Why “Cost Plus” Is A Very Bad Thing™

Traditional power rate setting mechanisms are a very inefficient and expensive way to set electricity rates. These mechanisms can, and many times do, incentivize electric utilities to invest in the most expensive forms of power generation. This means that you and I pay way too much for electricity.

In Japan and many other countries/markets, electric utility rates are set through a “Cost Plus” system. As I wrote the other day, the Cost Plus system works like this:

Costs + Profits = Electric Rates

Costs are all the costs that the utility incurs in supplying power to consumers. For example, a nuclear plant, salaries, coal, natural gas, generators, emergency equipment, etc. are all examples of costs.

Profits are typically decided on by the regulatory agency. For example, the regulator (or government in many countries) decides on a ‘fair’ profit margin that the utility can make on top of its costs. For example, the regulator might decide it’s ‘fair’ that the utility make a 5% or 10% profit.

Electric Rates are the prices you and I pay for electricity. These prices are, in many cases around the world, the result of adding the Costs plus the ‘fair’ Profit decided. Hence, this system is sometimes referred to as the ‘Cost Plus’ system.

There is a major flaw to this system. Other than encouraging lots more power consumption,  the only way for a power utility to increase its profits is to increase its costs!

Most companies seek to charge as much as possible for their products, while reducing their costs. Obviously, this results in more profits. However, in the “Cost Plus” utility rate setting model, the profit margin is locked in as a fixed percentage of costs, so if the utility reduces its costs, it is reducing its profits, too! What company would ever do that?

This fascinating and idiotic, in my humble opinion, reality twist is the mechanism which leads many utilities to push for the construction of very expensive power generation facilities such as nuclear plants.

In Japan, for example, the various *EPCOS have rates determined in a complex formula that pays for costs, as well as booked assets. Nuclear plants are humongous assets that the electric companies get to charge rates for.

Nuclear plants, by the very virtue of their high costs, make power companies more profits!

This is not unique to Japan. For example in Georgia in the southern United States, the Vogtle nuclear plants are being built via various govt subsidies as well as rate increase being charged to consumers. Interestingly the ratepayers are being charged before the plant is even complete! The utility gets to increase it’s profits for assets that aren’t even on the books yet!

Utilities and regulators will tell you that they’re doing their best to reduce costs, but in reality, they are not incentivized to do so, and it has been shown historically that their costs are far higher than they could be. For example in Japan, government panels recently found that electric rates could be reduced by thirty percent or more by allowing more competition in the power generation market.

Why do we allow this ridiculously inefficient system to exist? Legacy, pure and simple. In the past, power generation required huge investment and encouraged the development of monopolies in the industry. The Cost Plus system was a natural way to regulate the industry.

There are considerably better options now. Cheaper renewable energy systems which allow for distributed power generation, the growth of the modern grid and relevant grid technologies, as well as the development of highly effective and efficient feed-in tariff policies allows for the existence of a free market on the power generation market side.

There are numerous successful examples of a modern market system. Germany is a terrific example. Renewables represent over 20% of German energy, and the vigorous electric power market prices for wholesale electricity have dropped significantly over the past several years. In 2011, German individuals and farmers owned over half of all the renewable energy generation in the country. Germany is reducing costs, reducing emissions, and increasing standards of living through economic growth. And Germany is certainly not dependent on a traditional Cost Plus rate system.

The Cost Plus system was a necessary evil in the past, but the time has come to move on to more market oriented systems which encourage companies to reduce costs, reduce waste and emissions, and increase efficiency – economic and energy wise.

Next time you hear a politician or monopoly utility telling you that “the new nuclear plant is the cheapest way to give you power”, you can ask them how the rates are being set, and tell them you want a better way than “Cost Plus.”

Here is some additional interesting reading on related topics:

Wind-Works.org: 51% of German renewables now owned by its own citizens

REneweconomy: Why generators are terrified of solar

UCS: Vogtle Nuclear Plant Expansion (PDF)

Japan Times: TEPCO guarding its ground

Beyond Nuclear: Despite potential cancellation, Florida ratepayers may still have to pay for billion dollar boondoggle!

Lenz Blog: Renewable energy ownership in Germany

Lenz Blog: Ulrich Kelber on German feed-in tariff

As always, I look forward to hearing from you! Please let me know if anything is incorrect, or if you have a different opinion, or any other thoughts.

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