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Market-Based Electricity Pricing

Puget Sound Energy's pilot program

Lynne Kiesling
November 4, 2002

In all markets prices serve a valuable role in enabling exchange, and in leading to efficient outcomes and investment. Prices transmit a great deal of information about the costs and preferences of widespread and disparate economic actors, and do so very parsimoniously. This truth holds for the electricity industry as much as any other industry. Indeed, the ever-changing costs of providing electricity suggest that market prices would be an extremely valuable tool in leading to efficient resource allocation and investment, and that offering customers a portfolio of retail contracts from which to choose would reduce the overall costs in the industry.

Without retail pricing that gives consumers the opportunity to choose how they want to consume power, how much wholesale price risk they are willing to bear, and how they want to pay for it, electricity restructuring will fail to deliver efficiency and value to consumers. The "one size fits all" of regulated, fixed, average rates will become increasingly obsolete because of technological change, institutional change, regulatory change, and cultural change that recognizes the diversity of value propositions that the electricity industry can profitably present to consumers.

Market-based pricing in electricity can include time-of-use (TOU) rates, which are different prices in blocks over a day, based on expected wholesale prices, or real-time pricing (RTP) in which actual market prices are transmitted to consumers. As currently implemented, TOU is typically a program in which predetermined prices apply to specific time periods by day and by season. RTP differs from TOU mainly because RTP exposes consumers to unexpected variations (positive and negative) due to demand conditions, weather, and other factors. In a sense, fixed retail rates and RTP are the endpoints of a continuum of how much price variability the consumer sees, and different types of TOU systems are points on that continuum. Thus RTP is but one example of market-based pricing. Both RTP and TOD provide better price signals to customers than current regulated average prices do.

Several utilities have implemented some limited market-based pricing programs. Although small and exploratory, these have generated some positive results that will be useful as more utilities begin considering market-based pricing. None of these programs implements true market-based pricing, though; instead they are "demand response" programs that use time-of-day price changes to give customers incentives to shift load. That said, they do indicate how powerful price incentives can be for consumers, and how market-based pricing contributes to a reliable, efficient electricity system.

Puget Sound Energy (PSE) characterizes its demand response "Personal Energy Management" program as a conservation program primarily for residential customers. The Personal Energy Management program began in May 2001, and 300,000 customers enrolled in the first six months. This program is a typical TOU program, with lower prices in off-peak periods and higher prices in peak hours (PSE uses a four-period TOU framework). PSE also provides automated meter reading services and real-time pricing data to customers. Customers can see their daily electricity use according to the four time periods through PSE's website. Typical summer 2001 rates varied from 4.7 cents per kilowatt hour for overnight hours to 6.25 cents per kilowatt hour in peak morning and evening hours.

PSE found that in the first several months of the program, participating customers shifted approximately 5 percent of their demand away from peak hours; in addition, participating customers reduced their overall electricity use. Almost 90 percent of customers took some action to manage their own electricity use when facing TOU pricing. Customers also expressed satisfaction with the program, with 85 percent saying in a PSE survey that they would recommend the program to a friend.

In September 2001 PSE extended its Personal Energy Management Program to 20,000 of its business customers, who had been monitoring their peak load and off-peak load in anticipation of moving to a TOU rate structure. In late 2001 PSE applied to the Washington Utilities and Transportation Commission to make the TOU rate structure a permanent option in PSE's rate tariff. Last week, PSE announced that they would begin sending quarterly comparisons of their bills under TOU with what they would have paid with fixed rates, as described in this article. TOU customers already receive detailed information about their use.

Lisa Wood at the Brattle Group also has a good article about the benefits that come from market-based electricity pricing. She addresses the one of the important cultural questions — are customers opposed or complacent? I think customers don't think about the fact that their utilities could offer them more creative value propositions beyond just having the juice come through the wall, and that it's incumbent upon those of us who advocate for those value propositions to bring the debate into the open. The debate itself will benefit consumers.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

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