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Transition to Dynamic Pricing

A step-by-step approach to intelligent rate design.

Fortnightly Magazine - March 2009

One or more off the following steps might be useful in easing the transition.

Creating customer buy in : Customers need to be educated on why a century-old practice of ratemaking is being changed. They have to be shown how dynamic pricing can lower energy costs for society as a whole, help them lower their monthly utility bills, improve system reliability, prevent an energy crisis, and lead to a cleaner environment.

Offering tools : Energy management tools should allow customers to get the most out of dynamic pricing. At the simplest level, such tools should provide information on how much of the customer’s utility bill comes from various end-uses such as lighting, laundry and air conditioning and what actions will have the largest effect on their bill. At the next level, real-time in-home displays would disaggregate the customer’s power consumption and explain how much they are paying by the hour. Finally, these tools would include enabling technologies such as programmable communicating thermostats. Similar examples can be constructed for commercial and industrial customers.

Designing two-part rates : The first part would allow customers to buy a predetermined amount of power at a known rate (analogous to how they buy all their consumption today) and the second part would provide access to dynamic pricing and allow customers to manage their energy costs by modifying the timing of their consumption. They could be allowed to pick their predetermined amount, or it could be based on consumption during a baseline period.

Providing bill protection : This would ensure the customer’s utility bill would be no higher than what it would have been on the otherwise applicable tariff, but would not preclude it from being lower based on the dynamic-pricing tariff. Customers would simply pay the lower of the two amounts. In later years, such bill protection could be phased out. For example, in year one, the customer’s bill would be fully protected and would be no higher than it would have been otherwise; in year two, it would increase by no more than 5 percent; in year three, no more than 10 percent; in year four, no more than 15 percent; and in year five, no more than 20 percent. In the sixth year and beyond, bill protection would be provided for a fee.

Crediting customers for the hedging premium : Existing fixed-price rates are very costly for suppliers to service, since they transfer all price and volume risk from the customers to the suppliers. In addition, the supplier takes all volume risk. In order to stay in business, the supplier has to hedge against the price and volume risk embodied in such an open-ended fixed-price contract. The supplier can do so by estimating the magnitude of the risk and charging customers for it through an insurance premium. The risk depends on the volatility of wholesale prices, the volatility of customer loads, and the correlation between the two. Theoretical simulations and empirical work suggest this risk premium ranges between 5 percent and 30 percent of the cost of a fixed rate,