Optimal electricity rates and consumption externality

Despite the strong empirical evidence of heterogeneous customer outage costs and the recent theoretical arguments for unbundling service reliability, retail electric service remains homogeneous and causes an externality in electricity consumption. This paper, by integrating this peculiar aspect of the retail electric service market into a traditional second-best pricing analysis, derives a set of optimal pricing rules for retail electric rate designs. Such rules are sufficiently general that they encompass Ramsey pricing and peak load pricing under demand uncertainty and consumption externality. We apply these rules to analyze the economic inefficiency due to a fully distributed cost pricing method adopted in 1983 by the California Public Utilities Commission. This economic inefficiency is likely to be over-consumption by customers with relatively low outage costs and small price responsiveness. Copyright © 1988 Published by Elsevier B.V.