By unbundling usage from access, utilities can maximize contribution to margin and yet still retain load.

With deregulation and industry restructuring, energy utilities face price competition from marketers, brokers, independent producers and even other utilities. To succeed in this environment, utilities will need to develop innovative pricing strategies that better meet customer needs and respond more effectively to competition. The common response by utilities to competition calls for price discounting to retain "at risk"

customers by meeting the competition head-on.

To do that, electric utilities typically will employ one of two methods to discount prices. The first method adjusts the demand charge to make the average cost of utility service equal to the cost of the bypass threat or the least-cost competitive alternative. The second method adjusts the usage charge to attain the same end result.

Nevertheless, utilities can improve on these traditional discounting methods. The solution lies in pricing usage separate from access. Set the usage price at marginal cost and recover fixed costs through the access charge. By unbundling usage and access through a two-part tariff, a utility can maximize its contribution to margin and minimize the size of the discount needed to retain load.

This seemingly contradictory result comes directly from economic theory. First, by cutting usage rates, the seller can stimulate demand and deliver benefits to customers by what is known as "consumer surplus," compared to traditional approaches used by utilities to retain customers. Second, by recovering margin through an access charge, the utility avoids depressing demand

and actually boosts "producer surplus."

In fact, the utility can go one better. It can offer optional two-part tariffs. A key benefit of such pricing is that optional tariffs do not fall prey to the same restrictions

as the utility's base tariff.

Consequently, the utility enjoys much more flexibility in the design of the optional tariffs and can change them much more quickly in response to changing market conditions.

With optional tariffs, the utility offers one or more two-part tariffs to a particular customer class or market segment. %n1%n In fact, the same method used to design optional tariffs also can be employed to design and price services differentiated by quality. Such services should enable utilities to better meet customer needs and to increase profits. %n2%n

In telecommunications, AT&T offers its optional Reach Out America program. MCI counters with Friends and Family Program. These calling plans serve as examples of how energy utilities can use optional tariffs to tailor services and prices to the needs of customers.

Unbundled and Rebundled Services

Optional tariffs are well suited to rebundled services. Rebundled services mean combining unbundled or a la carte services to provide services that better meet the needs of a particular market segment.

Designing optional tariffs for unbundled services is relatively straightforward for basic functions such as generation, transmission and distribution, but can become quite complex for revenue-cycle services such as billing, meter reading and customer services. To design optional tariffs for an unbundled service such as transportation, a utility would use the same methods employed for bundled services; however, the usage charges would be based on the marginal cost of transportation, instead of the marginal cost of the bundled service. Also, the optional tariffs must be designed so that the customer prefers it to the base tariff and to any other unbundled transportation service. Also, the customer must prefer the bundled service (transportation plus generation for electricity or transportation plus procurement for gas) to available competitive alternatives.

The design of optional tariffs for rebundled services is much more complex for two reasons. First, the number of possible combinations that must be analyzed is much greater. For example, for three services, the number of possible combinations of bundled, unbundled and rebundled services is eight (23 = 8), although not all combinations are expected to be offered. Second, when designing optional tariffs for rebundled services, it is necessary to estimate own-price elasticities and marginal costs for each unbundled service, and cross-price elasticities (to reflect the complement and substitute nature of the services) for each possible pair of services. Estimating own-price and cross-price elasticities for unbundled services is expected to be very complex. Moreover, utilities will have little or no data to estimate these parameters, because most of these services have not been offered.

One solution to this problem is to use contingent valuation methods to estimate customer response to hypothetical offerings. Such an approach has been used to assess the value that customers place on reliability, and to estimate the demand for new products.

The Benefits: A Case Study

This section illustrates the design of optional tariffs based on a random sample of 75 large industrial customers (peak demands in excess of 2 MW). The sample is from an electric utility that was experiencing considerable load loss due to self-generation and cogeneration. The price elasticity and marginal cost estimates used in the example are shown in Table 1.

The analysis is based on price elasticity estimates that are deliberately low and marginal cost estimates that are set deliberately high. Conservative estimates of price elasticities and marginal costs are used to ensure the actual results will be at least as favorable as those shown in the analysis.

Of the 75 customers, 10 have peak demand greater than 10 MW and a load factor greater than 50 percent. These customers are considered in danger of bypass from either self-generation or cogeneration. The remaining 65 customers are not considered at risk. Data on the margin recovery for all 75 customers are shown in Table 2.

For the purpose of designing competitive tariffs, the 10 customers considered vulnerable to bypass have been separated into four market segments based on size and load factor. This segmentation is used, because the costs of the competitive alternatives depend on these factors. The distribution of the at-risk customers is shown in Table 3.

The first step in the analysis is to determine if the utility is in danger of bypass. Table 4 provides the average price of utility service compared to that of the competitive alternatives for each of the four market segments.

As shown, the average utility rate exceeds the price of the competitive alternatives in all four market segments. %n3%n Consequently, the utility is in danger of losing

all 10 customers to bypass with

an expected margin loss of $52 million/year.

At-Risk Customers. To maximize margin collection for the 10 at-risk customers, a utility can design optional tailored tariffs. Optional tailored tariffs have their usage charges set equal to marginal cost. The access charges for these tariffs are set to maximize margin recovery subject to the constraint that the optional tariff is preferred to the base tariff and the competitive alternatives available to the customer. Table 5 shows the optional tailored tariffs developed for the 10 at-risk customers.

The annual margin from using the optional tailored tariff is $47.8 million/year greater than the margin produced by the base

tariff, assuming complete bypass. However, the annual margin is $4.6 million/year (or 8.8 percent) less than the margin that could be collected without competition. This means that the minimum possible discount required to retain the at-risk customers is $4.6 million/year.

Table 6 compares discounts based on optional tailored tariffs with the methods traditionally used by utilities to retain customers. Under Method 1, the utility adjusts the demand charge to make the average cost of utility service equal to the cost of the competitive alternative. With Method 2, the utility adjusts the usage charge to make the average cost of utility service equal to the cost of the competitive alternative.

Table 6 shows that the minimum discount occurs with the optional tailored tariff. Notice that the methods typically used by

utilities produce discounts that are roughly double that produced using optional tailored tariffs.

It should be noted that while some customers may like the added cost certainty associated with a high access charge and a low usage rate, other customers may not. It is possible that some customers may wish to limit the access charge to some specified amount. In this case, the optional tariffs would have to be designed to recognize this constraint. A utility could accomplish this by designing a block declining tariff with the prior blocks designed to collect the same amount as the access charge. Or a utility could do this by selecting a usage charge that will maximize margin collection subject to the constraint that the access charge does not exceed the specified amount.

Secure Customers. The preceding section demonstrated how to

maximize margin recovery from customers with competitive alternatives by offering optional tailored tariffs. However, a utility can also derive benefits from offering optional tariffs to core customers who are not vulnerable to competition, such as core commercial and small-industrial customers. The optional tariffs can be designed to create a "win-win"

outcome in which both core customers and shareholders are better off. Table 7 shows the optional automatic tariffs designed for core customers. The usage charges are chosen to maximize profits.

The tariffs have common usage charges for peak and off-peak usage, and 65 separate access fees, one for each customer. The access charges range in value from a minimum of $32,900 per month to a maximum of $107,800 per month with an average of $50,900 per month. The standard deviation of the access charges is $16,900 per month.

With conservative price elasticity assumptions, offering optional automatic tariffs to core customers increases margin collection by $3.2 million/year (3 percent). To illustrate what would happen under higher and potentially more realistic assumptions, we increased the price elasticity assumptions to 0.5 for both the peak and off-peak periods. With the higher price elasticity, offering optional automatic tariffs to core customers increases margin collection by $7.4 million/year (7 percent).

Potential Obstacles

Regulators and competitors may challenge the introduction of optional tariffs for several reasons. First, regulators may be reluctant to allow utilities the flexibility to modify the optional tariffs on short notice, arguing that optional tariffs should receive the same level of scrutiny as the base tariff. Although this could happen, regulatory precedence exists for allowing utilities the flexibility to update optional tariffs with little notice. Telecommunication utilities are allowed to do this for residential and business customers as long as the tariffs satisfy the requirements of the Federal Communication Commission's Optional Calling Plan Guidelines. Many states allow utilities to offer flexible-pricing options designed to retain customers with competitive alternatives. %n4%n

Moreover, Niagara Mohawk Power Corp. has been granted permission to offer optional tariffs to both core customers and customers with competitive alternatives; and several utilities, such as the Southern California Gas Co., Boston Gas Co., Southern California Edison Co., and Pacific Gas and Electric Co. have either requested or have been granted authority to offer optional tariffs or flexible pricing options in addition to their base tariffs.

Second, regulators may be concerned that utilities will use optional tariffs to engage in anti-competitive practices. The usual concern is that utilities will price below marginal cost in an attempt to limit competition. This concern is usually dealt with by requiring utilities to set usage charges above marginal cost. %n5%n

Third, it is to be expected that competitors will spend considerable effort attempting to block the introduction of optional tariffs. The usual argument is that allowing monopoly-pricing flexibility will somehow limit competition, or disadvantage core customers. It has been our experience that the economic merits of optional tariffs (e.g., increased economic efficiency, minimization of the discount required to retain customers and reduction in the chance of uneconomic bypass) are sufficient to counter these challenges.

Fourth, regulators may be concerned that customers could be made worse off if they select the wrong tariff. While this can happen, allowing them to switch freely among the various tariffs offered by the utility can minimize the adverse consequences of customer mistakes.

Finally, it is sometimes argued that optional tariffs require inputs that are difficult to estimate and that these inputs are not required under traditional cost-of-service ratemaking. While it is true that optional tariffs do require knowledge of price elasticities, marginal costs and competitor costs, these inputs are required to price products in a competitive environment. The fact that traditional COS principles do not require these inputs would suggests that COS principles may be of limited usefulness in a competitive open-access environment.

Ronald Rudkin is vice president with Analysis Group Economics and head of the firm's utility consulting practice. He has 15 years of experience with the Southern California Gas Co. He has testified before the California Public Utilities Commission, the California Energy Commission and the Federal Energy Regulatory Commission. David Sibley is the John Michael Stuart Centennial Professor of Economics at the University of Texas at Austin and is an authority on utility pricing. He is co-author of The Theory of Public Utility Pricing. He has testified on energy pricing matters before state commissions in Texas, New York and Massachusetts.

Economic Principles and Tariff Design

Optional two-part tariffs allow utilities to stimulate demand by moving energy charges closer to marginal cost. Stimulating demand increases the size of the economic pie, benefitting both shareholders and ratepayers. This strategy also will minimize the discount required to retain at-risk customers with access to competitive alternatives.

Figure 1 shows a demand curve for an individual customer. At a price P0 the customer would buy Q0 units. P0 represents the best alternative available to the customer. This could be either the utility's base tariff or the competitive alternative available to the customer. However, notice that for all units less than Q0 the amount the customer would have been willing to pay exceeds P0.

Figure 1

The triangular area above the price level but below the demand curve is a measure of the benefit the customer receives from buying Q0 units for P0. Economists refer to it as consumer surplus.

The rectangular area between the price, P0, and marginal cost, MC, is referred to as producer surplus. It represents the sum of net benefits to the producer associated with each incremental unit sold, where the incremental benefit is the difference between price and the marginal cost of providing each unit.

By assuming that P0 is usage rate associated with the utility's standard tariff, an optional two-part tariff can be designed that benefits both the consumer and the utility. Suppose that the utility designs an optional two-part tariff with access charge A1 (equal to the base quantity, Q0, multiplied by

P0 - P1) and usage charge P1 (see Figure 2).

If the consumer selects the optional tariff, then his or her CS will increase by A2. The lower usage rate, P1, induces the consumer to increase consumption from Q0 to Q1, so the new CS is the triangular area above P1 less the access fee, A1. Producer surplus increases by A4. In effect the total economic "pie" grew larger as the usage rate moved closer to marginal cost, enabling both customers and shareholders to benefit.

Figure 2

However, the utility can do even better. Instead of setting the usage price equal to P1, the utility could set the usage charge equal to marginal cost, MC, and the access charge equal to A1 + A2 + A3 + A4 + A5. Doing this will produce the same consumer surplus as the base tariff or the competitive alternative, but will increase margin contribution (compared to the optional tariff shown in Figure 2) by A2 + A5. Moreover, this optional tariff will produce the smallest discount that will enable the utility to retain the customer.

Types of Optional Tariffs

Depending upon the situation, various types of optional tariffs can be designed for a particular customer class or market segment.

Optional tailored tariffs. The utility can offer these tariffs to large customers with competitive alternatives. The tariffs are designed to produce the maximum margin contribution, and therefore the minimum possible discount necessary to retain the customer. Separate tariffs are developed for each customer. The access charges and usage charges are selected to maximize margin contribution subject to the constraint that the optional tariff is preferred to the base tariff and to the competitive alternatives available to the customer. %n6%n

Optional self-selecting tariffs. The utility can offer this tariff to both core customers (customers that do not have competitive alternatives) and noncore customers (customers that have competitive alternatives). One or more optional tariffs are designed for customers in a particular market segment. These tariffs are not tailored to specific customers, but instead are available on a "self-selecting" basis to all customers in the group. Consequently, customers in a particular group can choose any of the tariffs offered to that group. The tariffs maximize margin subject to the constraint that the tariff designed for a particular customer is preferred to: (1) the base tariff, (2) the competitive alternatives available to the customer, and (3) the tariffs designed for other customers. Because of the additional constraint that the tariff designed for one customer must be preferred to tariffs designed for other customers, the margin collection with optional self-selecting tariffs will be less than that collected using optional tailored tariffs.

Automatic tariffs. Designed for customers that do not have competitive alternatives, these tariffs are similar to the optional tailored tariffs in that separate tariffs are developed for each customer. The tariffs have common usage charge(s) but separate access charges. %n7%n The access charge is computed by multiplying each customer's base usage by the difference between the usage charge for the standard tariff and the common usage charge for the optional automatic tariff. Computing the access charge this way produces the same revenue as would be collected under the standard tariff at the customer's base level of usage. Of course, the economic benefit to the customer and margin contribution under the optional automatic tariff will be greater than under the standard tariff if the reduction in usage charge stimulates consumption.

Table 1. Price Elasticity and Marginal Cost Estimates

Price Margin Cost

Period Elasticity (cents/kWh)

Peak 0.10 3.0

Shoulder-Peak 0.30 2.0

Off-Peak 0.30 2.0

Table 2. Margin Collection for Core And "At Risk" Customers

Customer Margin Recovery

Groups ($million/year)

"At Risk" 52.4

Core 101.0

Total 153.4

Table 3. Distribution of "At Risk" Customers By Market Segment

Load Factor Peak Demand (MW)

(percent) 10 £ MW <20 20 £ mw

5 £ LF <0.7 3 2

0.7 £ LF 3 2

Total 6 4

Table 4. Comparison of the Average Cost of Utility Service With the Average Cost of Competitive Alternative (cents/kWh)

Price of

Average Load Utility Competitive

MW Factor Rate Alternative Difference

10 £ MW 20 0.5 £ LF < 0.7 7.6 6.9 0.7

10 £ MW 20 0.7 £ LF 7.3 6.6 0.7

20 £ MW 5 £ LF < 0.7 7.6 6.5 1.1

20 £ MW 0.7 £ LF 7.2 6.4 0.8

Table 5. Optional Tailored Tariffs for

"At Risk" Customers

Peak Usage Off-Peak Access

Charge Usage Charge Charge

Customer (cents/kWh) (cents/kWh) ($000/month)

1 3.0 2.0 635

2 3.0 2.0 663

3 3.0 2.0 463

4 3.0 2.0 444

5 3.0 2.0 330

6 3.0 2.0 323

7 3.0 2.0 323

8 3.0 2.0 308

9 3.0 2.0 277

10 3.0 2.0 215

Table 6. Comparison of Discounts Under Alternative Pricing Methods Compared to the Optional Tailored Tariff ($million)

Optional

Tailored Tariffs Method 1 Method 2

Discount 4.6 8.7 9.4

Percent

Difference NA 89 104

* Comparison is with respect to optional tailored tariffs.

Table 7. Automatic Tariff for Core Customers

(Conservative Elasticity Estimates)

Usage Charge Access Fee

(cents/kWh) ($000/month)

Off- Standard

Peak Peak Minimum Maximum Average Deviation

4. 6 3.9 32.9 107.8 50.9 16.9

1 Optional tariffs appear to possess most of the attributes George Pleat discussed in "Pricing and Profit Strategies for a Stand-Alone Electric Distribution Company," PUBLIC UTILITIES FORTNIGHTLY, Jan. 15, 1997, p. 20. For example, as Mr. Pleat recommends, optional tariffs: (1) use two-part tariffs consisting of an access charge (flat charge as Mr. Pleat terms it) and usage fees; (2) allow the usage charges to vary by season; and (3) are based on marginal costs, price elasticities and the costs of competitive alternatives.

2 According to Michael Porter, a noted expert on business strategy, success or failure for a company depends upon either delivering product at the lowest cost, or developing unique benefits that enable the company to differentiate itself from its rivals and sell its products for a premium price. (See Porter, M., Competitive Advantage: Creating and Sustaining Superior Performance, The Free Press, New York, 1985).

3 The cost of the competing alternative is computed as the levelized cost of optimally sized generation unit for each market segment.

4"Anti-Competitive Impacts of Secret Strategic Pricing in the Electricity Industry," by William Shepherd, PUBLIC UTILITIES FORTNIGHTLY, Feb. 15, 1997, p. 24.

5 See for example, California Public Utilities Commission Decision 92-11-052, November 23, 1992.

6The usage charges can be allowed to vary by season or by time-of-use.

7For ease of exposition, the optional automatic tariff is described as if there is only one usage charge. The method is also applicable to time-of-use tariffs that have multiple usage charges.

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