Economics 101 teaches that he who takes on the risk should be afforded the opportunity for rewards for taking on this risk. In the utility world, that means that if the retail customer accepts this risk, the seller/utility can avoid it, thereby lowering its risk-related cost of supply. And, some commercial and industrial business customers of the utility implicitly are forced to pursue aggressive programs to minimize electricity cost to maintain their economic cost competitiveness.
An electric provider should offer a portfolio of pricing products based upon sound risk fundamentals and permit the customers in the target market to select those products individually that best match their needs. It should be noted that regulated and integrated utilities have introduced some product variations adjusted for risk, particularly since the advent of electric restructuring. But such efforts have been limited in scope and have failed to take advantage of the full spectrum of customer classes. Three major factors that separate businesses’ attitudes toward electricity pricing are: (1) the degree to which their energy bill variance threatens the value of their own product(s); (2) the business customer’s usage flexibility; and (3) the overall magnitude of electricity cost as a portion of the customer’s overall cost of product.
In other words, does the volatility of the customer’s energy cost create much concern regarding the impact on the customer’s core business? One customer may be very comfortable taking on significant electricity cost risk to obtain electricity price and subsequent bill concessions. Such a customer basically is accepting risk (possibly via the customer’s on-site usage flexibility), which otherwise would have been absorbed by the utility, in exchange for a lower price. Another customer may be willing and anxious to pay a premium to accept less electricity cost risk than normal, thereby placing more risk on the utility. Both of these customers, and all the customers in between, should be offered products that fit their needs, and these products should be priced upon sound risk fundamentals.
For example, assume an air separator at a chemical company has a major portion of its operating expenses tied up in energy cost. Oftentimes it must run its operations at a high load factor to minimize product cost, but it’s also quite common that they have some energy usage flexibility. Characteristics like these drive some customers to seek out “risky” electricity products such as Real-Time Pricing,1 which should have low risk premiums or markups due to the fact that the customer is now taking on risk costs that the utility would take on with a traditional fixed-price tariff.
Alternatively, a large building-products store might have somewhat limited usage flexibility due to the need to maintain “creature comfort” on its premises during business hours. However, it might be able to satisfy its comfort needs and lower its energy costs by installing air-handling equipment such as fans and ventilators. By doing so, it may be able to create energy-bill savings greater than the cost of the installation and related costs. A well-crafted time-of-use (TOU) tariff might be appealing to this customer as a means to accomplish this energy efficiency solution.
Conversely, a school or government organization might have an important need to meet its 12-month fiscal energy budget as excesses create major headaches. Weather variations and impacts on energy bills are a continual challenge. For this type of customer, a fixed bill might be best.
So, a supplier/utility should offer a portfolio of pricing products based on sound risk fundamentals. The more a pricing tariff transfers to the customer the fundamental underpinnings of electricity, the more complex and risky it becomes for the customer. If the commercial or industrial (C&I) customer wants simplicity (for example a constant fixed cents/kWh), it must come at a price premium commensurate with the risk retained by the utility provider.
Here are some illustrative portfolio-product additions that an innovative, customer-focused utility might provide to its customers:
Real-Time Pricing (RTP) - Hour Ahead (HA). The price per kilowatt-hour is based on the supplier’s marginal cost or market price, with a commensurate small risk adder. This tariff is the least risky for a utility to offer since it places nearly all cost and load-shape risk on the customer. The incremental RTP price changes hourly with an hour’s advance notice. Often there is an access charge (customer baseline load, or CBL) that covers non-marginal/market cost and offers some price guarantee. This product is very popular with large industrial customers (≥ 5 MW) that have considerable site-usage flexibility and low product margin. It induces very large demand response to high prices.
Real-Time Pricing (RTP) - Day Ahead (DA). This product is similar to RTP-HA except that price notification is a day ahead instead of an hour-ahead, and it carries a higher yet still relatively small risk adder. The day ahead version of RTP shifts much of the load shape and cost onto the customer, although not quite as much as does its hour-ahead RTP cousin. This product is popular with medium (> 250 kW) to large business customers. It induces large demand response to high prices.
Price Protection Products (PPP). PPP is a financial product that provides price assurance and stability to hedge against price volatility inherent with spot pricing or RTP. It enhances the overall RTP product line and makes it much more robust and popular.
Because it is a financial product, it does not disturb the RTP customer’s incentive to price respond.2 It accepts back from the RTP customer what would have been RTP cost risk (since PPP’s have fixed usage constraints, ultimate load-shape risk remains with the RTP customer subsequently retaining the value of price response) and therefore justifies a modest risk premium.
Efficient Interruptibles. These products usually take the form of rate riders and compensate the end user for the willingness to interrupt usage of electricity when requested. These products are typically voluntary offerings from the utility or the independent system operator (ISO). The major differences between these efficient interruptible products and the traditional interruptible product are: 1) they are based upon actual avoided cost; and 2) there is a fixed per-kilowatt-hour credit coupled with a per-kilowatt or per-kilowatt-hour usage credit applied whenever interruptions take place based upon the actual amount of load that is interrupted. Both these advanced features lower the utility’s product risk, while this last feature removes some of the distaste for an interruption that customers have with the traditional interruptible products.
Critical Peak Pricing (CPP). This innovative pricing product enables a form of RTP (or dynamic pricing) to be attractive to customers ranging in size from residential all the way up to moderate-sized commercial customers. It is fundamentally a time-of-use (TOU) tariff, but with a limited number of hours in which the utility can invoke a critical, high price. This limitation often is 75 to 100 hours per year. It is, therefore, a hybrid between RTP and TOU and is popular with those customers wanting to employ their limited usage flexibility for price concessions derived from the transfer of risk from utility to customer for the limited CPP hours. These limitations on critically priced hours should enable the product to be more attractive to residential and small to mid-size business customers than would be RTP. The product is in its infancy and drawing a lot of interest. Gulf Power Co. is a major advocate of CPP. Demand response for a utility employing CPP can be considerable because of the large numbers of participants that are attracted to CPP. Individual response can be in the range of 2 kW per customer per call and has the potential to provide up to 5 percent of the utility’s reserve needs. Another CPP variation is to pay customers for response via credits per kilowatt-hour but without a critical priced charge for usage during what would have been the critical priced hours. From the customer’s perspective this application therefore offers possible gain (credits) but without pain (high prices for CPP kilowatt-hours).
Efficient Time of Use (TOU). TOU pricing is nothing new to the utility industry. However, it has enjoyed limited success and customer interest. A major reason for this disappointment pertains to TOU design flaws. (Another is lack of marketing.) A successful TOU design must incorporate marginal cost strategically, while at the same time recovering embedded revenue requirements. It also must consider the target customers—not only their load shapes, but also their response capability. For example, an on-peak period lasting 8 to 10 hours makes it very difficult for a commercial customer to move significant load to an off-peak period. Efficient TOU-pricing products are similar to standard TOU products except for the following attributes:
a. The period durations (such as the hours within the peak period) consider customer load-shifting capability.
b. The on-peak price is based upon marginal cost or expected market price.
c. The on-peak to off-peak price differentials are sufficient to induce load shifting. Those differentials are often 4:1 to 5:1.
While not as effective in moving risk as RTP, well-designed TOU tariffs do signal period cost differentials. TOU customers consequently may pay their cost of service on an aggregate basis (as opposed to RTP, which enables cost coverage better on an individual basis). And these TOU tariffs can encourage load shifting away from the utility’s peak period, thereby lowering the utility’s risk, while creating bill savings for the participating customers. Since prices are stable during all hours of the designed periods, TOU tariffs appeal to many customers as ways to lower cost without taking on inordinate risk. Voluntary, efficient TOU tariffs can achieve very good penetration rates thereby providing large reductions to utility loads during difficult peak periods.
Multiple Load Management. This load-aggregation design allows large customers with multiple sites to aggregate their load into one load shape and account for their load diversity. This is quite appealing to companies with multiple locations. Traditionally, utilities have shied away from such products because of possible revenue erosion. Some innovations, however, use access charges to avoid this revenue erosion. The product can produce benefits for the utility as well as the participating customers, since the parent company’s load management of the aggregate load shape often shaves the utility’s peaks better than individual site-load management will do. The product inherently lowers the parent company’s risk by allowing it to choose sites to reduce usage, while in so doing also aids the utility by lowering its peaks.
Retail Auctions and Exchanges. These voluntary programs offer credits usually based upon bid prices or the utility’s avoided cost. Initiation of the event can be performed day ahead or day of. The customer normally has the right to participate on a specific day or choose not to participate that day. If he does participate, he’s paid the “strike” price multiplied by his load response. Because the utility normally has the ability to set or accept the “strike” price considering its expected avoided cost at a time very close to the hour(s) in question, this tool can reduce risk significantly for the utility. And since it’s usually voluntary for the customer, it shouldn’t add much risk to the customer. There may or may not be a penalty if the customer agrees to respond but fails to do so. Volatile wholesale markets normally create the appeal for these products.
Fixed-Price Energy Only (Fixed Cents/kWh). This is similar to a flat cents per kilowatt-hour pricing product often offered to residential and small commercial customers except: 1) It is based upon sound risk fundamentals; and 2) it is offered also to large customers.3 The implicit risk premium is correspondingly greater than TOU, traditional Hours-Use-of-Demand (HUD), and standard Customer-Energy-Demand (CED) tariffs, since it inherently absorbs considerable load-shape risk. This simple fixed-price product is attractive to residential customers as well as a broad range of commercial customers. An attractive feature of this product for business customers is the ability to avoid demand charges.
Fixed Bill (FB). This product, because it charges the customer a fixed bill amount per month, regardless of actual usage and without a true-up, places the greatest of all risk upon the utility and, therefore possesses the highest risk premium.4 A number of issues must be addressed to offer this product: 1) historical weather data along with customer-specific usage data must be linked to forecast weather-normalized consumption on a specific customer basis; 2) the change in consumption that the customer is expected to exhibit in the contract period next must be included; and 3) a risk premium must be added to cover extra risk for the utility to offer this type of product. The product is still in its infancy but is capturing 10 to 20 percent market share and experiencing greater than 90 percent renewals. It’s currently targeted to residential and small commercial customers, although interest is growing with moderate-size (100 kW to 500 kW) commercial customers. A new version is being offered both to small to moderate-size commercial customers. This variation sets ceilings on usage at the fixed-bill amount, and provides incremental usage charges for usage above the ceiling. This will be a vital product in providers’ portfolios for an open-access marketplace.
In summary, traditional utility tariffs have shielded customers from most of the direct risks associated with the volatility of electricity costs. The portfolio of pricing products described above explicitly offers customer choices that permit them to accept the level of risk that meets their needs and sets the corresponding price associated with the risk level chosen. These products all consider risk as an essential ingredient in individual tariff pricing. Traditional tariffs have not explicitly recognized risk on a tariff basis. The presumption has been that, in the aggregate, the regulation of all tariffs periodically would provide the necessary backstop (return on equity) or aggregate adjustment when appropriate.
A sound risk-based pricing product portfolio deals correctly with risk on a tariff basis via an appropriate risk premium and lessens the need for the regulatory “backstop.” This does not mean that risk-based pricing will cover actual tariff cost during every event. It means merely that over time, tariff price should cover cost and will do so on an expected basis. To ignore specific tariff risk and rely simply upon the aggregation of the costs of all individual tariffs into one “basket” of revenue requirements, as may have traditionally been the case especially in regulated arenas, means that individual tariff price likely will not match actual tariff cost during many events and over time price may not be expected to do so. It’s time to realign the portfolio upon sound risk fundamentals.
1. “Building a Better Pricing System,” Public Utilities Fortnightly, May 2004.
2. “Real-Time Pricing – Supplanted by Price-Risk Derivatives,” Public Utilities Fortnightly, March 1, 1997.
3. “Flat Prices for Peak Hedging,” Public Utilities Fortnightly, Nov. 1, 2002.
4. “Flat Bills, Peak Satisfaction,” Fortnightly’s Energy Customer Management, January/February, 2002.