Major Electricity Customers Pricing Options Presented by Anees S. Azzouni, President A.S. Azzouni Energy Consultants, Hethie Parmesano, Senior Vice President, National Economic Research Associates, Saud A. Al-Rashed, Executive Director Commercial

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Major Electricity Customers Pricing Options
Presented byAnees S. Azzouni, PresidentA.S.
Azzouni Energy Consultants,Hethie Parmesano,
Senior Vice President,National Economic Research
Associates,Saud A. Al-Rashed, Executive Director
Commercial Business, TransmissionSaudi
Electricity Company

Presented at Seminar on Electricity
Tariffs Riyadh, Saudi Arabia January 15 16, 2008
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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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Electricity pricing policies toward major
customers need to

• be compatible with the electricity sectors
  changing structure and the business environment
  of major customers
• lead to economically-efficient behavior and
• be compatible with stakeholders objectives.

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Major customer pricing can impact

• development of wholesale electricity market
• development of cogeneration and distributed
  generation
• effectiveness of load management and energy
  efficiency programs
• pace of required capacity additions
• electricity prices to smaller customers

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We will in this presentation provide

• brief description of the electricity sector
  restructuring efforts in Saudi Arabia.
• concerns of major Saudi Arabian electricity
  sector stakeholders with regard to rates.
• major alternative cost bases for pricing of power
  supplies, standby power, buy-back, and other
  supplemental services.
• recommended pricing alternatives that are
  compatible with electricity sector restructuring.

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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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Enabling legislation was passed in the last ten
years

• Key developments include
• removal of barriers to private investment entry
  into generation
• passage of the electricity law, the grid code,
  and implementing regulations
• the future creation of an independent
  transmission company
• the future introduction of open and
  non-discriminatory access by major electricity
  customers to the grid
• the future implementation of a wheeling tariff
• the invitation to qualified major electricity
  customers to establish their electricity rates
  outside the regulated industrial rate through
  direct negotiations with SEC

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Proposed electricity industry restructuring plan

• Stage one 2008
• the establishment of a single buyer model to
  accompany the unbundling of SEC
• the creation of an independent transmission
  company
• the introduction of open access to the grid by
  major customers
• the implementation of a wheeling tariff set by
  ECRA
• Stage two 2008 2015
• the creation of parallel wholesale markets where
  major customers can have direct supply agreements
  with SEC and/ or IWPPs and IPPs
• Stage three 2015
• full market competition

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Questions yet to be answered by present sector
reform efforts

• the development of competitive wholesale
  electricity market and the setting of goals for
  wholesale market institutions
• creation of independent transmission system
  operator(s),
• creation of large regional transmission networks
  with common transmission access and pricing
  rules, and
• creation of a set of basic wholesale market
  institutions which include
• Standard Market Design (SMD) rules,
• locational marginal pricing and congestion
  management, regional transmission planning,
• market power mitigation mechanisms.
• the creation of a legal framework for access to
  the network.
• clarification of ECRAs regulatory oversight over
  negotiations between major customers and SEC.

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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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Major Customer On-Site Generation Economics

• Major industrial facilities requiring both heat
  and power can build cogeneration facilities with
  thermal efficiency of 90 at cost for electricity
  competitive with local utilities.
• The optimization and sizing of a cogeneration
  scheme can result in more electricity produced
  than can be utilized within the plant.
• On-Site generation economics are governed by
• availability and cost of fuel
• market price for electricity
• cost and availability of stand-by power
• wheeling and
• market and price of excess power

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Energy profile of industrial facilities

• Basically, all industrial facilities reflect in
  their design
• low price for natural gas, electricity, and water
  
• heavy reliance on SEC for power supply,
• low level of plant heat integration,
• use of simple cycle technology for on-site
  generation,
• high energy intensive technologies.

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Energy profile of industrial facilities

• Major customers exhibit varying sensitivity to
  electricity cost.
• basic metals in excess of 30 of variable costs
• construction materials and cement in second place
  
• chemical industries, plastic products, and oil
  and gas 7 or below of variable costs.
• Major electricity customers have the capability
  for load shifting, the potential to improve load
  management, and interfuel substitution.
• Major customers hold a large reserve of DSM
  resources whose cost is competitive with the cost
  of new generating capacity.
• Captive power generation is a feasible option for
  petrochemical, gas, and oil refining facilities
  and is a feasible capacity resource to the
  utilities as well.

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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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Objectives and Concerns of Key Stakeholders

• The five primary stakeholders of wholesale
  electricity are
• major customers
• the Ministry of Water and Electricity
• ECRA
• SEC
• IPPs and IWPPs

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Major customers share the following primary
concerns

• adequacy of power supply to meet future power
  requirements,
• the effect of potentially rising and volatile
  electricity prices on competitiveness with
  industry peers, and
• cost-effectiveness of captive power generation
  investment decisions as a result of uncertainty
  over
• wheeling charges,
• price for sale of excess power, and
• standby power rates.

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Key major customers policy concerns include

• Energy and industrialization policies impact on
  energy intensity, fuel availability and pricing,
  and technology choice.
• Policies which impact the position of incumbent
  electric utilities market power, concentration,
  and market share.
• Rules governing the treatment of cross subsidies.
  
• Provisions for ancillary services buy-back,
  stand-by, wheeling, frequency imbalance, and
  voltage support and control.
• Policies, standards, and licensing with regard
  to on-site generation, distributed generation,
  interconnection standards, and dispatch rules of
  qualified independent generators.
• Rules on who is entitled to have access to the
  network.

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Key Ministry of Water and Electricity and ECRA
Concerns

• The impact of policy legislation and long range
  electricity planning on cogeneration legislative
  options, power system optimization, energy
  efficiency and subsequently pricing.
• The impact regulating the electricity market and
  restructuring of the electricity sector have on
  major customers decisions regarding energy use,
  energy procurement, and the efficiency and
  competitiveness of the market.

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SEC Concerns

• The retention of major customers is a key
  objective of SEC. Major customers represent a
  significant portion of SEC revenues with prices
  that fully cover the cost of service.
• A critical challenge faced by SEC over the period
  2008 2015 concerns balancing major customer
  pricing and wholesale electricity pricing and the
  balance of SEC sales governed by regulated rates.
  
• On-site generation makes it more difficult for
  SEC to forecast load and plan the system, and
  increases uncertainty of revenue recovery.
• Non-utility generation will increase uncertainty
  for the system operators as SEC becomes the
  residual demand supplier and provider of stand-by
  power.

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IPP/IWPPs Concerns

• Under the restructuring plan, IPPs and IWPPs will
  eventually be allowed to sell power directly to
  major customers
• They will be competing directly with SEC for
  major customers and thus have concerns with SECs
  industrial tariffs.
• IPPs and IWPPs are concerned about SEC pricing
  policies that affect the feasibility of captive
  power generationtheir potential competitors.
• IPPs and IWPPs have interest in the level and
  structure of wheeling charges they or their
  customers will pay to use the transmission grid.

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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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Design of appropriate prices for major customers
raises key interrelated issues

• economic efficiency
• transition to competitive electricity market
• cross-subsidies
• system reliability
• risk allocation

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Economic Efficiency means

• Efficient investment by consumers, utilities,
  other market participants
• Efficient use of existing infrastructure
• Avoidance of uneconomic bypass
• Use of marginal cost as the basis for electricity
  pricing promotes economic efficiency and enhances
  welfare.

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Transition to Competition is enhanced by major
customer pricing that

• mimics the structure of likely competitive
  offerings and avoids long-term agreements that
  preclude full participation in the market
• promotes new entry by basing prices on economic
  (marginal) costs
• encourages effective demand response through use
  of innovative rate structures
• provides transparent price signals, with key
  elements unbundled to permit comparison with
  alternatives

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Cross-subsidies

• distort customers decision about consumption and
  investment decisions
• are difficult to sustain if customers have supply
  choices (via self-generation or purchase from a
  competitive supplier)
• can be defined as the difference between amount
  charged and marginal cost (adjusted efficiently
  to match the regulated revenue requirement).

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Preservation or enhancement of system reliability

• Tariffs for all users should reflect marginal
  costs so that only capacity that customers are
  willing to pay for is built.
• Prices paid for power produced by major
  customers generators should provide incentives
  to supply that power when it is most useful to
  the system.
• Prices charged for standby power required by
  non-utility generators should provide incentives
  for them to manage their outages in a way that
  minimizes the effect on system reliability.

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Risk Allocation implicit in pricing to major
customers should

• allocate cost, price and operational risks to the
  parties best able to bear them
• consider pros and cons of short- and long-term
  agreements in terms of risk allocation
• consider the effect of higher risk on cost of
  capital.

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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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Alternative Cost Bases for Major Customer Pricing
Policies

• Allocated embedded (historical accounting) cost
• Backward looking
• Sensitive to the classification and allocation
  methods used
• Does not provide detailed information needed for
  time-of-day pricing
• Long-Run marginal cost
• Assumes hypothetically optimal system
• Does not reflect actual conditions of the system
• Incremental cost
• Change in cost given a specific assumed change in
  expansion plan or load
• Does not provide detailed information needed for
  time-of-day and other innovative rate structures
• Short-run marginal cost
• Includes both utility variable costs and costs of
  changes in reliability (shortage costs to
  consumers)
• Can be computed over several years to show trend
• Mimics market prices
• Provides all the details needed for efficient
  pricing

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Two Other Cost Alternatives

• Net Metering (for pricing excess energy generated
  by a customer)
• Customers meter is allowed to run backward when
  generation exceeds generating customers own
  load.
• Rather than based on cost, the price paid for
  excess energy is the full retail rate.
• Depending on retail rate design, this can be an
  efficient or inefficient approach.
• Pricing customer-generated power based on the
  customers generation costs
• Reduces risk for the customer-generator
• Provides little or no incentive to operate
  efficiently from total system point of view (e.g.
  rates are not time-differentiated).
• This can also be used for standby rates (i.e.,
  price at the customers cost of providing its own
  standby power)

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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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Key prices or tariffs applicable to major
customers must cover/include

• standard tariffs for purchases by major customers
  without generation
• interruptible tariffs under which customers
  without generation curtail load in system
  emergencies
• tariffs for the utilitys purchase of a
  generating customers energy production made
  available by curtailment of a customers load or
  additional energy production in critical periods
  
• tariffs for supplemental purchases by major
  customers whose generators do not serve their
  entire load on regular basis
• tariffs for backup energy and capacity, for use
  when a customers generation is down for planned
  or unplanned maintenance
• tariffs for sale of excess production of a
  customers generation to utilities
• tariffs for wheeling of excess production of a
  customers generation to the customers other
  sites or to third parties

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Tentative Recommendation Standard Tariffs for
Major Customers

• Two primary goals efficiency and transition to
  competitive market
• Short-run marginal cost is the cost basis most
  likely to achieve the primary goals
• Major customer tariffs should
• be differentiated by time of day and season to
  reflect time patterns of electricity production
  and as a prelude to market prices
• include a fixed charge based on contract capacity
  to cover the cost of facilities that must be
  sized based on the customers maximum demand
• include time-differentiated demand charges,
  unless there are sufficient pricing periods that
  capacity costs can be efficiently recovered in
  per-kWh charges.
• include optional real-time pricing programs.

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Tentative Recommendation Interruptible Tariffs
for Major Customers without generation

• Major customer interruptible tariffs should
• reward participating customers for their
  willingness to accept non-firm service in
  exchange for lower prices
• provide a discount from firm tariffs that
  reflects the marginal value to the system of the
  expected load reductions
• structure discounts in the form of reduced
  charges, credits when curtailments take place, or
  some combination of the two.

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Tentative Recommendation Interruptible Tariffs
for Major Customers with generation

• Major customers with generation may be willing to
  curtail load or increase generation in response
  to a request from the utility.
• Such arrangements may require individual analysis
  for proper pricing.
• An appropriate cost basis for the
  payments/credits for interruptibility should
  reflect the value of the interruptions to the
  system if economic efficiency is given a high
  priority.

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Tentative Recommendation Tariffs for
supplemental power required by customers with
generation

• Unless supplemental service has load
  characteristics very different from loads of
  similarly sized customers without generation, the
  standard practice is to charge standard tariffs
  for supplemental service.
• Thus, tariffs for supplemental service should be
  time-differentiated by time of day and season and
  based on short-run marginal costs.
• This approach provides incentives for
  economically efficient design of the generator,
  and serves as a transition to retail competition.

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Tentative Recommendation Tariffs for standby
power required by customers with generation

• For economic efficiency, tariffs for standby
  service must cover the utilitys short-run
  marginal cost of standing by to provide
  intermittent power when the customers generator
  is forced out of service or is taken down for
  planned maintenance.
• Charging less creates a cross-subsidy.
• The amount of reserve capacity (distribution,
  transmission and generation) required to provide
  this intermittent service without reducing
  service quality to other customers is very
  situation specific.
• Tariff structure should include reservation
  charges and time-differentiated charges for power
  consumed.

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Tentative Recommendation WheelingTariffs

• A marginal cost basis for wheeling tariffs
  promotes economic efficiency.
• However, cost shifting to other customers or
  stranded costs may occur if tariffs formerly paid
  by the third party did not reflect marginal cost.
  
• The costs (or avoided costs) associated with
  wheeling may be complicated if the utility must
  provide standby service to non-utility generator.
  
• These arrangements generally require individual
  analysis to identify costs, protect other
  customers, and result in economically efficient
  outcomes.

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Contents of this presentation

• Introduction
• Electricity sector restructuring and market
  reform
• Major customer electricity procurement economics
• Objectives and concerns of key stakeholders
• Key pricing issues
• Alternative cost bases for pricing
• Recommended alternatives
• Conclusions

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This paper focused on choice of appropriate cost
basis for major customer pricing.

• Our tentative recommendations point to short-run
  marginal cost as the appropriate basis for most
  tariffs involving major customers.
• The short-run marginal costs should mimic the
  market prices that will emerge as wholesale and
  eventually retail competition is introduced.
• They should be differentiated by time of day and
  season and be forecast out for the period the
  tariffs or contract arrangements are likely to be
  in effect.
• Adjustment mechanisms or index provisions can be
  used to keep the tariff levels tracking current
  costs within the term of a tariff or contract.

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Review of electricity pricing options has led to
the following insights regarding Saudi Arabias
electricity sector restructuring.

• The significant volume of transmission sector
  wholesale business allows the establishment of an
  electricity market at the transmission level
  without creating multiple distribution companies
  or competitive suppliers for lower voltage
  customers.
• Restructuring should encourage customers to
  invest in on-site generation or negotiate
  contracts with IPPs.
• Restructuring should encourage major customers to
  take actions that reduce SECs cost of
  maintaining operating reserves, and improve
  system reliability by raising the installed
  capacity reserve margin.
• Restructuring should encourage the development of
  market competition as a tool for achieving the
  least-cost mix of new generating resources with
  SECs tariffs for wheeling and standby fixed and
  in reflection of economic costs.