Discussion Paper

"Second-Best" Adjustments to Externality Estimates in Electricity Planning with Competition

Abstract

A number of state public utility commissions are using "social costing" methods to consider externalities in electricity resource planning. The most comprehensive and formal method is the use of monetary place-holders in the financial evaluation of new investments and potentially in system dispatch to reflect quantitative estimates of externality values. This approach necessarily must take existing environmental and social regulation as given. Furthermore, regulated utilities face increasing competition from electricity generators outside their service territory who may not be affected by social costing. The lack of universal and uniform social costing places PUC actions soundly in the realm of "second-best policy" and they may have unintended consequences that should be anticipated by regulators. This paper addresses two prominent possibilities: the potential substitution of unregulated supplies of energy services in place of electricity generated by the regulated utility, and the effect social costing may have on the relationship between the regulated price and marginal cost. These issues are considered within a normative model of social welfare maximization, which is applied to three representative hypothetical utility case studies to calibrate a second-best optimal adder to correct for externalities in electricity planning.