Conceptualizing the impact of demand elasticity of ... · The Giffen paradox relates to a special type of an inferior good (in contrast to a ‘normal’ good) which has the characteristic

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Conceptualizing the impact of demand elasticity of transmission services on the potential revenues to Hydro-Quebec TransÉnergie

prepared by London Economics International LLC October 18, 2005 London Economics International LLC (“LEI”) was retained by Brascan Energy Marketing Inc. (“BEMI”) to review the economic rationale of a possible rate change for Hydro-Quebec TransÉnergie’s (“HQT”) point-to-point transmission service, especially in the context of incentivizing more utilization of HQT’s system. Although HQT has proposed to retain its current point-to-point firm and non-firm transmission rates (for example, the non-firm hourly transmission rate will remain at $8.33 per MWh), it has also been forced to propose an increase of 7.35% in the annual invoice amount for transmission services to local load because of rising needs of local load. In our opinion, HQT could in fact increase its revenues by further incentivizing use of excess capacity on its transmission system for short-term market transactions by way of a rate decrease on certain classes of point-to-point transmission services.

Demand for short-term point-to-point transmission services is generally known to be highly sensitive to prices because of the nature of “wheel through” and “wheel in and out” energy transactions. The economics of such energy transactions depend not only on commodity prices for electricity but also on transmission system charges that the customer must pay; thus, the cost of short-term transmission service will have a direct impact on whether a “wheel through” (and “wheel in and out”) transaction is profitable and whether it will be executed. According to the principles of the Law of Demand, this price sensitivity translates into a very elastic demand for such short-term point-to-point transmission services. This is further enhanced in the case of HQT given its location at the cross-roads of several large wholesale power markets with varying capacity resources and demand needs and steadily growing cross-border trading in electricity. Moreover, HQT has confirmed, as does the data on actual flows across the interties, that there is spare capacity on HQT’s system.

Conceptually, a rate decrease for short term point-to-point services would reduce the opportunity costs for cross-border transactions and would increase the volume of trade in and out of Quebec. The increased utilization of spare HQT transmission capacity would raise overall revenues to HQT. This would directly benefit captive customers (local load), by reducing the share of the total revenue requirement that HQT must recover from local load.

Though HQT has not been satisfied with the results of its provisional rebate program, the design of that scheme did not prove that opportunities for increasing volume on HQT’s system are lacking. Indeed, we believe opportunities remain untapped. The conceptual ideas outlined in this paper are sufficiently impressive as to suggest that additional empirical analysis on the elasticity of demand for HQT’s electricity transmission services is warranted prior to accepting the current proposed rates, as there may be opportunities to improve market efficiencies and benefit Quebec native load through a rate decrease for certain classes of transmission service.


1 Introducing the Law of Demand

The fundamental economic theory of the ‘Law of Demand’ states that quantity demanded for a good or service should move in the opposite direction of price, holding all else constant. Economists like to illustrate this relationship using stylized graphs such as the one below, where we observe a downward sloping (linear) demand curve (see Graphs B and C in the figure below). Most (‘normal’) goods and services, with the exception of certain theoretical oddities1, exhibit this profile to some degree, though there are some products which may be more elastic than others. The graphs below also highlight the degrees of elasticity and how that reflects on the slope of the demand curve.

Figure 1. Illustrative examples of a downward-sloping demand curve and various levels of demand elasticity

Supply Curve

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(downward-sloping) Demand Curve Supply

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(downward-sloping) Demand Curve Supply

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What is the intuition behind the downward sloping demand curve? As consumers, all of our economic decisions are bounded by our budgetary constraints: if one good gets very expensive then we will switch to a relatively less expensive one that is a good substitute. As we discuss below, some customers of HQT’s transmissions services evaluate the cost of transmission services directly in their decision to purchase and trade electricity and have the discretion and

1 Alfred Marshall wrote in his treatise on economics: “There are however some exceptions (to downward sloping demand). For instance, as Sir R. Giffen has pointed out, a rise in the price of bread makes so large a drain on the resources of the poorer labouring families and raises so much the marginal utility of money to them, that they are forced to curtail their consumption of meat and the more expensive farinaceous foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it. But such cases are rare; when they are met with, each must be treated on its own merits.” (Principles of Economics, Marshall A., Macmillan 1946, pg. 132). The Giffen paradox relates to a special type of an inferior good (in contrast to a ‘normal’ good) which has the characteristic of falling demand when a person’s income rises. Thus a positive income effect outweighs a negative substitution effect and quantity demanded rises when prices rise. The Giffen paradox is an interesting model, but most economists agree that there is little firm evidence to support real-world examples.


ability to shift their electricity purchases geographically in order to avoid high-priced transmission service territories, and vice versa. Therefore, if HQT’s transmission services were comparatively cheaper than those of transmission service providers in neighboring regions, customers using those transmission services elsewhere would be encouraged to shift their usage to HQT’s transmission system, assuming there is excess capacity and technical feasibility.

2 What type of transmission services does HQT provide?

HQT’s transmission services can be classified along two general categories of customers: transmission services for domestic (captive) customers (i.e., local load) and transmissions services for market transactions.2 It is important for us to understand the fundamental characteristics of these two classes of services, as that will then drive our hypothesis regarding the overall demand for HQT’s transmission services.

Currently, most of Quebec’s electricity customers are captive, i.e., they cannot choose their electricity supplier. These customers, who are served solely through Hydro-Quebec Distribution (“HQD”), are provided with electricity derived principally from heritage assets but also from power obtained competitively. In economic terms, these customers’ demand can be described as inelastic, as they do not have the opportunity to respond to prices - they simply consume the quantity of electricity they need, irrespective of the overall cost of the service.3 Based on figures from 2002, total demand for electricity (and thus electricity transmission services4) from all domestic customers in the province of Quebec was 183.7 TWh.5 Assuming a growth rate of 1% per annum, an estimate of current domestic demand would be at approximately 189 TWh. HQT, as monopoly transmission operator in the province of Quebec, would be responsible for transmitting electricity to serve these customers.

Figure 2. Historical demand in Quebec (TWh)

1998 1999 2000 2001 2002Residential Sector 49.5 51.2 53.7 52.8 55.2% of total 30% 30% 31% 30% 30%Commercial Sector 31.1 32.0 32.8 32.7 34.1% of total 19% 19% 19% 19% 19%Transportation Sector 0.3 0.3 0.3 0.3 0.3% of total 0% 0% 0% 0% 0%Industrial Sector 84.3 85.9 88.3 90.8 94.2% of total 51% 51% 50% 51% 51%Total Provincial Demand 165.1 169.5 175.1 176.6 183.7

Source: Ministry of Energy, “L’Énergie au Quebec 2004”

2 In 1997, Québec opened its transmission system to third party access.

3 In the long-run, continued escalation of prices is likely to catalyze conservation efforts, which should change the consumption profile of these customers.

4 Ignoring, for simplicity, line losses.

5 Source: latest data from the Ministry of Energy


In addition, HQT provides transmission services to third-parties making market-based transactions in electricity, for example Hydro Quebec Production’s sale of excess energy to neighboring provinces and the United States.

While HQT has typically not provided a breakdown of transmission grid usage across different customer classes, it does state in its 2004 Phase I filing with the Régie de l’Énergie (Document HQT-3) that 6% of its revenues were derived from North American wholesale market transactions. This is consistent with the financial highlights in its 2003 Annual Report. In 2004, the Hydro-Quebec Annual Report states this figure is now 4%.

In contrast to transmission services for domestic customers, market-based transactions (i.e., “North American wholesale market activities”) are likely to be more sensitive to transmission costs, especially in those cases where the market transactions are based on the profitability of short-term commercial trades rather than long-term contracts. As we discuss further below, such market transactions are driven by price arbitrage opportunities between electricity markets that arise as a result of ‘instantaneous’ disconnects in market fundamentals (such as supply-demand imbalances) or as a result of long-lived and persistent cost advantages of production due to a regions’ natural endowments and resource base. As can be seen from the Figure 5, Quebec has a substantial amount of interconnection with its surrounding regions, which facilitates such market transactions.

Based on National Energy Board’s records of imports and exports from Quebec, Quebec’s transmission lines carried electricity in and out of the province in the range of 13 million MWh to over 24 million MWh per annum. It is important to note that these electricity trades include long-term contracts as well as the arbitrage transactions we discussed earlier. In fact, a substantial contributor to the drop off in exports over recent years from Quebec is the expiration of certain long-term contracts with suppliers in New England.

Figure 4. Quebec’s imports and exports (MWh)

IMPORTS EXPORTS TOTAL1999 2,452,966 16,560,101 19,013,067 2000 3,953,226 20,232,744 24,185,970 2001 3,448,796 14,819,802 18,268,598 2002 2,545,734 14,738,630 17,284,364 2003 3,924,972 10,038,238 13,963,210 2004 3,459,812 9,478,025 12,937,837 2005* 1,747,633 8,001,081 9,748,714

Source: NEB*Data from January through August

Figure 3. HQT’s break-down of revenue (2004)

Source: Hydro-Quebec 2004 Annual Report

North American Wholesale

Markets4%

Hydro-Quebec

Distribution82%

International Markets

8%

Others6%


Figure 5. Quebec’s transmission system and import/export capabilities

Source: NEB

What do these market transactions represent? There are two broad classes of trades represented in these market transactions – “wheel through” and “wheel in and out.” “Wheel through” transactions represent trades where Quebec’s transmission system is used solely for transportation purposes, in other words, electricity enters the Quebec system at one point of interconnection and then exits the system at another point of interconnection. These transactions are more likely to be affected by prices levels for transmission services, as they represent electricity that is simply “transiting” through the transmission system. Because of the availability of alternative transport paths, such as having power scheduled to be “wheeled through” neighboring markets, “wheel through” transactions are sensitive to transmission rates, relative to those in neighboring markets. We illustrate this point in a hypothetical example below. “Wheel in” and “wheel out” transactions are those that involve energy that originates in Quebec (i.e., Quebec as a supplier) or energy that is consumed in Quebec. A “wheel in” is effectively equivalent to imports into Quebec from an external market for consumption by consumers in Quebec; while, a “wheel out” is an equivalent to exporting electricity. All these transactions benefit the Quebec economy by providing for the opportunity to cheaply buy electricity for consumption in Quebec (and thus preserve scarce hydroelectric resources) or sell Quebec’s electricity services for a profit when conditions warrant.

Thanks to the evolution of technology, market constructs, and the very quick (if not instantaneous) dispersion of information, those entities and individuals transacting on the basis of arbitrage are making decisions on a very short timeframe. Their price sensitivity cannot be under-estimated. As in stock markets, very small price differences drive the decision regarding where to purchase power and where to sell power. Transmission costs must enter into this determination, as well any other levies and fees (such as export taxes, mandatory ancillary service charges, and system operator fees).


As an example, let us analyze the decision-making process that a customer would undertake for evaluating his opportunities. Though his main objective is to buy and sell power, his decision will affect transmission owners as well; as he will (at least financially)6 decide on which transmission system he uses and thus schedule his transaction accordingly. In other words, the economics of the transaction need to account for the costs of transmission services. Let us step into the shoes of Mr. Dupont, a hypothetical customer in upstate New York, who needs to acquire 100 MW of electricity for the next operating day in order to meet his other commitments. He will review market opportunities locally, but he will also look externally to interconnected markets, such as Ontario, Quebec, New England, as well as possibly other markets that are further away (such as the Maritimes). Let us assume that he observes the following hypothetical commodity prices for electricity:

Figure 6. Hypothetical customer example - commodity prices ( $/MWh)

New York New

England Quebec Ontario MaritimesElectricity prices (commodity only) $60 $60 $50 $55 $51

And let us assume that the hypothetical customer faces the short-term transmission rates7 noted below to get the electricity from the various locations delivered to New York:

Figure 7. Hypothetical customer example – transmission rates ($/MWh)

New York New

England Quebec Ontario MaritimesNon-firm transmission tariffs $4.3 $2.5 $8.3 $7.2 $4.2

The summation of the actual transmission costs (based on aggregate of all markets traversed) with the commodity cost of electricity results in the following hypothetical delivered prices of electricity to New York based on systems traversed:

Figure 8. Hypothetical customer example – total cost for economic decision ($/MWh)

New York New

England Quebec Ontario Maritimes

via NE

Maritimes

via QC Commodity $60.0 $60.0 $50.0 $55.0 $51.0 $51.0Transmission (NEW ENGLAND) $0.0 $2.5 $0.0 $0.0 $2.5 $0.0Transmission (ONTARIO) $0.0 $0.0 $0.0 $7.2 $0.0 $0.0Transmission (QUEBEC) $0.0 $0.0 $8.3 $0.0 $0.0 $8.3Transmission (MARITIMES) $0.0 $0.0 $0.0 $0.0 $4.2 $4.2Transmission (NY) $4.3 $4.3 $4.3 $4.3 $4.3 $4.3Total cost ($/MWh) $64.3 $66.8 $62.7 $66.5 $62.0 $67.8

6 As we all know, the physical flow of electricity on AC networks cannot be controlled. Thus, physical flows may differ with financial or contracted flows. Transactions are typically determined on the basis of financial or contracted paths, subject to certain over-arching physical limitations (such as available transmission capacity).

7 Transmission rates as of Spring 2005. For illustrative purposes, we have translated these into Canadian dollar terms,

however the currency is irrelevant to the conceptual framework of the example.


Based on these parameters, it is self-evident that Mr. Dupont will choose to wheel power from the Maritimes through New England and into New York, as that is the most economic alternative. Now let us assume that point-to-point transmission rates are decreased in Quebec by a hypothetical 15%. Although this is a hypothetical example, it is important to note that transmission charges play a major part in the delivered price of electricity. Therefore, although Quebec may have cheaper power, this may not necessarily be the case once all delivery charges are factored in.

Figure 9. Hypothetical customer example – total cost for economic decision with 15% transmission rate decrease on HQT’s system ($/MWh)

New York New

England Quebec Ontario Maritimes

via NE

Maritimes

via QC Commodity $60.0 $60.0 $50.0 $55.0 $51.0 $51.0Transmission (NEW ENGLAND) $0.0 $2.5 $0.0 $0.0 $2.5 $0.0Transmission (ONTARIO) $0.0 $0.0 $0.0 $7.2 $0.0 $0.0Transmission (QUEBEC) $0.0 $0.0 $7.2 $0.0 $0.0 $7.2Transmission (MARITIMES) $0.0 $0.0 $0.0 $0.0 $4.2 $4.2Transmission (NY) $4.3 $4.3 $4.3 $4.3 $4.3 $4.3Total cost ($/MWh) $64.3 $66.8 $61.6 $66.5 $62.0 $66.7

The 15% transmission rate decrease, holding all else constant, will change the economic parameters of the decision. Mr. Dupont will now consider importing power from Quebec as the most economic alternative and by so doing make use of the HQT transmission system. Were power to not be available from Quebec, then in this example with the 15% discount, the least cost option for Mr. Dupont remains importing electricity from the Maritimes through New England, thus leaving the surplus import/export capacity on the HQT system unused. However, if HQT’s were cut to $2/MWh for “wheel-through” transactions, Mr. Dupont would then find it more economical to source his power from the Maritimes and import it through Quebec and in doing so would contribute $2/MWh of revenue to HQT that they would not otherwise have received.

Let us look at the situation from a different perspective. What does the data on actual imports and exports suggest? Though a full empirical study of the transmission usage, interregional trade, prices, and transmission costs is outside the scope of this report, a simple review of the hourly flow data shows extreme volatility of both quantities of electricity transacted and prices.

As a further example, let us take electricity flows between Quebec and New England on the Phase II interface over the last two years8 and nodal prices at the Quebec-New England border (Phase II Intertie), as reported by ISO New England. The data graphed in Figure 10 represents hourly day-ahead transactions on the Phase II intertie over the March 2003 through August 2005 period. The nodal price represents ISO-New England’s reported cost of power (energy costs) plus marginal congestion and marginal losses in transmission to get power to the border

8 We have used flows and prices from March 2003 through August 2005. Since New England ISO transitioned to nodal prices only as of March 1, 2003, earlier data is not available for nodal price at interties.


with Quebec. If we believe in the efficient operation of markets (which eliminate arbitrage opportunities and thus reduce or remove price differences), then this price is also a proxy for Quebec’s cost of power and transmission costs to the border at each trading interval. As can be seen in the figure below, there appears to be a relationship between flows and prices, which as we note above includes the commodity cost of power and transmission costs. For illustrative purposes, the average pattern suggested by the raw data is represented by the red downward sloping trend line.

Figure 10. Illustration of relationship: hourly electricity flows between New England and Quebec and nodal prices at the intertie

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3 Hypothesis and recommendations

Having extensively observed and analyzed trading arrangements for market transactions, we can, under most circumstances, conclude that demand for short-term point-to-point transmission services is elastic. It is therefore our belief that customers other than native demand will make more use of HQT’s transmission services as HQT decreases its prices, provided there are no other barriers to using the transmission system. Thus, with a rate decrease, HQT could obtain greater revenues through an increase in transaction volumes from its point-to-point transmission services and could then pass along cost savings to local load.

We know that HQT has been granted a revenue requirement of $2,591 million by the Régie in D-2005-63. For the purposes of our hypothetical example below, we used historical data that


suggests that 4% to 6% of HQT’s revenues have historically been generated by “North American wholesale market transactions”, which we hypothesize are elastic in their demand (as opposed to transmission services for domestic demand, which is less likely to be sensitive to prices). On the basis of this notional demarcation, we estimate that transmission services for ‘wholesale market transactions’ may represent between $103.6 million and $155.5 million of the approved revenue requirement, depending on the percentage share of “North American wholesale market transactions” in HQT’s total revenue.

For illustrative purposes, let us further assume that HQT faces a linear demand curve for this class of services (we denote these as ‘wholesale market transactions’) based on the assumed elasticity of -2. The elasticity of demand measures the percentage change in quantity demanded of a product or service with respect to a percent change in the price (or cost) of the product. In other words, elasticity measures the responsiveness of quantity demanded to changes in price. Products that have an absolute value of price elasticity that is greater than one are called price elastic, and products that have an absolute value of price elasticity that is less than one are categorized as price inelastic. Given current published rates (hourly non-firm of $8.33 per MWh), we can, thus, estimate the potential impact of a 15% rate decrease on quantity of services demanded and the revenue this class of services would generate under the above assumption of elasticity.

The graph below highlights the results of our hypothetical model where the revenue generated by transmission services for ‘wholesale market transactions’ as a result of the 15% decrease (see the blue area) is larger than that amount generated by current tariffs (see yellow area), which is approximately $103.6 million. A 15% decrease would results in an estimated ‘wholesale market transactions’ revenue of $105.8 million based on our assumptions regarding elasticity. This represents a 2.14% increase in revenue generated using the recently approved revenue requirement level. The increase in revenues would be due to an increase in utilization of existing transmission capacity, assuming that capacity were available. Though this is a highly stylized example of the possible impact of lower tariffs on the revenue requirement with elastic demand, it nevertheless illustrates the basic benefits HQT could obtain.


Figure 11. Illustration of hypothetical example

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The figures above are purely for illustrative purposes as it is highly likely that demand elasticity would vary over time (and perhaps over transmission paths) and that a decrease of less than 15% would have positive effects on the revenue requirement. We have summarily tested various combinations of elasticities and rate decreases. At an elasticity level of -3 for example, a rate decrease of even 70% would produce a 7.5% increase over the revenue level generated using current tariffs, assuming that capacity were available. Additionally, a decrease of 15% in transmission rates would result in an increase in revenue at an elasticity level as low as -1.75. These figures simply serve the purpose to demonstrate that there are various alternatives that HQT should explore and that a thorough analysis of demand elasticity should be undertaken prior to any decision on transmission tariffs.

As an epitaph, it is interesting to note that HQT acknowledges having faced demand declines in the recent past for certain classes of services, which signals a need to review and reconsider the rate structure. In Hydro-Quebec’s Annual Report (2004), they state in the financial review section the following: “Sales amounted to $2,835 million down $127 million from 2003. The decrease is due to a $111-million reduction in revenue from long-term reservations for point-to-point transmission service”9. This decrease reflects a continuing trend, as the 2003 Annual Report, also reported decreases in profits as a result of declining point-to-point transmission services.10 This

9 Hydro Quebec. Annual Report (2004), pg. 64

10 The Hydro Quebec Annual Report (2003) on page 68 stated: “The transmission segment recorded income before financial expenses of $1,374 million, versus $1,467 million in 2002. This decrease is attributable to a decline in demand for long-term point-to-point service.”


reduction in demand for transmission services is directly related to the class of services we believe would be elastic, as demand by domestic customers increased rather than decreased over this time period with electricity sales to Hydro-Quebec Distribution increasing from 158 TWh in 2002, to 165.3 TWh in 2004.11 A decrease in transmission rates for the class of service we are suggesting (i.e. non native load) would enable HQT to reverse the recent trend in declining non native-load sales.

4 Concluding remarks

In order to stimulate demand for transmissions services and maximize the economic benefits of HQT’s transmission assets, it may be preferable for the Régie de l’Énergie to consider lowering rates for certain classes of transmission service (especially if the rate decline will be outweighed by the increased demand response). If elasticity is as substantial as implied by submitted evidence on market transactions and intuition on how these transactions work, then some of the additional revenue received from increased usage from market transactions could go to offset the rising needs of Quebec’s domestic (captive) customers. This type of tariff optimization follows the policy concepts of the Diamond extension12 of the famous Ramsey Pricing Rule, allowing the Régie de l’Énergie to then consider fairness and impact of rate changes on domestic customers and market transactions, alongside with arguments for efficiency (i.e., minimal distortion to economic social welfare).

The concept of demand elasticity is not new to the Régie de l’Énergie, nor to HQT. Both have acknowledged the fact that demand for transmission services could be increased through some form of a rebate or discount mechanism – this is equivalent to saying the demand for point-to-point transmission services is sensitive to price changes. The Régie de l’Énergie has noted these considerations in its directive to have HQT to pursue a provisional rebate policy on the belief that rebates could optimize the use of the system.13 While HQT has been ambivalent14 on the success of the provisional rebate scheme that the Régie mandated in 2002, it has nonetheless acknowledged in its recent discount policy proposal15 that demand on certain transmission paths is likely to be sensitive to price decreases. These complementary views reiterate the potential for improved system optimization and increase revenues and the need for a thorough empirical analysis on demand elasticity of transmission services. Furthermore, while conducting such an analysis, it is essential for the Régie de l’Énergie to direct HQT to consider the utilization level of the transmission system and the existing amount of spare capacity on it. Such a consideration would enable HQT to better determine the optimal rate decrease given existing system capacity for point-to-point services.

11 Hydro Quebec. Annual Report (2003), pg. 68 and Annual Report (2004), pg. 62

12 Diamond, Peter A. A Many-Person Ramsey Rule. Journal of Public Economics 4 (1975): 335-42.

13 Decision D-2002-95, pg, 280

14 Although HQT has mentioned that the provisional discount policy had provided inconclusive results, we wish to point out that the discount was only applied to off-peak hours and that the rebate level was not based on a quantitatively rigorous analysis of the elasticity of demand for transmission services.

15 Application R-3549-2004-Phase 2, HQT-2, Document 1 & 5


Therefore, we recommend that Régie de l’Énergie direct HQT to undertake more substantive studies on the elasticity of demand for transmission services in order to better address the impact that rate decreases may have on demand for point-to-point services and ultimately, on achieving the necessary revenue requirement for HQT while minimizing rate increases to native load customers. There is a wealth of data in the public and private domain on costs, market prices, and the transmission flows for the Quebec market (and more so) for neighboring regions. We would recommend that HQT undertake a thorough econometric analysis of elasticity for those transmission services that are likely to be responsive to price/cost changes (such as those described as ‘North American wholesale market operations’).

From an econometrics perspective, elasticity can be estimated using an estimated demand model, where the quantity of demand for transmission services (for ‘wholesale market transactions’) would be explained by key drivers, like transmission costs (rates), supply conditions, path location, and arbitrage opportunities. With econometrics, the marginal impact of the change in transmission costs could be isolated from other variables that impact transmission services. In our opinion, such a model would require the inclusion of the simultaneous market dynamics that exists between interconnected regions to Quebec, such as Ontario, New England, New York, and Maritime. Though this is an intensive and challenging quantitative exercise, it is also one that would add substantial rigor to the determination of future transmission rates taking into account capacity utilization to the ultimate benefit of ratepayers.

Documents

Conceptualizing the impact of demand elasticity of ... · The Giffen paradox relates to a special type of an inferior good (in contrast to a ‘normal’ good) which has the characteristic