An economic analysis of fuel adjustment clauses for utility regulation

The fuel adjustment clause (FAC) is the most fundamental means of automatically reducing regulatory lag. In this dissertation we focus on two aspects of FAC: the consequence of replacing FAC by futures trading and the impacts of including purchased power in FAC on a firm's choice of capacity level and own utility generation.;In the electric industry, utility-to-utility transactions are common place. Most states' public utility commissions (PUCs) allow purchased power costs being included in FAC. We construct a two-date model to study the impact of different degree of pass-through on a utility firm's choice of capacity level and own utility generation. Assume the utility generation function is of a Cobb-Douglas type, it is shown that the adjustment clause tends to discourage the risk neutral firm from investment in capacity when the demand is perfectly inelastic. Similar conclusions apply to the firm's output choice whenever the fuel cost accounts for more than a half of the total revenue. In case that the production process exhibit nearly constant return-to-scale, the adjustment clause always leads to less of own utility generation.;While the use of FACs is widespread and in most cases long-standing, they have been the object of numerous criticisms for several years. FACs reduce the incentive to search for the least cost source of fuel, distort the incentive to produce efficiently, and exacerbate problems associated with self-dealing. Much of the response to those criticism has been aimed at improving the design of the FAC mechanism. This dissertation explores and advances a completely new method for insuring the financial integrity of the utility but avoiding the incentive problems associated with the FAC. We demonstrate the FAC can, under certain conditions, be successfully displaced by futures trading. By efficiently transferring risk to speculators the utility can improve the welfare levels of risk averse ratepayer and itself. Thus, futures trading provides a Pareto improvement over the FAC.