Russell J. deLucia

Overview

This paper discusses pricing policies at the wholesale level, with particular emphasis on domestic fuels. First, the factors influencing wholesale pricing, including issues related to the energy-supply system, scarcity rent, risks and contract terms, and other general contract issues are reviewed. Second, various approaches to policy analysis, including sensitivity analysis and contract and taxation schemes, are discussed.

Analysis

Factors Affecting Wholesale Pricing

Supply Systems-Some of the characteristics of the supply system that affect wholesale pricing are the source of the fuel (imported or domestic), the characteristics of the fuel (traceable or nontradeable), the nature of the supply companies (public or private and, if private, local or multinational), and the stage of development of the resource. Each of these features affects how the efficient wholesale price of fuels is determined. For example, in the case of domestic fuels, the efficiency price includes a cost of supply and a scarcity rent. The relative weights of these elements are strongly influenced by the risks associated with the development of local fuel resources, which are, in turn, related to the characteristics of the fuel system.

Scarcity Rent-The framework used to analyze the economic price of a depletable resource is based on the economic theory of exhaustible resources (Hotelling 1931). The theory suggests that the depletion cost today of using a unit of an energy good (for example, coal) for power generation is equal to the present-valued difference, at the time of exhaustion of the coal resource, between the cost of using coal and the cost of using the next-best substitute (for example, oil) for the same purpose. Depletion cost is also called depletion premium, scarcity rent or premium, and user cost. The economic (efficiency) price of coal is the sum of the extraction (producer) cost and the depletion cost. If coal reserves were infinite, the economic price would simply be the extraction cost because the price of the substitute would be irrelevant. At the other extreme, if reserves are small relative to demand and, therefore, the time interval to resource exhaustion is nearly zero, the economic price is close to that of the substitute.

It is often assumed that the scarcity rent is captured by government, whereas the cost of supply goes to the supply company. In practice, the distinction is less clear. Supply costs depend on more than physical factors and include the economic returns required on not just capital, labour, and other material inputs, but also risk, the use of scarce knowledge or technology, and the structure of the market (for example, control of information or technology). These complications are often present in the supply of coal, oil, and natural gas, and they influence how much of the scarcity rent is captured by the government. The negotiated sharing arrangements for these rents is a critical element of pricing policy for developing countries.

Risk and Contract Terms-The earlier the stage of development of the resource, the more difficult it is to distinguish the cost of supply from the scarcity rent and to determine who captures the rent. Contracts between suppliers and governments must address a number of uncertainties pertaining to geology (the size of the resource), markets (future world prices of energy goods), and contracts (how the partners will live up to their agreement). Governments generally want to minimize the cost of supply and maximize both the scarcity rent and the portion that is captured by them. In contrast, suppliers want to maximize the supply cost and, therefore, the portion of the scarcity rent they capture. Policies that both minimize the cost of supply and capture the maximum scarcity rent are not easily designed, particularly because of the risks that affect the supply cost. Many tradeoffs must be made. For example, a stringent policy can deter investment, whereas a lax policy raises the effective cost of supply and allows much of the scarcity rent to flow to suppliers. Efficiency goals may also conflict with revenue considerations. Governments generally have large current-revenue needs, and these lead to policies with contracts and tax regimes that distort the investment decision away from the most efficient one. However, more flexible contracts and tax policies have been devised recently.

General Contract Issues-In contracts, a critical factor is the sharing of risk. If the government chooses to bear the risk, it may offer a "pure-form service contract" in which the supplier receives a specified return on investment regardless of the success or failure of the project. More common are "risk-service contracts" in which the supplier bears the geological risk and gets a service contract for resource development if an exploitable reserve is found. The degree to which costs and returns are fixed or conditional is important. For example, fixing the expenditures for exploration or development is relatively easy to administer, but it may lead to overinvestment or underinvestment. A different and more usual alternative is to fix the amount or rate of the revenue stream by using either a percentage share or an income or profit tax independent of the relative success of the project.

Policy Analysis

An overall study of pricing policy specific to wholesale pricing contains an analysis of the scarcity rent and an analysis of domestic pricing, taxation, and contract structures. Other elements relevant to both retail and domestic wholesale pricing are the generation of government revenue and an estimate of how the pricing policies will affect the finances of supplier companies.

Sensitivity Analysis-An example of an estimate of efficiency prices that includes sensitivity analysis is the study done for the Electricity Generating Authority of Thailand (Meta Systems Inc. 1983; PEIDA 1983). The purpose of the study was to establish the economic transfer price of lignite for power generation, which in turn could be used to determine the appropriate level and structure of electricity rates. Some of the key study tasks included evaluations of lignite reserves, estimates of mining costs, projections of alternative uses, calculations of the costs and value of lignite, analysis of substitute fuels, and adjustment of economic prices to reflect nonefficiency objectives. The risks that were considered included future demands for lignite, international prices of energy commodities, and the size of lignite reserves. An important source of uncertainty was the future price of imported coal. The analysis showed the impacts of different energy prices on the economic price of lignite.

Contracts and Taxation-An example of a comparative analysis of different contract and taxation schemes is the study by Palmer (1980). A simulation model was used to compare a proportional profits tax, a version of a resource-rent tax, and a "tripartite" tax. The resource-rent tax is a high tax on profits after a prescribed return has been achieved. The tripartite alternative was designed to combine the resource-rent tax and a corporate tax that included conditional accelerated depreciation. Ideally, the tax scheme that is selected will collect a high fraction of the rent but not squeeze the supplier to a point below the target return, which represents the investor's supply price. The pure resource-rent tax always collects the same percentage of rent. The proportional profit tax is the least attractive because it sacrifices collection of some rents (relative to the resource-rent tax) from highly profitable projects and pushes returns below target for marginally profitable endeavours. The tripartite tax appears to be the most attractive alternative because it comes close to capturing the rent share of the pure resource-rent tax at high levels of profitability and narrows the range of profitabilities in which investors" returns fall below target.

The analysis of issues surrounding scarcity rents, contracts, and taxation policies must be tailored to specific countries and situations. It should consider, for example, the treatment of local taxes under the tax code of the supplier's home country (or dividend distribution for local subsidiaries of multinationals) and the administrative feasibility of the various policy options.