Why We Can’t Avoid Avoided Cost

by Tanya Bodell, Charles River Associates

The concept of opportunity cost is an underpinning of economics; it reflects the value of the next-best alternative of that resource. The electricity industry equivalent is avoided cost. Introduced by the Public Utility Regulatory Policies Act (PURPA) in 1978, the concept of avoided cost is assuming new meanings as the industry adopts new technologies.

The Original Avoided Cost Rate

In 1978, PURPA required electric utilities to buy power from nonutility electric power producers at the avoided cost rate—the cost the utility would incur if it were to generate or purchase power from another source. Each state translated this rate differently, with some applying the short-run marginal cost—or fuel cost to produce power—and others interpreting avoided cost to mean the long-run marginal cost of power—the all-in levelized cost of the next plant to be built. As PURPA implementation coincided with the rise of natural gas generation, the next plant to be built by independent generators was a natural gas combined-cycle power plant.

Often a more competitive alternative to the cost of the utility’s next plant to be built, power purchase agreements (PPAs) flourished. As initial PPAs expired and deregulation of the industry created spot markets for power purchase, the use of the avoided cost concept declined. It has experienced a recent resurgence.

Renewable Energy

State legislators and regulators are encouraging investment in renewable energy and often are using avoided cost to do so. California has implemented the Market Price Referent (MPR) to set the benchmark against which PPAs with renewable resource providers can be approved for recovery through rates. If a PPA price is below the MPR, a utility may automatically roll those costs into rates. If above the MPR, the utility must receive regulatory approval before including in rates. The MPR is based on the long-run marginal cost of a 500-MW natural gas plant, adjusted for various factors to reflect the plant’s producing power under the PPA. Other states have used the concept of avoided cost, formally or informally, to approve contractual prices paid to renewable power generators.

Distributed Generation

Avoided cost also is applied to renewable resources behind the meter. The Energy Policy Act of 2005 amended PURPA’s requirements, and section 1251 obligates electric utilities to provide net metering service, allowing any electricity consumer with an eligible on-site generating facility to offset electric energy provided by the utility during the billing period. State implementation has interpreted this requirement inconsistently. Each state sets rules related to net metering subscriber limits, distributed generation capacity limits, reimbursement and rollover rules for excess power and annual true-ups. Annual true-ups may occur at incremental cost, avoided cost, retail rates or not at all.

Retail Service

The avoided cost of distributed generation is similar to the debate that raged during competitive retail market design when stakeholders grappled with the credit retail customers should receive for switching from a utility to a marketer or competitive retailer. Outside of power, the incremental cost savings to the utility of losing a retail customer is primarily the cost of billing, relatively small compared with a retailer’s customer acquisition costs. To support retail competition, some states established a shopping credit to reflect the longer-term avoided cost of customer migration to retailers.

New Technologies

As new technologies commercialize and offer solutions to higher penetration of variable energy resources, the concept of avoided cost is likely to appear again. Energy storage may be priced as a new type of ancillary service based on the avoided cost of self-regulation or the opportunity cost of injecting energy during periods other than superpeak prices. Transmission investment, considered a complement and substitute to generation, may be valued according to the cost of new generation capacity the transmission investment avoids. Smart grid technology that delays expansion or upgrades may be priced according to its avoided cost.

Opportunity cost measures the economic value of a resource. Avoided cost effectively uses the concept of opportunity cost to set prices paid for power. As technologies emerge, we are sure to see alternative measures of avoided cost again.


Tanya Bodell is vice president of Charles River Associates. E-mail her at  Tanya.bodell@fticonsulting.com

“It is the good fortune of the affluent country that the opportunity cost of economic discussion is low and hence it can afford all kinds.”

John Kenneth Galbraith, “Economics, Peace, and Laughter”


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