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Retail Pricing Critical Element for Electricity Industry

Choice would reduce costs, outages

Lynne Kiesling
September 10, 2002

Retail prices have always played an important role in enabling exchange, and in leading to efficient outcomes and investment. Prices are a good tool for efficient resource allocation precisely because they transmit a lot of information about costs and preferences of disparate and anonymous economic actors, and do so very parsimoniously. This truth holds for the electricity industry as much as any other industry, even though the complex engineering and network system requirements, and the history and culture of regulation in the industry, have led to an industry where retail rates are guaranteed, fixed and regulated. Indeed, the costs of providing electricity change frequently, even hourly, which suggests that market prices would be an extremely valuable tool in leading to efficient resource allocation and investment. For that reason, integrating supply-side and demand-side response in wholesale and retail electricity markets, and offering customers a portfolio of retail contracts from which to choose, would reduce the overall costs of electric service and benefit consumers.

Since state regulation of utilities began in 1907, retail customers have faced average rates that do not change frequently. Retail electric service is provided on a guaranteed-price basis, under the state-enforced regulatory "obligation to serve" remit. Fixed, regulated rates insulate customers from the price decreases or increases that excess supply or demand would produce, and from the financial risk that often occurs in markets for commodities like electricity. The must-serve obligation on the regulated utility is an obsolete relic of the political dynamic of regulated electric power in the U.S., in which supply reliability is the highest priority, regardless of how much it costs to provide that reliability. Reliability has historically been considered only a supply-side problem, and the industry, regulators, and political institutions have internalized that belief, which persists to this day.

Regulated, average retail rates disconnect the prices individual consumers pay from the marginal cost of providing them power in any hour. Their prices also do not fluctuate to reflect changes in those marginal costs. Regulated rates also provide no consumer incentive to change their consumption as marginal cost changes, because the prices they see bear no relation to the marginal cost of serving them. Inefficient energy consumption and production is the logical consequence of this disconnect, which means that fixed average rates do not satisfy either static efficiency conditions, or dynamic efficiency conditions that induce optimal capital investment in the electricity system. The declining reserve margins and the lack of transmission construction that we have seen in the past decade indicate the absence of dynamic efficiency incentives in the regulated average price system as it currently exists. These existing rate structures also contain embedded cross-subsidization — within the residential, commercial, or industrial customer class, those who could have more elastic demand subsidize those who have more inelastic demand. This cross-subsidization not only leads to inefficient resource, but also is a political obstacle to changes in electricity pricing business models at the retail level.

When institutions are stable and supply capacity is not binding, the negative consequences of these average, fixed retail rates to consumers are not obvious. In the past decade, though, the dynamic factors influencing the electricity industry have revealed the flaws inherent in regulated average rates. In particular, technological change and resulting regulatory change have raised the benefits attached to efficient resource allocation, and prices that communicate information well are an important tool in achieving that efficiency. Regulatory change in the states in the U.S. in the past decade has emphasized wholesale market deregulation because of the technological change that has decreased efficient scale of generation. That focus, however, has disconnected the wholesale and retail markets, and has ironically done so in the states that have been restructuring pioneers. The hodge-podge of partial deregulation at federal and state levels has left fixed average retail rates in place. Proponents of retaining fixed retail rates argue that they protect consumers from the "unpredictable vagaries of the market." In fact, these fixed rates do nothing more than protect consumers from innovative service offerings and contracts, while also protecting the historic profit margins of utilities.

Retail pricing is a crucial component of an integrated, healthy, dynamic electricity industry. Offering consumers a portfolio of contract choices in a range of market-based prices would make many diverse consumers better off, and would also bolster system reliability and reduce forced outages. This portfolio of contracts approach, though, is a novel value proposition in this historically regulated, vertically integrated 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.

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



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