresponding increases in peak

demand in the period under consideration are optimal. To

ensure correspondence of investment and peak demand, one may

include some historical period as we11. 19

Marginal transmission capacity cost should include only

those investment costs which are caused by unit increase in

demand.· The rest of the investment costs should be excluded

from ·marginal cost calculation. There are two types of

transmission investments which are more properly attributable

to the generation function rather than to transmission

function. They are those costs that are ( i) incurred to

utilize source of cheap energy available only at location

remote from the load centre; and (ii) associated with the

establishment of power pool which connects a system to the

regional grid. This reduces the requirement for reserve

margin. It may thus be said that if certain transmission

lines are specifically associated with specific generating

plant sites, they could be considered a generation rather

than a transmission cost. Some transmission lines may be

associated with specific loads and therefore the costs of

such facility should be allocated to those specific consumers

served. Some of the other transmission investments also take

place which are not caused by incrmental demand. They should

also be excluded from the marginal calculations. These are:

(a) investment undertaken due to dislocation because of

some Government policy say widening of roads, etc;

(b) all those expenditures which may be undertaken in

thf, period under consideration but will benefit

(c) any investment on the lines to be shared with some
other state or system. These costs should be

shared in proportion in which the lines are

actually used by various states.

Estimat~ng Marginal Capacity Cost of Transmission


The transmission system cost consists of two elements:

(i) Expansion of transmission lines at various voltage
levels; ·and (ii) Grid sub-station transformation capacity

In Tamil Nadu and Uttar Pradesh, the systems under

consideration, electricity is transmitted at 400 kv, 220 kv,
132 kv, 66 kv and 33 kv and distributed at 11, 6.6 & 3.3 kv
and 400/220 volts. The design of transmission and
distribution facilities are determined principally, by the
peak kW that they carry rather than the energy transmitted.
Generally all transmission and distribution costs are

allocated to incremental capacity installed. Given the

voltage wise increase in peak demand and corresponding
investment increments for the next few years, marginal
transmission capacity cost shall be estimated by the
application of the average incremental cost method. Turvey

and Anderson take the transmission network expansion

programme for the next few years. Given the yearly

investments and corresponding increase in demand, they

compute investment cost per kw of increase in demand. This

method is defective as it does not take the present value of

investments and capacities, which should be the case. Even

though the effect of inflation is neglected, investment in

various time periods should be added only after computing its

present value by using. certain social rate of discount.

Gellerson and the World Bank study of Kenya System use the

AIC method to estimate marginal transmission capacity cost.

Marginal Transmission Capacity Cost at the Different Voltage


Given the average incremental capital costs at various

voltage levels, transmission capacity cost per kw demanded

at the time of system peak per month can be computed as


CTV = 1/12 [A.Ctv+O&MtJ1/(1-%L)


CTV = Marginal Capacity Cost per kW demanded per month at

the time of system peak at the supplying end of the

transmission lines at a given voltage level.

Ctv = Average incremental cost of capacity expansion at a

given voltage level.

A = Annuitizing factor
%L = Peak period energy losses at voltage 'v'
O&Mt = Operation and maintenance cost of the given voltage

transmission network

By the application of the above method marginal transmission

capacity cost at various voltage levels can be estimated.

Marginal Distribution Capacity Cost:

In distribution, unlike generation, the marginal costs

may vary between consumers, depending upon geographical

20. Turvey and Anderson, op. cit p.36.

location, population density, terrain and local conditions.
Theoretically, distribution cost will differ from consumer to

consumer. But from the ·operational point of view consumers

with similar load characteristics may be grouped into

different consumer classes. The difference in consumer

class-wise tariff may be justified by the supply cost

differentials. Distribution costs depend upon the number of

consumers as well as consumer class-wise share in peak demand

on the distribution system.

Transmission and Distribution Capacity Costs called

network capacity costs relate to the constraint of

Transmission and distribution capacity at the peak period of

each network component, World Bank has suggested calculation

of these costs together as long-run and/or cross-sectional

averages to smooth over the effect of investment

indivisibilities. A first approximation is the Average

Incremental Cost (AIC) with respect to peak demand at each

voltage level. It is agreed that although system peak and

peak periods of Transmission and distribution components can

be taken as identical yet, in practice, there may be cases

where peak usage of e.g. rural distribution networks may not

correspond with total system peak periods.

In this study it is assumed that all the investments in

distribution lines and distribution transformers excluding

investment on connecting up the consumers, metering equipment

etc. are taken as related to peak distribution demand. For

the distribution system, marginal cost is computed as in the

case of transmission cost.

Connecting up and metering equipment costs are consumer

related and are computed separately as cost per consumer.

Operation and Maintenance Costs:

Apart from the fuel cost which is being characterised as

energy cost, some other costs have to be incurred to operate

the power system and to keep it in the operational form.

These costs can be grouped as follows:

i) Wages and salaries of the skilled and unskilled

staff manning the system;

ii) Repair and maintenance cost including consumable

spares; and

iii) General Establishment and Administration Cost.

These costs will increase with the increase in the size

of the system. They will also increase with the level of

utilisation of the existing system or the amount of energy

generated from the given installed capacity. In this study,

it is assumed that all the operation and maintenance co~ts

increase with the size of the system and do not materially

vary with the level of operation. This is a plausible

assumption for the two systems . under consideration (Tamil

Nadu and Uttar Pradesh systems) . These systems are almost

always operated at their full capacity. Though there may be

daily or seasonal variations in demand, the system has to be

kept in readiness to meet the demand as and when it may

arise. Therefore, neither can the staff be reduced nor

establishment be changed seasonally. Therefore, it is quite

plausible to assume that the operation and maintenance costs

are fixed costs which vary not with the level of operation

but with the size of the system.

As total power system has been divided into three sub-

systems namely generation, transmission and distribution

systems, the operation and maintenance costs are also

estimated separately for these sub-systems. One method to

estimate the operation and maintenance costs associated with

each of the sub-system can be to project the past trend.

Whereas this method gives fairly accurate results when the

rate of expansion is uniform over time, this is not a precise

method for relatively newer systems where huge investments

have been taking place in a discontinuous and lumpy manner.

Turvey and Anderson have computed increments in the

operation and maintenance costs and the corresponding

increases in the value of assets for the past few years. From

these increments an average ratio of the increments in the

operation and maintenance costs to the increase in the value

of assets is computed. This ratio is assumed to remain

constant in the next few years. Given the investment

schedule, associated operation and maintenance costs or its

components were computed. One of the defects in Turvey's

method is that it does not take inflation into account and

this results in costs to be under estimated. Following

Turvey's method and using price indices some exercises were

carried in connection with the present study to bring all

asset costs and associated operation and maintenance costs to

common base year. However, it was found that there existed

no relationship between the increments in the asset value

(book values) and

corresponding increments in the various

21. op~ cit., p.36.

components of the operation and maintenance costs for the

Tamil Nadu and Uttar Pradesh Electric Systems in the years

1980-81 to 1985-86. Though the value of assets increased over

time, increments in operation and maintenance costs were

erratic. and showed no particular trend. In fact variations

in operation and maintenance costs were even negative for

some years. Therefore, this method was not found to be

useful. The World Bank in its studies regarding estimation

of marginal costs of some electric power systems assumed the

operation and maintenance costs to be a certain fixed

proportion of the incremental capital costs. World Bank's

marginal cost study of the Upper Indravati project has taken

operation and maintenance expenditure as 2.5% (thermal), and

2.0% (hydro) and 1.0% (transmission)of the aggregate

investment cost. 22 Tewari 2 3 has also assumed the operation

and maintenance costs as a fixed proportion of the margiqal

capital costs. Central Electricity Authority and the

concerned State Electricity Boards use following standard

assumptions regarding operation and maitenance costs in

project planning for generation, transmission and

distribution schemes.24

The Operation and Maintenance Costs

For the generation system: 2.5 per cent of MCC of


22. World Bank

23. S.W. Tewari

24. Various Project Reports prepared by Central Electricity

EHV Transmission System: 1.5 per cent of MCC of the EHV

HV(33/11KV) System 2 per cent of MCC of 33/11

KV systems

L. T. distribution System: 5 per cent of MCC of the

L.T. distribution.

These assumptions used as norms are based on their

experience of additional establishment requirement as

well as . consumable spares for operation and maintenance of

new capacities installed in generation, transmission and

distribution system. These have also been made the basis for

calculation of marginal costs in the present study.

The Marginal Consumer Costs

The marginal consumer costs are the incremental costs

directly attributable to consumers including costs of hook-

up, metering, billing, collection etc. These costs are a

function of the number of consumers served and do not depend

on the amount of power or energy being demanded. Increments

in the consumer costs corrected for inflation and

corresponding increases in the number of consumers or the

number of connections may be computed. This cost can be

assumed per consumer to remain the same for the next few

years. It may be noted that consumer cost will vary for each

consumer class, for example for the tubewells, it will be

very high in comparison with a densely populated domestic and

commercial area. Relative difference in the consumer costs

have been ignored in this study though they could be

estimated by giving relative weights to various categories of


The first stage of the application of the LRMC approach

to tariff setting is the calculation of long-run marginal (a)

capacity costs (b) energy costs and (c) consumer costs. But

the first step in the LRMC approach is to provide a detailed

description of the system including system's operational

characteristics, the system load duration curve, the past

demand position and how the demand deficit was met. The next

step is to forecast the future demand spanning a number of

years and future developments needed to satisfy the

anticipated increment in demand. The future development

includes both completing schemes under construction and new

schemes to be commissioned during the expansion period


Accurate system and economic parameters are crucial for

the estimation of LRMC. Some of the major system parameters

to be determined are:

i) Load duration Curve:Any grid system uses a

combination of hydroelectric units, fossil fuel fired thermal

units and gas based thermal plants/turbines to generate

electricity. Normally, based on daily load duration curve,

the units in the system are brought into operation, as base

load units or peaking support units for the specific peak


The daily load duration curve indicates the peak

requirement. Capacity has to be built up to meet the maximum

value of daily peaks occuring during the period. The

operation of various units in the order of merit efficiency,

however, depends on the annual load duration curve.

The daily load duration curve contributes significantly

towards the LRMC as it indicates the peak, average and the

daily total energy requirement. In addition, it will also

indicate the contributors to the peak so that the capacity

charges- can be levied on them. The daily curves may undergo

considerable change on a day to day basis, even though the

average and the maximum may vary over a small range. Since

the peak requirement of all customers may not occur exactly

during the system peak, this diversity enables the system to

be managed with less installed capacity. It is the daily

load duration curve which provides the basis for time-of-use

metering and peak load pricing.

(ii) System loss coefficients by voltage levels for

appropriate periods (e.g. peak and off-peak). Loss can be

defined as power expended in the system and not delivered to

consumers. Losses in supplying electricity consist of

auxiliary losses, trans former losses, and distribution and

line losses. Such loss coefficients are expressed as a per

centage of energy available for transmission.

(iii) Simultaneity or Diversity factors

Simultaneity factor is the inverse of the diversity factor.

The diversity factor is the ratio of the sum of the

individual maximum demands of the various subdivisions to the

maximum demand of the whole system. Peak demand may not be

registered at the same time in different grid substations due

to diversity.

(iv) Desirable Standby Capacity margin.

The standby capacity margin is the ratio of needed unused

19 14~
capacity to total installed capacity available. The estimate

of the standby capacity is based on the probability of supply

interruptions because of·factors such as unplanned outages of

plants, required spinning reserves, deratings of plant,

scheduled outages for maintenance etc.

Some of the other parameters to be determined inc 1 ude

plant life i.e. the number of years a plant is expected to be

in useful operation, discount rate to annuitize capital costs

etc. In India Central Electricity Authority lays down norms

for capacity planning and energy availability. These are

revised from time to time. Norms for Capacity Planning for

Seventh Plan are given in App~ndix to this Chapter.

Determining the Costing/Pricing Time Periods.

There are generally significant variations in the hourly

demand for electricity which are depicted by the daily load

curve. The demand may vary with the seasons as well. To me,et

the demand, the generating plants are operated in a way so as

to minimise the cost of generation of the system as a whole

for a year. Different plants may have significantly different

cost characteristics. As price to be charged at a given time

should be put equal to the marginal cost of supply, the day

needs to be divided into periods in which cost

characteristics are significantly different. Theoreti- cally,

cost of supply at every moment differs. As these costs are

to be reflected in the tariff structure, the number of

periods have to be 1 imi ted to a reasonable number. The

probability that the load will exceed a particular capacity

should be used as the primary criterion for determining

costing periods with significant differences in marginal
costs. The probability that load will exceed a given capacity

is known as loss of load probability (LOLP). The periods of

equal LOLP are grouped together. Thus the question of

determining pricing periods is reduced to estimation of the

loss of load probability.

Normally, the day may be divided into two periods, peak

period arid off-peak period. So, potentially peak hours need

to be determined. One convenient way may be to determine

periods when load is in the range of 80 to 100 per cent of

the peak load. This period may be taken as potentially peak

period and the rest as off peak period.

The above methodology has been applied to work out all

the components of marginal cost of supplying power to each

voltage class.

Application in Pricing - LRMC Based Tariffs:

The cost of supplying the incremental unit to a

particular consumer is the sum of the energy and capacity

costs including losses down to the delivery point. Before

being added up, the peak capacity costs are to be adjusted to

reflect the fact that the consumer's maximum capacity

requirement may not coincide with the time of system peak.

The ratio of consumer's demand at system peak to consumer's

maximum kW demand is referred to as the consumer's

22. i) Ray Rees, Public Enterprise Economics

(Weidenfold and Nicolson, London, 19 7 6) 1 PP •
ii) T.W. Berrie, "The Economics of System Planning
in Bulk Electricity Supply" in R. Turvey, ed.,
Public Enterprise (Penguin, 1968) p. 179-185.
coincidence factor. LRMC - based prices may need adjustments

by the Utility in the effective tarriff rates on account of

the following

(i) Equity in alleviating the burden on lowest income

(ii) Adaptation of power pricing to other distortions in
the economy, such as subsidised kerosene or diesel
and generally willingness of consumers to pay,
compared to alternatives.

(iii) Financial performance targets

(iv) Capabilities of utility in sales management (load

control, metering and billing).

Adjustments in the LRMC - based tariff structure have to

be necessarily made to arrive at the actual tariff structure

that meets economic second-best. This, however, needs to be

performed with the aim of inflicting the least possibl~

distortion to avoid misallocation of resources. The present

study does not propose any such adjustments.