[BETA] Fortnightly

A simple formula method shows utilities exactly how much to discount prices. Electric utilities have drawn attention recently (and criticism from some quarters) for granting off-the-tariff discounts to customers deemed at risk for migration to lower-priced competitive alternatives. Typically, utilities have offered discounts to high-load customers in exchange for a long-term purchase commitment providing either more certain earnings, higher expected earnings, or both. How much utilities should discount rates depends, among other things, upon the likelihood and timing of retail access, the spread between existing tariffs and market power prices, and the likely level of stranded cost recovery.

Utility managers should consider rate discounts as a marketing strategy. They will want to do so to maintain sales, revenues and margins. In fact, a well-crafted agreement can protect a utility against substantial margin losses from market upheavals, such as retail choice for consumers. However, managers and their analysts must define the bounds of such a strategy and ensure that any discounting proposals will prove economically beneficial and consistent with their view of how competition will unfold in the future.

A simple, analytical framework can evaluate the effectiveness of offering discounted rates in exchange for long-term purchase commitments. A numerical example can derive the utility's maximum supportable discount, or MSD. A utility might offer this maximum discount in exchange for long-term purchase commitments. However, the MSD will vary with changes in underlying assumptions.

Trading Price for Security

Many electric utilities charge a bundled retail rate that includes a generation component two- to three-times higher than the market price of wholesale power. Such a rate threatens a significant reduction in the utility's gross margin, with all the attendant consequences for cost recovery and earnings impairment.

One way to hedge this risk is to offer rate discounts tied to long-term purchase commitments from certain high-risk customers. The discount trades off a reduction in price and cash flow for more secure sales and gross margins over the long run.

Customers would have at least two reasons to consider extending their purchase commitments, even if the discounted prices should exceed expected market prices. First, they cannot know with certainty when, or if, changing regulations will provide them with access to power at market prices. The more distant the prospect, the more a customer may prove willing to trade off long-term purchase commitments for immediate rate reductions. Second, customers may wish to hedge the price risk inherent in market-based purchases by signing a more certain, long-term pattern of prices even if they exceed expected market prices.

How should a utility choose a discount? The first step is to determine the maximum supportable discount it is willing to offer given certain assumptions regarding critical variables. These variables may appear complicated, but the key point is simple: How will changes in the regulatory structure alter future revenues and, more importantly, gross margins.

A Hypothetical Example

Suppose a hypothetical utility is concerned that retail wheeling might occur at some point over its five-year planning horizon, giving customers access to power at market prices. It will either lose sales to competitors or will