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Rethinking 'Dumb' Rates

Achieving the smart grid’s potential requires a revolution in electricity pricing.

Fortnightly Magazine - March 2009

taking on risk associated with price volatility.

By and large, retail electricity consumers don’t realize they’re paying for a premium product—a hedged, blended rate—that’s more expensive to provide than a dynamic rate. The hidden “hedge premium” reflects the costs of guaranteeing a flat rate around the clock. Quantification is difficult, but an ISO New England study estimated this hedge premium to be about 15 percent of customer rates, and other estimates even are higher. 12

The advent of competitive wholesale markets and the unbundling of consumer rates for residential and small commercial customers in some jurisdictions offers the potential to reveal the true value of this hedge premium. In theory, consumers who take on this added risk of price volatility should be relieved of the burden of the hedge premium to the extent that their electricity provider no longer is incurring these costs.Even though dynamic pricing may not be suited to all customers, there clearly is substantial value left on the table when price signals are masked by a blended rate. Those customers who are willing to take on added risk should be compensated for the savings incurred by their service providers.

Regulatory Decision-making

State regulators will need to weigh all of these factors in making decisions about the deployment of AMI and implementation of dynamic pricing. And because every utility service area is unique, these decisions must be made on a case-by-case basis. Critical assumptions must be made about penetration rates and levels of customer response. Regulators also must make judgments about the functionalities of advanced meters and communications technologies, as well as the standards for interoperability. Above all, if AMI is approved, regulators must ensure that AMI and dynamic pricing deliver their intended benefits and not just higher customer costs. 13

After a thorough examination, California regulators approved mass market AMI deployment for residential customers and are moving toward making dynamic pricing a default tariff for the state’s three major electric utilities. 14 Meanwhile, deployment of AMI and/or dynamic pricing is moving forward in states such as Alabama, Delaware, Florida, Illinois, Maryland, Michigan, and Ohio. 15 Nationwide, U.S. utilities are planning deployment of 52 million advanced meters over the next five to seven years, representing more than one-third of the nation’s active meters. 16

If it were just a question of whether or not the benefits outweigh the costs, making a decision about rolling out AMI might seem relatively simple. However, regulators may be faced with multiple options with regard to both AMI deployment and dynamic pricing. For example, is a utility’s proposed AMI plan the optimal one? Which dynamic-pricing method is best, and should it be the default rate design or just another customer option? What expenditures and investments would have to be incurred if the decision to deploy AMI is deferred?

Perhaps most difficult of all, how should regulators take into account unquantified and intangible benefits associated with AMI? Should they count local benefits only, or consider the effects of demand response in reducing market prices that spill over into neighboring states? Answering these complex questions will take