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Transition to Dynamic Pricing

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

Fortnightly Magazine - March 2009
Figure 2

kWh x $0.19/kWh = $190.

An even simpler pricing scheme is to charge the customer a flat fee per month of $190 plus a certain amount to capture the risk posed to utility earnings by month-to-month variation usage. However, completely decoupling electric costs from the rate of usage sends customers the wrong signal about the scarcity of the underlying resources required to supply electricity.

While this rate example achieves simplicity, it’s limited in its ability to achieve other objectives, such as promoting conservation and energy efficiency. One design to achieve this goal would charge customers a higher price the more they consumed (see Figure 2) . The higher rate charged to consumption beyond 500 kWh per month would encourage customers to reduce their electricity consumption. At the same time, the rate for consumption up to 500 kWh is lower than the flat rate described in the previous example. This gives the customers the opportunity to save on their electricity bill if they are able to cut back on usage.

Without any price elasticity, the same customer’s bill would remain unchanged from the previous example: 500 kWh x $0.17/kWh + 500 kWh x $0.21/kWh = $190.

However, several studies have shown that customers do exhibit small but significant price elasticities, so in this example the customer likely would reduce consumption and achieve bill savings. 3

While this example shows how rate design can encourage conservation, the design doesn’t provide any means for encouraging reductions in consumption during the peak (expensive) time of day. When customers reduce consumption during the peak hours, this allows the utility to improve its load shape and reduce the need for lightly used, and therefore very expensive, capacity. At the same time, this would achieve some of the conservation-related benefits that also would’ve resulted from the previous example. For such a time-of-use (TOU) rate, the peak period might last from 1 p.m. to 6 p.m. on weekdays, with all remaining hours being considered off-peak hours. Assuming the average customer in the previous examples consumes 250 kWh during the peak period and the remainder (750 kWh) during the off-peak period, the average bill would be calculated as follows: 250 kWh x $0.31/kWh + 750 kWh x $0.15/kWh = $190.

Figure 3

This example again assumes no price elasticity. In reality, customers might be expected to reduce peak energy usage in response to the higher rate. They also might increase usage during off-peak periods because the price is relatively lower. Of course, some customers would respond more than others to the time-varying price signal, with some perhaps not responding at all. However, in the aggregate, substantial customer response likely would occur.

This progression of rate designs illustrates how various objectives can be met. However, the tradeoffs also are apparent. While the TOU rate is still a straightforward way of charging customers for electricity, it’s not as simple or as easy to explain as the original flat rate. In the past, as rates were designed to accomplish an increasing number of objectives, they have tended to become more complex. It’s important to keep this