A Pricing Strategy for a Lean and Agile Electric Power Industry

A Pricing Strategy for a Lean and Agile Electric Power Industry Facing new financial and operational challenges, America’s electric power companies ar...
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A Pricing Strategy for a Lean and Agile Electric Power Industry Facing new financial and operational challenges, America’s electric power companies are searching for measures that can improve their performance and operating efficiency. An integrated strategy that includes dynamic pricing and engaging intelligent devices in homes and businesses is a low-cost means to do so, while saving customers money. by Paul A. Centolella

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n the wholesale electricity market, the price of power can be as much as 10 times higher during peak hours than at other times. Most individual consumers, in Paul Centolella is a Vice President at Analysis Group, an economic and strategy consulting firm. An economist, attorney, and formerly a member of the Public Utilities Commission of Ohio, Mr. Centolella has more than 30 years of experience in energy law and economics. He played a central role in Ohio’s electricity restructuring, has worked to align regulation with competition policy, and has helped clients identify opportunities to take advantage of emerging technology. He is a member of the Smart Grid Interoperability Panel Governing Board and the Secretary of Energy’s Electricity Advisory Committee

contrast, pay a flat rate for every kilowatt-hour they consume and have little idea what their various energy uses actually cost. This is equivalent to receiving your grocery bill weeks after you visit the market and being charged the same price for each item, whether you bought chewing gum or caviar. The flat-rate billing system is an artifact of a time when the best available technology was the analog meter — a device introduced in 1889.1 One consequence of flat-rate billing2 is W. Bernard Carlson, Innovation as a Social Process: Elihu Thomson and the Rise of General Electric (Cambridge Univ. Press, 2003). 1

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By a flat rate, I mean one that is neither dynamic nor time-differentiated for periods shorter than a season. Some utility rates have an inclining block component, under which high-use customers pay

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that the power system must be engineered to meet virtually any demand and accommodate any contingency. This has produced a power system in the United States whose asset utilization is highly inefficient. The average electric generation capacity factor has been below 50 percent since 2002 and was only 45 percent in 2009, the most recent year for which the US Energy Information Administration has reported capacity factor data.3 Many transmission and distribution facilities have average utilization rates that are even lower. These rates are well below the average rates of capacity utilization in other capital-intensive industries, which generally exceed 75 percent.4

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s the power industry heads into another major investment cycle, its failure to use its capital assets efficiently is a major challenge it must tackle.

Requirements and Hurdles for New Investment Much of our electric infrastructure was built more than 40 years ago and is in urgent need successively more for additional blocks of energy that they consumer over a monthly billing period. However, an inclining block rate does not take account of the higher prices (or marginal costs) for the utility to provide service at peak use periods, the lower cost of power in off-peak periods, or price changes related to supply variability and transmission constraints. U.S. Energy Information Administration, Electric Power Annual 2009, Table 5.2, at 48 (April 2011). 3

U.S. Federal Reserve Board of Governors, Industrial Production and Capacity Utilization (Aug. 15, 2012). 4

Average capacity factor for US utilities has become highly inefficient – below 50 percent since 2002 and only 45 percent in 2009. of replacement and modernization. The American Society of Civil Engineers (ASCE) recently estimated that maintaining the US electric infrastructure will require $673 billion in new investment by 2020.5 The ASCE is not alone in identifying the need for large and essential investments in the power sector.6 According to a 2008 utility survey, most distribution-system equipment is approaching or has exceeded its expected useful life.7 Moreover, although pending litigation has contributed to uncertainty,8 a significant amount of existing generating capacity is nearing the end of its useful life and may be retired before 2020.9

American Society of Civil Engineers, Failure to Act: The economic impact of current Investment Trends in Electricity Infrastructure (2011). 5

M. Chupka, R. Earle, P. Fox-Penner, and R. Hledik, Transforming America’s Power Industry: The Investment Challenge 2010 – 2030 (Edison Found. (Nov. 2008); Dan Eggers, Impediments to Achieving the Vision (Credit Suisse, July 3, 2010). 6

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Black & Veatch, Electric Utility Survey (2008).

EME Homer City Generation L.P. v. U.S. Environmental Protection Agency, 42 ELR 20177, Opinion (D.C. Cir. August 21, 2012). 8

NERC, 2011 Long-term Reliability Assessment (Nov. 2011); Institute for Energy Research, Impact of EPA’s Regulatory Assault on Power Plants (June 12, 9

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o put the ASCE’s $673 billion in required new investment in context, investor-owned electric companies had net property in service worth $664 billion in 2010. Total market capitalization of US shareholder-owned electric companies was $407.3 billion as of December 31, 2010.10 The ASCE has predicted some striking consequences if the power industry fails to fill the investment gap: “As costs to households and businesses associated with service interruptions rise, GDP will fall by a total of $496 billion by 2020. The U.S. economy will end up with an average of 529,000 fewer jobs than it would otherwise have by 2020…. In addition, personal income in the U.S. will fall by a total of $656 billion from expected levels by 2020.”11

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learly, making the required investments is critical to the health of the US economy.

Unfortunately, the industry must undertake this investment at a time when most electric utilities have a credit rating of BBB or lower.12 In 1992, only about one in five electric utilities

had such low ratings.13 Furthermore, the industry is experiencing slow sales growth, which will limit its opportunities to spread investment costs over a growing base to minimize rate impacts. Worse, since 2000, the cost of new power plants in North America has increased by 80 percent on average.14 Global competition for resources with developing economies — many of whom are seeing annual growth in electricity demand of 5 percent to 7 percent — could push the cost of new investments in North America even higher.

Demand Optimization: A Strategy for a Leaner and More Agile System A business-as-usual approach will require a heavy burden of new investment leading to potentially unacceptable rate increases or — if needed investments are not completed — a substantial restraint on economic growth. Because it is far from clear that the power industry will be able to fund new investment on the scale required, utilities and regulators should be considering strategic alternatives.15

Eric Ackerman, Edison Electric Inst., Electric Utility Industry Update (Presented to Accounting Standards Committee Annual Meeting, Nov. 17, 2010). 13

2012); PJM, Presentation to PJM Transmission Expansion Advisory Committee (March 12, 2012).

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Edison Electric Inst., Industry Data: Statistical Highlights (Sept. 1, 2012).

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American Society of Civil Engineers, Failure to Act: The economic impact of current Investment Trends in Electricity Infrastructure, at 10 (2011). 11

Edison Electric Inst., Credit Ratings, Charts Final Q2 2012 (2012). 12

IHS CERA, North American Power Capital Cost Index without Nuclear (Aug. 2012). For a view of how financial markets may respond to utilities that adopt sustainable practices, see, R. J. Rudden, Sustainable Utility Regulation and Socio-Economic Success, ElectricityPolicy (July 2012) at http://www.electricitypolicy.com/images/pdf/Ru dden-Sustainability-7-10-12-final.pdf

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Here’s one powerful alternative: develop A more efficient model is the one found in market structures that optimize demand. The virtually every other competitive market: goal is a leaner and more agile power system. Give the consumer a dynamic price that Such a system will not only be more efficient reflects the marginal cost of providing the but also will address two other challenges the next increment of service and allow the industry faces: (1) integrating variable consumer to respond. This approach permits renewable resources into the existing system consumers to compare the price of the power more effectively and (2) meeting the growing they receive in each interval with the power’s reliability requirements of a digital economy. value to them in each interval and program Both of these devices to respond to challenges will price triggers. Also, become easier to Storage is often referred to as the holy grail of if accompanied by meet in a more indicative energy technology. What is commonly resilient system information on likely overlooked is that a great deal of storage in which demand prices for future responds to time- already exists in customers’ end-use devices. intervals, it permits and locationintelligent end-use specific devices to schedule conditions on the power usage when it power grid. is most cost-effective, consistent with devicespecific constraints and consumer Reforming the system begins with engaging preferences. consumers to adopt smarter end-use technologies in their homes and businesses.

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ost current demand-response programs pay certain high-demand customers to accept a reduction in the power supplied to them during peak periods or system emergencies. Payments are based on comparisons to an administratively determined baseline, which is derived from the consumers’ usage during a recent period. But such programs pay some consumers to do what they might have done anyway, without any incentive. What’s more, the determination of baselines creates administrative costs and is subject to being gamed.

Demand optimization differs from the demand-response programs in place now. It is not focused on simply cutting peak demand or curtailing customers when the system approaches emergency conditions. It is intended to improve the utility’s asset utilization and enable demand to respond automatically and in real time to grid conditions. Demand optimization is not a program that runs on top of existing rate structures. It is a comprehensive strategy that would change the relationship consumers have with their utility or competitive retail supplier by making it more interactive, and would promote a robust market for consumer services.

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torage is often referred to as the holy grail of energy technology.16 What is commonly overlooked is that a great deal of storage already exists in customers’ end-use devices. A majority of the devices powered by electricity either have thermal inertia (for example, those for heating, cooling, water heating, and refrigeration) or flexibility in the timing of their power draws (for example, many pumping loads, industrial batch processes, pool pumps, dishwashers, clothes driers, and the charging of vehicles and battery-powered devices). These devices are becoming more intelligent, but so far our pricing structure does not allow them to respond to electricity prices or conditions on the power grid.

Steps to Achieve Demand Optimization Some commentators have looked at dynamic retail pricing in isolation, without considering a means to provide consumers with the information and technology they need to take advantage of such pricing. Their assessments are often discouraging. The case for dynamic retail pricing becomes much stronger when analysts seek to identify measures that exploit flexibility on the consumer’s side of the meter while enhancing value to customers. Dynamic pricing engages and empowers consumers by means of smarter devices in their homes and businesses. It is an element of a larger strategy: optimizing demand. 16 See, e.g., In Presidio, a Grasp at the Holy Grail of Energy Storage, N.Y. Times (Nov. 7, 2010), http://www.nytimes.com/2010/11/07/us/07ttba ttery.html?pagewanted=all.

Other commentators have questioned why competitive retail electric suppliers are not pursuing dynamic pricing more aggressively. One reason is the existing market’s structure and interfaces. In many areas, a competitive supplier may have to absorb significant additional costs to pursue alternative pricing options. For example, a supplier that chooses to do consolidated billing with the distribution utility may either be limited to the rate structures already offered by that utility or be required to pay for the utility’s billing system to be reprogrammed.

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he following sections describe a set of steps for a demand optimization strategy. They describe in general terms approaches that utilities and retail suppliers might take as well as complementary regulatory policy options. The most effective strategies and policies will be tailored to specific companies and jurisdictions. Moreover, the sequence in which steps are best taken may depend on factors outside the scope of this article. Creating an efficient structure of choices for the consumer

Over the past few decades, the field of behavioral economics has demonstrated that the way choices are presented to customers can have a profound impact on their decisions.17 The field has provided a variety

See, e.g., R. Thaler and C. Sunstein, Nudge: Improving Decisions about Health, Wealth, and Happiness (New Haven, CT: Yale Univ. Press 2008.) 17

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of insights into consumer behavior,18 at least two of which apply to the presentation of options to utility customers.

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tilities and regulators also should consider the application to dynamic pricing of the general rule that consumers should, in the absence of their  First, choices that are given a prominent affirmative selection of another alternative, be position are more likely to be selected. assigned their least costly rate plan. In many This is why firms are willing to pay for instances, this could mean that a dynamic better placements in search results and on pricing plan will be the default rate. When store shelves. competitively priced, a flat rate may include a  Second, default options – the choice that hedging premium of as much as 10 percent to will be implemented if the consumer fails 20 percent to cover the supplier’s price and to affirmatively choose an alternative – volumetric risks.19 Moreover, making a plan matter a great deal. that includes a dynamic price component the default rate lets Today, consumers know the competing time-varying cost of Even under time-differentiated rates, prices options often the electricity they are presented in in most off-peak hours may remain well above use and gives them terms of rate marginal cost and thus are a barrier more control over comparisons. their electric bills. to improved asset utilization. Enabling consumers to understand the benefits of a dynamic price will require showing them the bills they are likely to receive under different pricing alternatives, given past or anticipated load patterns. Ideally, such a bill comparison also would estimate the savings to be gained by replacing conventional equipment with communicating thermostats and other smart devices.

By objectively comparing different pricing options, a utility or competitive retail supplier can become the trusted partner of its customers, and in so doing lay the foundation for selling a broader range of services. Adopting dynamic pricing

Market prices across the power grid change continuously in response to large swings in power flows and shifting constraints.20 R. Zarumba, Dynamic Pricing for Commercial and Industrial Customers, Navigant Consulting (Presentation to Public Utilities Commission of Ohio, March 27, 2012); ISO New England, Basic Service vs. Real-Time Price Analysis (2010). 19

See, e.g., Daniel Kahneman, Thinking Fast and Slow (New York, N.Y., Farrar, Straus, Giroux, 2011); Dan Ariely, Predictably Irrational: The Hidden Forces that Shape our Decisions (New York, N.Y., Harper Collins 2008). 18

See, e.g., Paul Feldman, A Day in the Life of the Grid, Presentation to the Smart Response 20

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Taking full advantage of the flexibility present in most end uses and providing efficient incentives for local generation and innovation will require communicating these continuously changing market prices (or, in the absence of an organized market, marginal costs).



When developing a dynamic pricing plan, utilities and regulators might consider the following three objectives:

Customer subscription pricing would be a simpler approach to two-part pricing and could be used by residential and small commercial and industrial as well as larger customers. It combines a dynamic real-time price with an insurance component. The dynamic component permits intelligent enduse devices to optimize the timing of their energy demand. The insurance component permits consumers to minimize month-tomonth variation in their energy bills by allowing them to subscribe to a specific quantity of price protection (which could be expressed as a percentage of a consumer’s



Give consumers the opportunity to address their fear of an isolated high monthly bill (“loss aversion”). Give consumers choices that match their price and risk preferences.

All these objectives can be achieved through two-part pricing, which separately identifies ime-differentiated rate alternatives the dynamic component and the insurance (or such as critical peak pricing or peak hedging) component that have always been time rebates may help cut peak implicitly present in flat rates. Some utilities demand, but they fail to convey enough have offered twoinformation to enable part real-time intelligent devices to pricing to large The important questions are likely to shift optimize their periodindustrial and to-period use of from whether to adopt dynamic pricing to commercial power. Moreover, even how to achieve improved efficiency with the consumers for under timemany years, help of technology and efficient markets. differentiated rate allowing them to plans, the prices in buy a set load most off-peak hours profile at a fixed may remain well above marginal cost. Such rate, sell back any unused power at the utility’s rates are a barrier to improvements in asset marginal cost, and buy additional increments utilization. of power as needed.

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Convey efficient, dynamic real-time prices (RTP).

Collaborative, NARUC Winter Committee Meetings (Feb. 5, 2012). This presentation is available in text with graphics at http://www.electricitypolicy.com/images/pdf/mi so-24hours-5-3-12-final-116.pdf, or on video at http://www.youtube.com/watch?v=HTvsgeOxb 00

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anticipated peak demand). Thus, when market prices exceed a price set by the subscription, the consumer is entitled to a certain amount of power (also set by the subscription) at the fixed price, not the market price. Consumer subscription pricing includes what economists refer to as a call option. Whenever the market price exceeds an agreed-upon “strike price,” the consumer is entitled to his or her subscribed quantity of kilowatt-hours at the strike price. If consumers use fewer kilowatt hours than the subscription allows, they would be entitled to a rebate. The rebate is funded by other consumers, who buy the unused portion of the subscriber’s power in the real-time market. If a consumer uses more than the subscribed amount, only the additional amount is billed at the higher market price. The opportunity to subscribe to price insurance allows riskaverse consumers to control variations in their monthly bills.21 Another variation on this approach is described in: H. Chao, Competitive Electricity Markets with Consumer Subscription Service in a Smart Grid (2011), available at: http://faculty.chicagobooth.edu/workshops/oms cience/archive/pdf/Chao%20%20Consumer_Subscription_Service%20in%20a %20smart%20grid%20-%20April%202012.pdf . The Customer Subscription Pricing described herein is a financial subscription. It does not include provisions in the subscription tariff offered by Southern California Edison (SCE) in the 1980s and some subscription plans in Europe that permit load curtailments when the subscription amount is exceeded. For a description of the SCE plan, see H. Chao et al., Multi-Level Demand Subscription Pricing for 21

A default pricing plan initially might include an insurance subscription for the consumer’s full anticipated peak demand. However, unlike a flat-rate plan, this default pricing plan lets consumers choose the level of price insurance that best meets their individual needs. Less risk-averse and more responsive consumers can save money by subscribing to less insurance and managing their energy use when prices increase. Providing tools for consumers to manage energy use and finance energy-efficiency

The nature of a utility’s interface with its customers and with the end-use devices in their homes and businesses will be key factors in the power industry’s conversion to demand optimization. Although other efforts may be necessary in specific settings, three are likely to have a determining effect on demand optimization everywhere.

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irst, end-use devices must be enabled to receive and respond automatically to price signals broadcast through a nearubiquitous medium. Ideally, an air conditioning system would receive both a current interval price and indicative forward prices for periods of several hours so the system could decide whether to pre-cool a building based on price trends, weather forecasts, system constraints, and consumer preferences. Similarly an intelligent water heater could decide to operate now or 15 minutes from now based on a comparison of current and indicative forward prices. The Electric Power, ENERGY ECON. (1986) at 199217.

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technology already exists to broadcast price or control signals through (for example) the sideband of FM radio stations, and produce a response from a device located virtually anywhere in the United States in less than two seconds. It would be very inexpensive — from less than a dollar to a few dollars per device — to put chips into new appliances, thermostats, and other end-use devices that could receive and authenticate such signals and determine the device’s location on the power grid. In 2009, the National Institute of Standards and Technology (NIST) created the Smart Grid Interoperability Panel (SGIP): a publicprivate partnership of more than 785 organizations to accelerate the development of standards for the smart grid.22 Through its expert working groups on business and policy and on home to grid, SGIP has been working with all of the US regional transmission organizations and independent system operators, utilities, regulators, home appliance manufacturers, and consumer electronics companies to identify a standard format for communicating prices to end-use devices. Adoption of a standardized approach could rapidly bring millions of grid-aware end-use devices into service each year.

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econd, giving customers detailed information on their own energy use in standard, machine- readable formats is essential for people (or their smart devices) to make intelligent decisions about their patterns of energy consumption. As a result See: http://collaborate.nist.gov/twikisggrid/bin/view/SmartGrid/WebHome. 22

of the SGIP’s ability to accelerate the development of standards and the Obama Administration’s Green Button initiative, 23 there has been substantial progress toward providing electric customers access to their own detailed energy usage information. Twenty-four utilities and more than 30 vendors have committed to implement the Green Button data standards. Millions of consumers soon will be able to receive or download their detailed energy-usage information on their computers or mobile devices and take advantage of a growing number of applications that are available to help them analyze this information.24 With the advent of detailed energy-usage information online, attention is being paid to protecting the privacy of consumer information. In August 2010, NIST published its Guidelines for Smart Grid Cyber Security, which includes a volume on privacy protection and the implementation of Fair Information Practices.25 In 2011 the North American Electric Standards Board published standards governing third-party access to customer energy usage data.26 And, work is under way to develop a seal to assure 23

See: http://www.greenbuttondata.org/.

The rapid development of applications to take advantage of this data has been supported through contests and developer forums. See, e.g., http://appsforenergy.challenge.gov/. 24

The SGIP Cyber Security Working Group, Smart Grid Cyber Security: Vol. 2, Privacy and the Smart Grid, NIST Interagency Report 7628 (August 2010). 25

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NAESB, Standards REQ 21 (2011).

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consumers that their privacy will be protected and to make third parties subscribing to the seal liable for any failure to abide by their privacy commitments. Third, barriers must be removed that keep consumers from financing energymanagement and energy-efficiency improvements on terms that more closely balance the cost of supply- and demand-side investments.

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he Ohio and California public utilities commissions and other forums have been exploring “on-bill repayment,” which would allow the financing charges for permanent energy management and efficiency investments to appear on the customer’s utility bill and remain attached to the property when it is sold or a tenant moves.27 This billing strategy should be attractive to consumers, because it follows two golden rules: that the consumer’s monthly finance charge should not exceed the consumer’s expected savings and that the length of the payment period should not exceed the expected life of the measures installed. The approach could significantly lower consumer borrowing costs, because consumers tend to pay their utilities before paying down other

For a further description see Brad Capithorne and James Fine, On-Bill Repayment: Unlocking the Energy Efficiency Puzzle in California, Environmental Defense Fund (2011); California Public Utilities Commn, Rulemaking 09-11-014. A similar approach has been adopted for energy efficiency financing the United Kingdom, see: http://www.decc.gov.uk/en/content/cms/tacklin g/green_deal/green_deal.aspx. 27

consumer debts.28 With the ability to finance improvements on the customer side of the meter, regulators will have enabled the development of a potentially competitive, innovative, and efficient market for beyondthe- meter services. These services could include distributed generation and storage, power quality services, vehicle charging, direct current micro-grids, energy efficiency, building and equipment commissioning and maintenance, energy management, and systems that provide ambient intelligence personalizing spaces for the individuals present.

Summing Up Dynamic Pricing As the power industry faces huge new challenges, the important questions are likely to shift from whether to adopt dynamic pricing to how to achieve the significant improvement in efficiency offered by the combination of technology and efficient markets. If these questions are asked from a strategic rather than a merely incremental perspective, dynamic pricing can play a significant role in the industry’s future as part of a package of services designed to more efficiently and reliably meet consumer demand for energy services. ■ The priority of financing charges with respect to other utility charges and whether standard utility disconnection policies will apply to the financing component of the utility bill are among the issues to be addressed under this approach. If repayment charges are treated similarly to other rate elements, this could further lower borrowing costs, improving the comparability of the cost of capital between utility and beyond-the-meter investments. 28

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