the greater the costs consumers impose on the system.
The structuring of LRMC-based tariffs also meets subcategories
a) and b) of the second, or fairness, objective mentioned
earlier. The economic resource costs of future consumption
are allocated as far as possible among the customers
according to the incremental costs they impose on the power
system. In the traditional approach, fairness was often defined
rather narrowly and led to the allocation of arbitrary accounting
costs to various rating periods and consumers thus violating
the economic efficiency criterion. Because the LRMC method
deals with future costso ver a long period-for example, atl east
5 to 10 years-the resulting prices in constant terms tend to be
quite stable over time. This smoothing out of costs over a long
period is especially important given capital indivisibilities or
“lumpiness” of power system investments.
Using economic opportunity costs (or shadow pricesespecially
for capital, labor, and fuel) instead of purely financial
costs, and taking externalities into consideration whenever
possible also link the LRMC method and efficient resource
allocation.
The development of LRMC-based tariff structures which also
meet the other objectives of pricing policy mentioned earlier,
are discussed next.
C. Practical Tariff Setting
The first stage of the LRMC approach is the calculation of
pure or strict LRMC that reflect the economic efficiency criterion.
If price was set strictly equal to LRMC, consumers
could indicate their willingness to pay for more consumption,
thus signaling the justification of further investment to expand
capacity.
In the second stage of tariff setting, ways are sought in
which the strict LRMC may be adjusted to meet the other objectives,
among which the financial requirement is most important.
If prices were set equal to strict LRMC, it is likely
that there will be a financial surplus. This is because marginal
costs tend to be higher than average costs when the unit costs
of supply are increasing. In principle, financial surpluses of
the utility may be taxed away by the state, but in practice the
use of power pricing as a tool for raising central government
revenues is usually politically unpopular and rarely applied.
Such surplus revenues can also be utilized in a way that is consistent
with the other objectives. For example, the connection
charges can be subsidized without violating the LRMC price,
or low-income consumers could be provided with a subsidized