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Transition to Dynamic Pricing

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

Fortnightly Magazine - March 2009

the time-varying nature of electricity supply costs.

A tariff that incorporates both an increasing block structure and time-varying pricing can provide adequate price incentives for encouraging energy efficiency and demand response. On the other hand, challenges in implementing such economically efficient pricing have been a key driver in the use of incentives to promote economic efficiency and demand response (DR). Incentives for energy efficiency are designed to account for the market failure in setting correct electricity prices that incorporate social marginal costs. Incentives for DR options, such as direct load-control, reflect the historical perception that load-control technology is cheaper than time-of-use metering. They also reflect a perception that behavioral response to time-varying pricing is more unreliable than push-button technology options.

It’s not hard to design economically efficient rates, even ones that incorporate the inherent uncertainty in supply conditions. What is difficult is designing economically efficient rates that customers understand well, that overcome the political challenge of transitioning from longstanding cross-subsidies to more equitable and efficient cost allocation, and that can be implemented cost effectively. The interplay and tradeoffs between economic efficiency and the other criteria needs to be re-examined in future regulatory deliberations.

Promote equity : Equity in ratemaking can mean different things to different people. For some, it means preserving cross-subsidies and making sure that no one is made worse off relative to their existing situation. Of course, for this to be good for society, one has to assume that the existing situation was good to begin with. If the existing situation consists of significant cross-subsidies, some individuals will be made worse off when those cross-subsidies are eliminated—even though all they are giving up are financial gains that weren’t theirs to begin with. Thus, the most conservative definition of optimality, attributed to the economist Vilfredo Pareto, rears its head and crimps forward progress.

A Pareto improvement is one in which at least one person is made better off by a change in policy, while no one is made worse off. Adherence to only Pareto-optimal changes makes it impossible to move to a better allocation of resources through more efficient pricing, even if people agree it’s ultimately the correct outcome. An alternative and less restrictive economic metric is the Hicks-Kaldor optimality criteria, which states that if, as the result of a price change, winners gain enough to be able to pay off losers, and still be ahead, then that constitutes a welfare improvement for a society as a whole—even if the winners are not required to make such compensation. Note that if the winners were required to make the compensation, we would be back to the Pareto Optimality criterion.

An alternative definition of equity means having lower rates for low-income consumers, as is the case with the California Alternative Rates for Energy (CARE) program that provides a discount of at least 20 percent for low-income users. While rate options such as these are common throughout the industry, most economists would argue they distort price signals and lead to excess electricity consumption.

A third definition of equity is accurate cost allocation—that is,