Pricing Electricity: More Questions than Answers

May 2004 Energy & Utilities, Pricing

How are prices set at the industry level? In a competitive market, Adam Smith’s invisible hand drives prices to a dynamic equilibrium set by suppliers’ willingness to produce at a price and consumers’ willingness to purchase. Yet residential electricity markets are hardly competitive. Since the Public Utility Holding Company Act of 1935, government regulations have replaced market forces in setting residential electric prices. Today, a little over 65 years later, advances in technology coupled with divergent consumer demands are straining the ability of the current structure to react.

At the AESP/EPRI 2004 Pricing Conference held in Chicago IL on May 18 & 19, 50 individuals including government regulators, utility representatives, economists, and industry consultants discussed the future of pricing residential electricity. The presentations and discussions touched on numerous rate structures, but raised more questions than answers.

Questions and Challenges

In his keynote address, Ahmad Faruqui of Charles River Associates highlighted the increased challenge to electricity pricing. He pointed to the need to link wholesale prices to retail prices; the Cap Gemini report suggesting that metering and rates are the key to utility profitability; and the unresolved issues in dynamic pricing, demand curtailment, regulatory hurdles.

Underlying these challenges is the dominant treatment of residential electric service as a commodity good. As a commodity market, all electric suppliers and customers are treated in the same manner. The regulatory structure replaces market forces in forcing both suppliers and consumers to act as prices takers in the commodity market. While politically this may appear equitable, it is not. Like other services, the way in which electric service is packaged and provided affects its value to consumers and its cost to suppliers. Furthermore, different customers will desire their electricity packaged in different ways. Service differentiation threatens the treatment of electricity as a standardized commodity.

The friction between the dominant treatment of electricity as a commodity versus the market demand to treat electricity as a differentiable service challenges rationality.

Industry Standard Falls Short of Pricing to Value

After 20 years of use, Performance Based Rates are the de-facto standard in residential pricing. They are designed to encourage utilities to improve productivity while passing on a portion of any cost savings to consumers. According to Michael Ballaban and Kathleen Kelly of Stone & Webster Management Consultants, there are two standard approaches to Performance Base Rates. In the Price Cap approach, current electric rates are based upon last year’s rates adjusted for inflation and expected productivity improvements. In the Earnings Sharing approach, rates adjust only when utility profits move outside of a dead-band zone from a baseline return on equity.

Despite the simplicity and ubiquity of Performance Based Rates, this structure for setting prices is straining to meet demands of the current market potential. Vic Niemeyer of EPRI raised three key value issues of reliability, environmental concerns, and customer response times in setting Performance Based Rates related to industry metrics. Outside of these service quality issues, two other pressures are lowering the relevancy of Performance Based Rates. These are the variation in demand between residential customers and the value to implementing demand response programs.

Power Quality

A basic implementation of Performance Based Rates using last year’s rates or managed earnings does not provide an incentive for improvements in power quality or outage management. Without an incentive structure with regards to the quality of their product, utilities have nothing to gain by investing in power quality. The current challenges in transmission and distribution are directly related to the lack of incentive to invest in this infrastructure.

To overcome the obvious shortcoming of Performance Based Rates, states are regulating reliability standards using sticks instead of carrots. According to Richard Wight of Energy Market Solutions, the number of states that have implemented reliability standards has increased from 3 in 1996 to 26 today. This leaves 24 states without reliability standards not to mention the US territories.

But using the stick of reliability standards may not be the best incentive. For instance, power quality and outage management are often measured using industry standard indices of SAIFI, CAIDI, SAIDI, and similar others. Utilities have found that Advanced Metering Infrastructure (AMI) can be used to alert them of power outages sooner, thus restore power faster. Unfortunately, using AMI data for power reliability has a corollary effect of tracking the duration of outages more accurately. Thus, outages that were once recorded to be as short as a few hours are now properly measured to last much longer. This drives the standard indices up giving the false impression that power quality has degraded. The end result is that a utility taking a desired step to improve reliability may actually be more at risk of being fined for poor quality. Clearly sticks are not supposed to be used to punish good behavior.

Divergence of Demand

Electricity is packaged for consumers in a service contract. In most markets, a standard service contract is applied to all residential consumers with rates determined by the state regulatory body. In this structure, consumers have little choice in the contract they accept for electricity and utilities have limited options in constructing their offers.

The use of a single rate structure fails to capture the full variation in possibilities, many of which both increase utility profits and fulfill broader consumer demands. For instance, Georgia Power has packaged their electricity for residential customers in no fewer than five different contract types. Jon Kubler of Georgia Power described the various residential contracts to include Flat Bill, Flat Rate, Green Power, and Premium Services as well as the state regulated standard rate. Importantly, consumers have expressed demand for each contract type and Georgia Power has achieved greater profitability. Pre-paid electricity is yet another approach that utilities have taken and has been well received by some customers.

[For readers unfamiliar with these approaches, consider either Green Power or Pre-Paid Electricity. In Green Power contacts, the utility commits to use renewable energy sources to generate electricity in proportion to the power consumed by customers under the Green Power contract. Because electricity generated from renewable sources costs more than that generated from fossil or nuclear fuels, the price of Green Power is usually higher than the standard electric rates. Environmentally conscientious consumers however are willing to pay the higher rates because it meets their concerns. Alternatively, in Pre-Paid contracts, the consumer is required to purchase electricity credits on a swipe card prior to receiving power. Many consumers find that Pre-Paid electricity contracts enable them to budget their consumption better thus avoiding having the power shut-off and incurring expensive turn-off and turn-on fees.]

Creating a variety of electricity contracts each with its own pricing structure falls well outside of the realm of Performance Base Rates. When utilities can tap into variations in demand to create higher-valued contracts, both customers and utilities win. As Mr. Kubler stated, “Look at the skyline of Atlanta and no two buildings are alike. When we create prices, the same forces are at work.”

Demand Response

Electricity rates do not have to be constant over the duration of the day. They can vary and in many markets they do. Demand Response rates vary the price of electricity over the course of the day according to the demand for electricity at that time.

In the late afternoon when people return from work, demand peaks as people turn on their air conditioners and lights. At times, in certain markets, the demand for electricity can strain the capacity of utilities to generate, transmit, and distribute. Faced with capacity constraints, electric utilities have options of building more capacity, purchasing capacity rights from the open market, or asking consumers to decrease their consumption. Demand Response rates take the third approach by dynamically raising prices during periods of peak demand to encourage energy conservation.

Using Demand Response rates to curb demand faces a number of challenges. Outside of regulatory hurdles and concerns of fairness, many analysts are unsure of the ability to count on consumers to lower their demand in response to a price signal. Experience demonstrates otherwise.

Dan Violette of Summit Blue Consulting countered the three major objections to Demand Response programs. First, he pointed out that the myths concerning the inability of the poor and elderly to understand the program and adjust their consumption according to a variable price are false. In fact, when given the opportunity, these are the exact target segments that desire demand response programs the most. Second, a common objection to implementing Demand Response programs is the concern that few customers would select the program. However, if only a minority converts, there is still value to the program. Mr. Violette reminded the audience of the Los Alamos National Labs study which demonstrated that the value of flexibility in electric markets almost always exceeds the cost. The third objection to implementing Demand Response programs comes from the unwillingness of power risk managers to value Demand Response programs in a similar manner as they would other hedging instruments. To overcome this challenge, Mr. Violette and others pointed to the value of experimentation to quantify the relationship between demand and prices and also to the Berkeley study demonstrating that a single digit decline in demand would have avoided the large spikes in costs during the California energy crisis.

Demand Response programs are a far cry from the industry standard Performance Based Rates. Clearly, they provide value to the industry as a whole in their ability to lower the overall cost to serve, yet their dynamic nature and the need for constant adjustment challenges the industry structure of setting rates at the regulatory level on a yearly or every five-year basis.

Under Attack

As the discussions at the AESP/EPRI Pricing Conference highlighted, the treatment of electricity as a regulated commodity is under attack by numerous market and industry forces. In a free and competitive market, much of the discussion on how to price electricity would be settled by market forces where consumers would choose quality and contracts that best suit their needs. However, residential electric markets are neither free nor competitive in the US. Until that day comes, questions will continue to outpace answers.

About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

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