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Avoided Cost

What is meant by the term "avoided cost"?

"Avoided Cost" is essentially the marginal cost for a public utility to produce one more unit of power. Because QFs reduce the utility's need to produce this additional power themselves, the price utilities pay for QF power has been set to the avoided, or marginal, cost. In California, the utilities' avoided costs are determined by the California Public Utilities Commission (CPUC) in public hearings. These prices are designed to simulate a "market price" for energy, and have helped make utilities more efficient in their operations.

What is the energy component of avoided costs?

A utility will commit the required amount of its power plant system to meet the daily expected peak electric load plus a "reserve margin" to maintain service in the event of a power plant failure. If a QF delivers energy into the utility system, the utility will reduce the amount of energy generated at their most expensive operating plant (which are often older, dirtier facilities). The energy-related costs of that "avoided" plant, which are typically the cost of fuel and a portion of operation and maintenance cost, comprise the energy component of avoided cost paid to QFs.

What is the capacity component of avoided costs?

QFs are also paid a capacity price that reflects the independent producer's contribution to enhancement of the utility's system reliability. As demand grows in a utility's service area the "reserve margin" begins to decease. After a certain level of demand growth, the utility may need to increase its system capacity by building a new generation resource. Generally, utility additions are large plants with capacity in excess of what is necessary today. QFs are able to defer the construction of these plants and add the need capacity in smaller increments the "lumps" of capacity that would be build with the large utility plants. In California, the cost of a gas turbine peaking plant is used as a "proxy" for capacity value. QFs receive money in proportion to the capacity they add to the system, according the needs of the utility system. The capacity price is subject to adjustment depending on the utility system need for increased reliability both in the short run and long run.

Are avoided cost figures the same in the short run and long run?

No. California's ratemaking proceedings, and the prices paid to QFs, make an important distinction between short-run avoided costs and long-run costs. QFs in California typically enter pre-approved contracts (called Standard Offer Contracts) with utility companies. These contracts reflect the differences between short- and long-run costs. Often certain QF resources are particularly well suited for a particular contract because of the utility costs they displace.

Short Run Avoided Cost is calculated to reflect the costs that would be displaced when a QFs makes a short term commitment to deliver energy. These costs are based upon the utility's marginal operating and shortage costs (i.e. the utility's instant costs to provide the power, or the "spot market" price). These cost are naturally variable with seasonal demand, the fuel in use, and the utilities operating resources.

Long-Run Avoided Costs are designed to reflect the type and costs of a resource that the utility would construct if the QF resources did not exist. Contracts based upon Long-Run Avoided Cost has longer terms, typically in excess to 15 years and up to 30 years. In California, Long-Run Avoided Costs are based upon the identified Deferrable Resource (IDR) which the utility declares to be a cost effective resource addition. The value of that resource (capital related costs) and added to the value of the plants capacity (the "shortage cost") to determine the price to be paid to a QF.

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