Journal of Industrial Economics vol:27 issue:3 pages:243-261
This article investigates the implications of fuel adjustment mechanisms for the economic efficiency of the U.S., focusing on fuel adjustment clauses (FAC) for electricity rates. Fuel adjustment mechanisms used in electricity and natural gas pricing are formulae that provide for automatic adjustments in output prices in response to changes in the factor prices of boiler fuels and wellhead gas, respectively. Fuel adjustment mechanisms were first utilized in the U.S. during World War I to enable the regulatory process to function in response to the rapid increase in coal prices. A central feature of an FAC is that it acts directly on the output price without a specific consideration of its effect on the rate of return earned by the firm once the adjustment has been made. One of the principal arguments against fuel adjustment clauses is that they dampen incentives for the choice of the least-cost fuel supply. Fuel adjustment mechanisms can lead to inefficiency both with respect to the choice by utility of a technology and its selection of fuel supply sources. The fuel supply decision poses an efficiency problem primarily in conjunction with decreasing returns to scale, since a firm with non-decreasing returns to scale and an output price at least as great as marginal cost will choose the fuel supply source that is anticipated to have the smallest factor price increase. When there is an incentive to purchase the inefficient fuel, the collection lag can be extended to induce efficiency. This extension, however, affects the choice of technology by reducing both the technically efficient fuel-capital ratio and the ratio preferred by the firm. Fuel adjustment clauses thus pose a complex efficiency problem, which can be compensated for but not eliminated by the design of the adjustment formula.