Time-Varying Retail Electricity Prices: Theory and Practice

1. Time-Varying Retail Electricity Prices:Theory and Practice by Severin Borenstein

2. Outline of Talk • The Value of Time-Varying Retail Prices • Time-Varying Prices in Practice • Issues in Implementing RTP • Risk Mitigation for Customers • Meeting Retailer Revenue Requirements • Mandatory vs. Voluntary RTP • Role of Demand Response in Reserves

3. The Value of Time-Varying Retail Prices • Efficient pricing in the short-run gives efficient incentives to consume • and efficient load shifting among periods • Efficient pricing gives optimal long-run incentives to invest in capacity • More immediate demand response reduces generator incentive to exercise market power in wholesale market • Bottom Line: Lower Long-Run Costs, Higher Consumer Benefits (Borenstein & Holland, 2002)

4. Methods for Implementing Time-Varying Retail Pricing • Key differences among plans • Granularity of retail prices • Timeliness of retail price setting - “dynamic” • Adaptability to varying revenue target • Bill Volatility – protection against price spikes • Granularity and Timeliness are different, but interact in important ways • Adaptability need not conflict with protection against volatile bills

5. Flat-Rate Service Revisited • poor granularity, no time variation • prices are not timely, change annually (?) • very adaptable -- change rate to hit revenue target, but prices are very inefficient • protection against volatile bills • Wholesale price spikes smoothed over long periods

6. Real-Time Retail Pricing (RTP) • Excellent Granularity • Prices usually change hourly • Very Good to Excellent Timeliness • Using “day-ahead” or “real-time” price • Arguments against RTP • bills will be volatile • not adaptable to meet revenue requirements • BUT straightforward alterations to RTP overcome these objections

7. Alternatives to RTP • Time-of-Use Pricing • TOU with Demand Charges • Critical Peak Pricing • Interruptible Demand • Paying for Demand Reduction

8. Issues in Implementing RTP • Customer Price/Bill Risk on RTP • Meeting Retailer/Utility Revenue Requirements • Mandatory versus Voluntary RTP • RTP and Reserve Requirements

9. Mitigating Customer Risk Under RTP • Customer risk comes from the possibility of unexpected high, and persistent, wholesale prices -- leading to high bills • Hedge through long-term contracts • Hedging by Retailer on Behalf of Customer • How to pass along gain/loss from hedge while minimizing distortion of retail price? • Active Hedging by Customers

10. Mitigating Customer Risk Under RTP • Retailer Hedges for Customers • Still charges RTP on the margin • Passes through gains/losses from hedge with minimum distortion of retail price • Customer Baseline Load (CBL) approach • Constant adder/subtractor to retail RTP • Active Hedging by Customers • “BYO Baseline” offered by retailer • Hedging instruments from energy sector

11. Meeting Retailer/Utility RevenueRequirements Under RTP • RTP revenues won’t match retailer’s costs • if some power bought under long-term contract • if some power generated by retailer • if retailer has fixed costs unrelated to energy • e.g., distribution costs • if retailer has sunk/stranded costs

12. Meeting Retailer/Utility RevenueRequirements Under RTP • Collect differential as lump-sum, so marginal price is still RTP • CBL approach does this • Politics of setting lump-sum levels/baselines • Collect differential as constant per kilowatt-hour adder or subtractor • still have variability in RTP • small inefficiency of consumption

13. Example: Passthrough of Fixed Hedging Gains with Constant “Subtractor”

14. Mandatory versus Voluntary RTP • If RTP is so great, why do we have to make it mandatory? We don’t. • But don’t cross-subsidize flat rate customers • The vicious cycle of equalizing average price between RTP and non-RTP customers • some RTP customers will always be paying more than they would on flat rate so will switch to flat • eventually RTP collapses

15. Voluntary RTP Without Cross-Subsidy • The virtuous cycle of allowing each group to stand on its own -- no cross-subsidy • lowest-cost customers on flat-rate better off switching to RTP • mimics a competitive market outcome • lower prices for those who are cheaper to serve • if that’s “cherry picking,” I’m for it • all customers still pay for fixed/sunk costs, • not a method for dodging sunk cost liability

16. The Role of Demand Response in System Reserves • RTP will not eliminate the need for reserves • so long as price-responsive demand is slower than callable supply • But RTP offers more than peak demand reduction • demand “tilts” as well as shifts • RTP will gradually reduce use of reserves • as system operators recognize its reliability • Eventually, RTP will reduce the standard for percentage reserves

17. How Price-Responsive is Demand? • Evidence from California 2001 and other conservation programs • Evidence from RTP programs and pilots • Evidence from dynamic pricing programs and pilots • These estimates almost certainly understate price responsiveness as technology improves • The next programmable thermostat

18. Conclusions • Static pricing of electricity is based on old metering technology, has large inefficiency • RTP is the gold standard of electricity pricing • Resistance to RTP is understandable, but not difficult to address • Real barrier to RTP is metering cost, but only for small customers (and maybe not even them) • start with large customers to get biggest bang for buck • but offer small customers RTP (and CPP)