Aspects of pricing in electricity supply in Malta

Abstract

The pricing policy of public utilities has been a topic which, over a number of years, has been the subject of considerable controversy and debate. More specifically such discussions have centered around arguments for and against marginal cost pricing in public sector enterprise The setting of prices equal to marginal cost has long been a primary rule in welfare economics. Framed within principles of marginal analysis, this claim for marginal cost pricing is that it ensures a more efficient allocation of resources and thus secures a welfare optimum. Yet, although for many years economists have long stressed the merits of such a pricing rule, the concept has been slow to win acceptance. On the theoretical plane, the framework within which the case for marginal cost pricing has been developed is based on a number of implicit assumptions to be discussed shortly. While such abstractions simplify exposition, they remove from the discussion some of the most important issues and problems which arise in practice. The aim of this study is to investigate the implications of marginal cost pricing in the electricity supply industry. No attempt will be made here to, argue the case for marginal cost pricing, on the grounds that the general principles of welfare theory, and arguments in favour of such, have gained sufficient familiarity. The first section examines the major perspectives of the electricity supply industry, with a view to setting the frame of reference upon which to base subsequent chapters. Chapter Two deals with an analysis of the technical features, the primary aim of which is that of isolating a number of key considerations relevant in the context. Although some technical terms cannot be dispensed with, they have been limited to a minimum. This is then followed by a brief review of the theoretical aspects of marginal cost pricing. Treatment of such a vast subject must unavoidably be very limited but still it should suffice for the purposes of this paper. It will be shown that apart from a number of minor complications, adoption of marginal cost pricing leads to serious problems in three particular cases. We thus proceed to analyze each particular case with respect to the local supply industry. Chapter Four deals with the aspects of technological progress, while Chapter Five deals with an analysis of returns to scale as estimated by means of a production function. An analysis of costs, developed in Chapters Six and Seven, is an alternative way of measuring returns to scale. This latter approach is attractive insofar as it discloses the structure of costs of the industry. The paper then proceeds with the aspect of excess capacity; a problem which electric utilities customarily exhibits and as a result of which, difficulties arise in the application of marginal cost pricing. Having highlighted the general arguments in price setting, and the complications which arise in actual application, we proceed to analyze the actual pricing structure at present adopted by the supply authorities, and to see how far these considerations are taken into account in practice. On the basis of such considerations and other related aspects implied by marginal cost pricing, it would ultimately be possible to arrive at some judgement concerning the applicability and desirability of such a pricing policy.