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Optional Two-Part Tariffs: Toward More Effective Price Discounting

Fortnightly Magazine - July 1 1997

the competitive alternatives in all four market segments. %n3%n Consequently, the utility is in danger of losing

all 10 customers to bypass with

an expected margin loss of $52 million/year.

At-Risk Customers. To maximize margin collection for the 10 at-risk customers, a utility can design optional tailored tariffs. Optional tailored tariffs have their usage charges set equal to marginal cost. The access charges for these tariffs are set to maximize margin recovery subject to the constraint that the optional tariff is preferred to the base tariff and the competitive alternatives available to the customer. Table 5 shows the optional tailored tariffs developed for the 10 at-risk customers.

The annual margin from using the optional tailored tariff is $47.8 million/year greater than the margin produced by the base

tariff, assuming complete bypass. However, the annual margin is $4.6 million/year (or 8.8 percent) less than the margin that could be collected without competition. This means that the minimum possible discount required to retain the at-risk customers is $4.6 million/year.

Table 6 compares discounts based on optional tailored tariffs with the methods traditionally used by utilities to retain customers. Under Method 1, the utility adjusts the demand charge to make the average cost of utility service equal to the cost of the competitive alternative. With Method 2, the utility adjusts the usage charge to make the average cost of utility service equal to the cost of the competitive alternative.

Table 6 shows that the minimum discount occurs with the optional tailored tariff. Notice that the methods typically used by

utilities produce discounts that are roughly double that produced using optional tailored tariffs.

It should be noted that while some customers may like the added cost certainty associated with a high access charge and a low usage rate, other customers may not. It is possible that some customers may wish to limit the access charge to some specified amount. In this case, the optional tariffs would have to be designed to recognize this constraint. A utility could accomplish this by designing a block declining tariff with the prior blocks designed to collect the same amount as the access charge. Or a utility could do this by selecting a usage charge that will maximize margin collection subject to the constraint that the access charge does not exceed the specified amount.

Secure Customers. The preceding section demonstrated how to

maximize margin recovery from customers with competitive alternatives by offering optional tailored tariffs. However, a utility can also derive benefits from offering optional tariffs to core customers who are not vulnerable to competition, such as core commercial and small-industrial customers. The optional tariffs can be designed to create a "win-win"

outcome in which both core customers and shareholders are better off. Table 7 shows the optional automatic tariffs designed for core customers. The usage charges are chosen to maximize profits.

The tariffs have common usage charges for peak and off-peak usage, and 65 separate access fees, one for each customer. The access charges range in value from a minimum of $32,900 per month to a maximum of $107,800 per