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Transition to Dynamic Pricing

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

Fortnightly Magazine - March 2009
Figure 4

in mind when discussing ratemaking criteria, and particularly when discussing the strengths and weaknesses of alternative dynamic-pricing rates.

The Bonbright Criteria

In addition to such rate-design objectives as simplicity, efficiency and load management, a utility or policymaker might want rates to achieve several other goals, from bill stability for customers to revenue stability for the utility. These were first codified in 1961 by Professor James Bonbright of Columbia University. 4

After years of research, Bonbright formulated eight criteria for establishing the rate structure. The original list of eight was subsequently expanded to the following 10:

Figure 5

1) Effectiveness in yielding total revenue requirements under the fair-return standard without any socially undesirable expansion of the rate base or socially undesirable level of product quality and safety.

2) Revenue stability and predictability, with a minimum of unexpected changes that are seriously adverse to utility companies.

3) Stability and predictability of the rates themselves, with a minimum of unexpected changes that are seriously adverse to utility customers and that are intended to provide historical continuity.

Table 1

4) Static efficiency, i.e., discouraging wasteful use of electricity in the aggregate as well as by time of use.

5) Reflect all present and future private and social costs in the provision of electricity ( i.e., the internalization of all externalities).

6) Fairness in the allocation of costs among customers so that equals are treated equally.

7) Avoidance of undue discrimination in rate relationships so as to be, if possible, compensatory (free of subsidies).

8) Dynamic efficiency in promoting innovation and responding to changing demand-supply patterns.

9) Simplicity, certainty, convenience of payment, economy in collection, understandability, public acceptability, and feasibility of application.

10) Freedom from controversies as to proper interpretation.

These criteria have served as guiding principles in electricity ratemaking for the past half century. They are simple and comprehensive but somewhat duplicative and verbose, and thus can be collapsed into three broadly defined criteria without any loss of content: 1) efficiency, 2) equity, and 3) simplicity.

While the Bonbright criteria are a good starting point for designing today’s rates, they’re insufficient for meeting the changing needs of a smart-grid world. The advent of advanced metering infrastructure, coupled with the introduction of in-home displays and price-responsive appliances, are bringing about a revolution in how consumers approach electricity. It’s necessary to update the criteria that we use for designing electric rates.

Next Generation Rate Design

It’s possible to conceive innovative rate designs that meet the requirements of the smart grid world by conforming to four criteria: promote energy efficiency; promote equity; facilitate customer choice; and clearly and simply communicate prices and costs.

Promote economic efficiency : The desire to achieve economic efficiency has been one of the key drivers underlying the increasing complexity of electricity pricing in the last two to three decades. When consumers pay prices that reflect the marginal cost of supply, societal resources are employed optimally in the economy; everybody wins. Increasing block rates are designed to reflect the fact that the marginal cost of electricity supply now exceeds the average cost, and time-varying prices reflect