Pricing in Retail Markets: Innovation and Resource Allocation

1
Pricing in Retail MarketsInnovation and
Resource Allocation

• Prepared for the
• AESP/EPRI Pricing Conference Chicago,
  Illinois
  
• By
• Daniel M. Violette, Ph.D.
• Summit Blue Consulting
• Boulder, Colorado Phone [phone] dvi
  olette_at_summitblue.com
  
• May 15, 2003

2
Demand Response Defined

• Three Components
• 1. Load response called for by others -- includes
  direct load control, partial or curtailable load
  reductions, load interruptions.
  
• 2. Price response -- includes real-time pricing,
  dynamic pricing, fixed time-differentiated rates
  (e.g., time-of-use rates), and demand bidding at
  different prices.
• 3. Distributed generation -- includes backup
  generation and net on-site generation.
  
• All three represent a form of price response.

3
Prominent Commentators

• Given the clarity of the debate on DR and
  Pricing, commentary that would seem to fit
  includes
  
• An Energy Trading Company CEO -- "I suppose you
  think that, on our board, half the directors do
  all the work and the other half do nothing. As a
  matter of fact, the reverse is true."
• Dan Quayle -- "I stand by all my misstatements."
• Gerald Ford -- "Things are more like they are now
  than they have ever been."
  
• Richard Nixon -- "I was not lying. I just said
  things that later on seemed untrue."

4
Pricing Myths

• Time-differentiated pricing offers are valuable
  only if customers change their consumption in
  response to price.
  
• Must also consider 1) equity impacts of pricing
  basing, and 2) Long term impacts on energy using
  technologies.
  
• Most customers want simple, flat-rate pricing.
• This may be true, but it does not matter as along
  as 1) Rates incorporate all hedging costs, and
  2) Some customers do accept time-differentiated
  rates.
• Pricing programs dont work (e.g., Puget Power
  and Ontario, CA).
  
• Moving to RTP will cause major distortions in
  customer bills.
  
• Monthly bills change, but annual energy costs are
  more stable.
  
• Phase-in options can be used for customers with
  high bill impacts.

5
Current Trends

• The value of demand response offers (pricing and
  load) is becoming more widely recognized
  
• As a risk management tool -- past planning tools
  understated value and did not appropriately
  address low probability high consequence events.
  
• Fewer counter-parties exist to trade with today
  -- DR is one hedging option.
  
• As a supplier of reliability and operational
  services to grid operators.
  
• Projections of modest wholesale electric prices
  for the next few years has interesting effects
  
• Creates more headroom for retailers in markets
  open to retail choice.
  
• Returns the willingness of regulators to
  experiment with pricing and demand response
  offers.
  
• Still, risks remain from unexpected events such
  as forced outages, transmission bottlenecks and
  natural gas price run-ups.

6
Key Factors

• Demand response is important to the continued
  development of wholesale and retail markets.
  
• Competitive markets are based on the interaction
  of supply and demand in response to price
  signals.
  
• However, the history is one of cost-based
  administered pricing in retail markets with
  average rates that ignore the fact that costs
  vary across hours, months and seasons.
• So, what are markets about?
• 1. Markets should be designed to to allocate
  resources efficiently.
  
• 2. This is done through price signals.
• 3. A promise of innovation and improved
  productivity -- this was a promise made by
  regulators as part of restructuring activities.

7
Bottom Line for Markets

• If we dont price whats scarce (e.g.,
  peak-period commodity), how do we incent
  innovation and enhance productivity.
  
• If we dont price whats scarce, how do we
  improve load factors in one of the countrys most
  capital-intensive industries.
  
• Issues
• Uncertainties from restructuring and bifurcation
  of incentives have discouraged investment in
  infrastructure.
  
• While wholesale competition has been encouraged,
  it can be argued that price elasticity and demand
  response capabilities have actually decreased in
  recent years.
• This creates a disconnect between wholesale and
  retail markets.
  

8
Key Factors

• Opportunities for generators have increased with
  open access and market based rates -- this needs
  to be balanced with market incentives and access
  for demand response resources.
• Market designs need to support this balance
  between supply-side and demand-response
  resources.
  
• This is a long term proposition -- markets that
  incorporate economic demand response capability
  will promote efficient resource investments over
  time.
• The appropriate transition path to markets with
  economic demand response may be uncertain and
  open to debate but markets are going to change.
  
• Now we need to look for the appropriate points of
  leverage.

9
RTO and ISO Issues

• A liquidity point is needed for DR, i.e.,
  customers able to respond to price need to
  benefit from taking these actions.
  
• RTOs and ISOs can provide price signals and
  settlements
  
• ONE VIEW Any market in which generation
  competes should be open to DR resources
  including
  
• Energy resource markets (day-ahead, hour-ahead,
  and real time)
  
• Ancillary services markets (as appropriate)
• Replacement reserves
• Emergency demand response
• Capacity markets
• In these markets, demand response resources
  should be treated on an equal footing with
  generation.

10
Opposing Arguments

• As long as most consumers have flat rates, there
  is no incentive to manage what is scarce in this
  industry.
  
• But, why havent we moved more aggressively on
  this issue -- opposition focuses on
  
• Status quo bias,
• high infrastructure costs, and
• the fact that customers don't want
  time-differentiated rates.
  
• These issues are worthy of consideration but
  are
  
• 1. generally overstated, and
• 2. fail to consider all the ramifications of the
  pricing decision.
  

11
Infrastructure Cost

• Putting more customers on real-time pricing
  (RTP), time-of-use (TOU) rates, or developing
  demand response programs will require
  infrastructure investment.
• RTP represents the extreme and would require that
  interval meters be installed for essentially all
  customers on that pricing offer.
  
• However, current metering technology not only
  enables appropriate pricing but also enables
  other productivity enhancing capabilities.
  
• Infrastructure costs are a valid concern, and
  they can impact the rate of change to
  time-differentiated pricing.
  

12
Customer Opposition

• It is true that customers don't want the types of
  time-differentiated rates that are described by
  the opponents of these rates.
  
• A common straw man argument focuses on the hassle
  these rates would cause
  
• e.g., "your grandmother does not have the
  capability to watch her electric meter and adjust
  her energy use every hour."
  
• While true, it is irrelevant.

13
How it Would Work

• What would happen if all residential customers
  woke up tomorrow and found themselves on a
  real-time pricing (i.e., prices that varied
  hourly reflecting the costs of production)?
• Most would not notice (if current average rates
  reflect average costs).
  
• Why? Customers would receive a monthly bill that
  still represents an averaging of electricity
  costs.
  
• This average would be based on their electricity
  use in each hour multiplied by the price for that
  hour.
  
• Only the largest users would find it in their
  interests to manage usage hourly.
  
• For most customers, annual energy costs would not
  vary by more than 5 up or down. Although this is
  an empirical question for each utility, as a
  general rule this should be true, particularly in
  todays environment.

14
How it Would Work (cont.)

• What would happen
• Customer bills would be higher in some months
  (e.g., summer) and, lower in other months.
  
• Most utilities offer monthly budget billing which
  can address this issue, i.e., it would provide an
  equal bill each month.
  
• For customers whose bills do increase by more
  than 5, utilities can follow the time-honored
  rate-setting process of phasing in price changes.

15
What has been accomplished?

• Now, customers receive a level monthly bill that
  for most of them is not much different from what
  they received in the past.
  
• But, these bills are based on real-time prices
  for each hour.
  
• Residential customers are not expected to check
  electricity prices every hour, but they would
  generally know the hours in which electricity is
  most expensive.
• Modest adjustments could produce a 3 change in
  peak demand could have substantial effects on the
  overall generation, transmission and distribution
  infrastructure.
• A 5 change could be truly dramatic, and studies
  have shown that a changes in use of this size are
  attainable.

16
Innovation

• More importantly, the newly rationalized
  electricity market can support business cases for
  innovation.
  
• Technology companies can develop equipment that
  will allow customers to manage demand, while
  quite possibly increasing overall comfort and
  providing other benefits.
• The business cases for the development of these
  technologies depend, in part, upon the dollar
  savings resulting from managing demand.
  
• Appropriate pricing reflecting what is costly and
  scarce will allow customers to be passive and
  still save money.

17
Bottom Line

• Those working on the design and/or regulation of
  electricity markets need to develop price signals
  that provide incentives to manage what is scarce.
  
• Is there a rationale that justifies not taking
  action?
  
• Proxy pricing through demand response programs
  also can achieve this goal.
  
• With price signals, sizeable efficiencies can be
  gained and infrastructure costs reduced.
  
• End result -- end-use energy needs will be met at
  a lower overall cost.

18
Some Questions

• Do you believe that the retail industry is facing
  change?
  
• Think about the regulatory initiatives going on
  across the country.
  
• Think about the FERC SMD NOPR and White Paper
• Demand response is essential in competitive
  markets to assure the efficient interaction of
  supply and demand.
  
• Demand response options should be available so
  that end users can respond to price signals.
  
• What are the implications of this attention to
  demand response?
  
• Are customers willing to discuss innovative
  pricing for electricity?

19
Customer Experience

• Customers are not homogeneous.
• Price volatility is a reality and must be dealt
  with.
  
• Customers are used to peak and off-peak pricing
  for other commodities
  
• Customers have also experienced quantity-based
  pricing, e.g., a set number of phone time for a
  fixed price with extra charges for additional
  calls.
• Two part real-time electricity tariffs designed
  around a base load are already in use.
  
• New tariffs that specify the customers maximum
  use are starting to be negotiated.

20
One Market Research Effort

• A segment of large business customers in the
  Midwest was targeted.
  
• In-depth telephone interviews were conducted with
  larger business customers.
  
• Customers were sent several pages of information
  that described three basic types of pricing
  options (fixed price, spot price, and partial
  guarantee plus spot).
• Other interview content covered
• Pricing offer information.
• Energy IQ -- Knowledge of and experience with the
  energy environment.

21
Survey Results Flexible Pricing

• Approximately 20 percent of the customers
  believed that flexible pricing was preferred or
  was an acceptable option.
  
• Some believe they can actively manage load in
  response to price signals and want a compromise
  option to taking spot prices for their entire
  load
• Some indicated a belief in the balance of this
  choice, i.e., it balances cost advantage against
  the budgetary unpredictability of spot prices
  
• Appropriate investment in risk management was
  expressed as a key customer concern -- how to
  balances benefits with the time and resource
  investment necessary to fully manage spot
  prices.
• Forecast of spot prices needed to allow for price
  response.

22
Customer Needs

• Read between the lines to get at customer
  attributes and needs
  
• Need to gain cost advantage in markets.
• Need for predictability in energy expenses.
• Perceived operational flexibility to respond to
  price signals.
  
• Ability/willingness to devote managerial time to
  load management.
  
• Uncertainty about how market pricing will play
  out.
  
• Overall risk acceptance.
• Belief that the middle ground, or balance, is
  best

23
Pricing Options

• Innovation in Demand Response and pricing is
  already occurring
  
• quantity limits
• two-tiered fixed/spot contracts
• variable TOU rates where the peak and off-peak
  periods are tailored to or defined by the
  customer
  
• hour-ahead and day-ahead quantity adjustments in
  contracts and demands
  
• bidding contracted quantities back into supply by
  customers
  
• standby and buy-through contracts
• retailer serving as a broker for portions of
  customer load on peak days
  
• Customer load control through on-site or
  proximate generation options

24
Take Action

• Develop strategies for 5 and 10-year time
  horizons.
  
• Seek to create appropriately priced product
  offerings
  
• Develop customer service/sales tools and
  techniques that engage customers in the process
  of procuring energy.
  
• Lead with services and follow with demand
  response.
  
• Analytics are needed to develop alternative
  pricing offers
  
• A pricing offer may confer future rights to
  buyers which can be represented as a strip of
  options.
  
• Setting prices that appropriately reflect the
  value of these options to the seller and buyer is
  a challenge.

25
Take Action (cont.)

• Provide choices
• Offer alternate programs to serve different
  customer segments and provide different types of
  pricing or DR.
  
• Multiple programs help spread the risk of relying
  on one program.
  
• Choices stimulate greater customer participation
  and accommodate the different needs of specific
  customers.
  
• Leverage existing customer infrastructure -- Take
  advantage of their existing resources (e.g.,
  energy management systems).