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
Electricity Policy – the website ElectricityPolicy.com and the newsletter ElectricityPolicy Daily – together
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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
I
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
contrast, pay a flat rate for every kilowatt-hour
they consume and have little idea what their
various energy uses actually cost. This is
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 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
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
1 W. Bernard Carlson, Innovation as a Social Process:
Elihu Thomson and the Rise of General Electric
(Cambridge Univ. Press, 2003).
2
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
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.
Average capacity factor for US utilities 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
has become highly inefficient – below 50 percent since 2002 and only 45 percent in 2009. 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
T
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
A
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.
5 American Society of Civil Engineers, Failure to
Act: The economic impact of current Investment Trends in
Electricity Infrastructure (2011).
Requirements and Hurdles for New
Investment
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
Much of our electric infrastructure was built
more than 40 years ago and is in urgent need
of replacement and modernization. The
American Society of Civil Engineers (ASCE)
recently estimated that maintaining the US
electric infrastructure will require $673 billion
7
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,
2012); PJM, Presentation to PJM Transmission
Expansion Advisory Committee (March 12, 2012).
9
3 U.S. Energy Information Administration, Electric
Power Annual 2009, Table 5.2, at 48 (April 2011).
U.S. Federal Reserve Board of Governors,
Industrial Production and Capacity Utilization (Aug. 15,
2012).
4
Edison Electric Inst., Industry Data: Statistical
Highlights (Sept. 1, 2012).
10
September 2012 / 3
consequences if the power industry fails to fill
the investment gap:
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.
“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
C
Demand Optimization: A Strategy
for a Leaner and More Agile System
learly, making the required
investments is critical to the health of
the US economy.
A business-as-usual approach will require a
heavy burden of new investment leading to
potentially unacceptable rate increases or — if
Unfortunately,
needed investments
the industry
must undertake Storage is often referred to as the holy grail of are not completed — a
substantial restraint on
this investment
energy technology. What is commonly economic growth.
at a time when
Because it is far from
overlooked is that a great deal of storage most electric
clear that the power
utilities have a
already exists in customers’ end-­‐use devices. industry will be able to
credit rating of
fund new investment
BBB or lower.12
on the scale required,
In 1992, only
utilities and regulators should be considering
about one in five electric utilities had such low
strategic alternatives.15
ratings.13 Furthermore, the industry is
experiencing slow sales growth, which will
14 IHS CERA, North American Power Capital Cost
Index without Nuclear (Aug. 2012).
11 American Society of Civil Engineers, Failure to
Act: The economic impact of current Investment Trends in
Electricity Infrastructure, at 10 (2011).
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
15
Edison Electric Inst., Credit Ratings, Charts Final
Q2 2012 (2012).
12
Eric Ackerman, Edison Electric Inst., Electric
Utility Industry Update (Presented to Accounting
Standards Committee Annual Meeting, Nov. 17,
2010).
13
September 2012 / 4
Here’s one powerful alternative: develop
market structures that optimize demand. The
goal is a leaner and more agile power system.
Such a system will not only be more efficient
but also will address two other challenges the
industry faces: (1) integrating variable
renewable resources into the existing system
more effectively and (2) meeting the growing
reliability requirements of a digital economy.
Both of these challenges will become easier to
meet in a more resilient system in which
demand responds to time- and locationspecific conditions on the power grid.
they receive in each interval with the power’s
value to them in each interval and program
devices to respond to price triggers. Also, if
accompanied by indicative information on
likely prices for future intervals, it permits
intelligent end-use devices to schedule power
usage when it is most cost-effective,
consistent with device-specific constraints and
consumer preferences.
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.
Reforming the system begins with engaging
consumers to adopt smarter end-use
technologies in their homes and businesses.
M
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.
S
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
A more efficient model is the one found in
virtually every other competitive market:
Give the consumer a dynamic price that
reflects the marginal cost of providing the
next increment of service and allow the
consumer to respond. This approach permits
consumers to compare the price of the power
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.
September 2012 / 5
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.
required to pay for the utility’s billing system
to be reprogrammed.
T
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.
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.
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
of insights into consumer behavior,18 at least
two of which apply to the presentation of
options to utility customers.
•
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
First, choices that are given a prominent
position are more likely to be selected.
This is why firms are willing to pay for
better placements in search results and on
store shelves.
17 See, e.g., R. Thaler and C. Sunstein, Nudge:
Improving Decisions about Health, Wealth, and
Happiness (New Haven, CT: Yale Univ. Press
2008.)
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
September 2012 / 6
•
that includes a dynamic price component the
default rate lets consumers know the timevarying cost of the electricity they use and
gives them more control over their electric
bills.
Second, default options – the choice that
will be implemented if the consumer fails
to affirmatively choose an alternative –
matter a great deal.
Today, competing options often are presented
By objectively comparing different pricing
in terms of rate comparisons. Enabling
options, a utility or competitive retail supplier
consumers to understand the benefits of a
can become the
dynamic price
trusted partner of
will require
its customers, and
showing them
Even under time-­‐differentiated rates, prices in so doing lay the
the bills they are
in most off-­‐peak hours may remain well above foundation for
likely to receive
selling a broader
marginal cost and thus are a barrier under different
range of services.
pricing
to improved asset utilization. alternatives,
Adopting dynamic given past or
pricing anticipated load
Market prices across the power grid change
patterns. Ideally, such a bill comparison also
continuously in response to large swings in
would estimate the savings to be gained by
power flows and shifting constraints.20
replacing conventional equipment with
Taking full advantage of the flexibility present
communicating thermostats and other smart
in most end uses and providing efficient
devices.
incentives for local generation and innovation
tilities and regulators also should
will require communicating these
consider the application to dynamic
continuously changing market prices (or, in
pricing of the general rule that
the absence of an organized market, marginal
consumers should, in the absence of their
costs).
affirmative selection of another alternative, be
assigned their least costly rate plan. In many
instances, this could mean that a dynamic
Ohio, March 27, 2012); ISO New England, Basic
Service vs. Real-Time Price Analysis (2010).
pricing plan will be the default rate. When
20 See, e.g., Paul Feldman, A Day in the Life of the
competitively priced, a flat rate may include a
Grid,
Presentation to the Smart Response
hedging premium of as much as 10 percent to
Collaborative, NARUC Winter Committee
20 percent to cover the supplier’s price and
Meetings (Feb. 5, 2012). This presentation is
volumetric risks.19 Moreover, making a plan
available in text with graphics at
U
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
19 R. Zarumba, Dynamic Pricing for Commercial and
Industrial Customers, Navigant Consulting
(Presentation to Public Utilities Commission of
September 2012 / 7
T
ime-differentiated rate alternatives
power at the utility’s marginal cost, and buy
such as critical peak pricing or peak
additional increments of power as needed.
time rebates may help cut peak
Customer subscription pricing would be a
demand, but they fail to convey enough
simpler approach to two-part pricing and
information to enable intelligent devices to
could be used by residential and small
optimize their period-to-period use of power.
commercial and industrial as well as larger
Moreover, even
customers. It combines
under timea dynamic real-time
differentiated rate
The important questions are likely to shift price with an insurance
plans, the prices
component. The
from whether to adopt dynamic pricing to in most off-peak
dynamic component
hours may
how to achieve improved efficiency with the permits intelligent endremain well
help of technology and efficient markets. use devices to optimize
above marginal
the timing of their
cost. Such rates
energy demand. The
are a barrier to
insurance component permits consumers to
improvements in asset utilization.
minimize month-to-month variation in their
When developing a dynamic pricing plan,
utilities and regulators might consider the
following three objectives:
•
•
•
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 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.
Convey efficient, dynamic real-time
prices (RTP).
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.
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.
All these objectives can be achieved through
two-part pricing, which separately identifies
the dynamic component and the insurance (or
hedging) component that have always been
implicitly present in flat rates. Some utilities
have offered two-part real-time pricing to
large industrial and commercial consumers for
many years, allowing them to buy a set load
profile at a fixed rate, sell back any unused
September 2012 / 8
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
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.
F
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
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.
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
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
Electric Power, ENERGY ECON. (1986) at 199217.
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
September 2012 / 9
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.
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
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.
S
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
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
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.
T
he Ohio and California public utilities
commissions and other forums have
been exploring “on-bill repayment,”
which would allow the financing charges for
24 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/.
The SGIP Cyber Security Working Group,
Smart Grid Cyber Security: Vol. 2, Privacy and the
Smart Grid, NIST Interagency Report 7628
(August 2010).
25
22 See: http://collaborate.nist.gov/twikisggrid/bin/view/SmartGrid/WebHome.
23
See: http://www.greenbuttondata.org/.
26
NAESB, Standards REQ 21 (2011).
September 2012 / 10
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
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.
27 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.
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
September 2012 / 11