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Is Electricity Pricing Different from “Real Markets”? Should It Be?

“No company in a real market would ever price that way.”  If you’ve discussed electricity pricing much, you’ve surely heard this said by a person opposed to one retail tariff or another.  In almost every instance, however, the claim is both incorrect and irrelevant.

Incorrect, because firms in unregulated markets are constantly experimenting with the pricing.  Whether it’s fixed charges, increasing-block pricing, decreasing-block pricing, demand charges, or even exit fees, there is something analogous in the unregulated economy.

Irrelevant, because the structure of providing grid services – a monopolist grid operator that has to assure second-by-second network-wide balancing across all transactions — has no analog in the unregulated sectors. We’ll get back to relevance.

But first how about a fun game of Name That Market Pricing Practice?

I give you the electricity price structure and you come up with the unregulated market that has a similar pricing model.  But don’t peek at the line below each structure where my suggested answers are.

We’ll start with an easy one.

Fixed Charges: 

The view that a consumer should have to pay only for the bits s/he uses is common.  But so is pricing that violates it.  There are the print and web-based media companies that charge a fixed subscription fee to read as much or as little as you like.  Amazon Prime shipping (and other services bundled with it) carrier a single fixed annual fee.   Rental car markets are generally a fixed daily charge with some free mileage, and usually a charge for additional miles beyond that.  The Zipcar model is a fixed annual fee plus a per-hour charge.  Gyms charge for membership that covers some basic activities, but then charge extra for certain classes, training or other add-ons.

Easy and fun, huh? Ok, how about a slightly more challenging one?

RealElectricityMarkets1Exit fees:

Cell phone contracts were the obvious example, but those contracts are changing.  Markets evolve.  But not always in the same direction.  Try paying off your mortgage early and you are likely to be hit with a pre-payment penalty, that is, an exit fee.  Cable television, internet service, and home security services all have exit fees.  Many students in business or law school have some part of their tuition paid by their employer, but if they don’t return to work for that company for X years they have to pay back the tuition subsidy when they exit.

RealElectricityMarkets2

Now for something tougher.

Increasing-Block Pricing (the price for additional units of a good rises as you buy more):

The fare to fly San Francisco to Boston may be $600 if you want 31 inches of legroom, but if you want 34 inches, about 10% more legroom (and no extra pretzels or luggage), that will be an extra $200.  The practice is simple price discrimination; the people who most value the extra legroom have a higher willingness to pay overall.   Sign up for Dropbox and they will give you 2 Gb of storage for free.  If you want more, you’ll have to pay.  That additional charge for rental car mileage beyond the bundle miles is increasing-block pricing.

RealElectricityMarkets3

In case that wore you out, here are a few softballs.

Decreasing-Block Pricing (the price for additional units of a good declines as you buy more):  

Too many example to list here.  Any quantity discount.

Minimum Bills:

Call a plumber or an electrician and the first hour is likely included in the $100+ charge for showing up. If they can fix your problem in 20 minutes, you still pay the minimum bill.  Many restaurants have a minimum charge per person.

Time-Varying Pricing:  

Ski resorts (cost more on weekends), Uber (surge pricing), strawberries (by season), theater tickets (cost more on weekends), baseball tickets (many teams charge more for big games), restaurants (lunch vs. dinner, and day of week at some).   It’s hard to get through a day without paying a price that varies with time.  And to the person who said “those aren’t necessities, like electricity”, take a look at housing in a college town, where rents drop in May and rise in August.

 

Have you caught your breath?  Ready to stretch your brain?

Demand Charges (a fee based on the customer’s highest rate of usage during a period):

For the most part, demand charges are just highly imperfect approximations to time-varying pricing.  This has become more clear with the many recent proposals for “demand charges” that apply only to specific time blocks.  They may be simpler than true dynamic pricing, though I’ve argued they probably aren’t in most cases, but they are usually attempting to price the same variation.  So, many of the answers to time-varying pricing apply here.  But there is at least one interesting example of something close to a classic demand charge, really intended to price customer-specific peak usage: cloud computing charges, such as Amazon’s server pricing, where the charge increases to account for a period of heavy demand for a company’s server.

In fact, buried in the many server payment options Amazon offers are examples of practically every type of pricing you can imagine.

And to finish up, how about the ultimate challenge?

Net metering – (a customer delivering electricity to the grid is credited at the same rate they are charged when they take electricity from the grid):  

OK, on this one, I’m pretty stumped. Some colleagues and I spent part of a long car ride last week trying to think of a market in which a seller of a good buys units of that same good from small retail customers and pays them the retail price.  The closest we could come up with is a customer buying items from store A and then returning them to store B for full retail price by claiming they were bought at store B.   Hmmm…not a great model.

 

You may have noticed that many of these real market pricing policies are very unpopular with customers.  In real markets firms occasionally exercise market power, charge more to a customer who really needs the product, take advantage of consumer misinformation or myopia, or just make a lot of money by selling something that has become very scarce.

Nearly everyone hates the exit fees on cable contracts and the exorbitant charges for a little more legroom on a long flight.  Many people bristle at having to pay for all the cable channels when they only watch a few of them, or paying a monthly gym membership fee, at least once they’ve discovered they really aren’t going to be there every morning at 6am.  And resistance to the rents in Bay Area and other housing markets is spurring new policies to make these less like real markets.  So, while there are real market analogs to nearly all electricity pricing models, that is hardly a justification for using them in a regulated setting.

Likewise, the absence of a close market analogy isn’t an argument against an approach.   Delivering electricity is not like services that are sold in real markets.  The transmission and distribution grids are natural monopolies, where it is more efficient to have one system used by all, rather than every seller building their own set of wires to deliver their own electricity.  And customers want the reliability value of that pooled network, which enables one generating source to instantaneously fill in for another if a gas plant suddenly shuts down, or a cloud passes over solar panels, or the wind stops blowing, or a tree falls on a transmission line.

But what makes a natural monopoly natural is that the cost of adding one more customer is lower than the overall average cost per customer.  That means that the attractive notion of cost causality – that Joe Bob Customer is responsible only for the costs that are caused by adding him to the grid – won’t generate enough total revenue to pay for the whole system.   Somebody has to pay more to cover the costs.  The array of prices that policy makers, utilities, and other interested parties have cooked up are an attempt to cover costs, follow cost causality, be fair to customers, help lower-income households, and be environmentally friendly, among other goals.

In real markets, companies cook up pricing to maximize profits and…that’s it.  There are many things done by the government, or under government regulation, that wouldn’t be financed the same way, or possibly done at all, in the private sector: national defense, local policing, disease control, environmental protection, free K-12 education, and consumer protection to name just a few.  Some private sector ideas can be very valuably applied in these area, but almost no one would say that the fundamental organization of these activities should be driven by a private-sector model.

So, let’s continue debating the pros and cons of the pricing alternatives in the rapidly-changing electricity world, but let’s do it without pretending that “real companies don’t price that way” is a useful contribution to the discussion.  Whatever the model, there is likely some real company that does price that way, but who cares.

Tweet me your “real market” analogs of electricity pricing @BorensteinS

Severin Borenstein View All

Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.

40 thoughts on “Is Electricity Pricing Different from “Real Markets”? Should It Be? Leave a comment

  1. Ken – if you are net positive with the bank in any month (i.e. you have more on deposit with them than is drawn on your HELOC), do they give you interest at the HELOC rate or higher? If so, I’d like to know the name of your bank…
    Mine gives me less than 1% on savings or even Money Market while charging 4% or more for a HELOC. I think your example is closer to a “no NEM rate” like in Hawaii or Nevada where you get to reduce your charges at retail rate until you get to net export, but when sending net energy to the grid in any month you make less money than the utility does when they net sell to you.

  2. “The array of prices that policy makers, utilities, and other interested parties have cooked up are an attempt to cover costs, follow cost causality, be fair to customers, help lower-income households, and be environmentally friendly, among other goals” [including inclusivity, sustainability, and renewability]. No company in a real market would ever price that way.

  3. Stimulating and provocative, splendid examples, good value as always. I am with you all the way – until you reach the conclusions.
    “In real markets, companies cook up pricing to maximize profits and…that’s it.” No, that’s just the beginning. What if that’s the only way to produce the product and survive? What if their competitors are doing the same thing?
    Why can’t you find examples of net metering? Because it’s loss making. No private sector company could do it and survive.
    Here’s another pricing policy you didn’t try to find examples of: single uniform prices. The kind that are found in economics textbooks. Are there any such examples that are not subject to quantity discounts, negotiation, “I’ll throw in this since you’re a good customer”, etc? Probably only in the public or regulated sector.
    So “real companies don’t price that way” is indeed a useful contribution to the discussion, if the aim of policy is in some sense to replicate what real companies (ie privately owned companies operating in competitive markets) would do. All the examples you give (except net metering) are tried and trusted methods of surviving in a competitive market place.
    But if there is some other aim of public policy, then what real companies do may indeed be irrelevant, and single uniform prices and net metering may (or may not!) have a role to play.

  4. My bank and I have a net metering relationship… my home equity credit line. When I consume more cash than I generate (eg, kids’ tuition is due), I “buy” cash from the bank at my credit line interest rate. When I generate more cash than I need (eg, tax refund arrives), I “sell” cash to the bank by paying down my home equity line. I thereby avoid interest charges that are exactly the same as the interest charges incurred when “buying”, and it’s this equivalence of prices (as well as the complete flexibility to buy and sell whenever one wants) that are hallmarks of net metering. Incidentally, my home equity credit line has a variable rate tied to prime, so it is also an example of peak-load pricing!

  5. Electricity is seemingly different from most other products/ services; but similarities exist with technicians [they get paid by employer any way], airplanes [they fly empty seats or cargo capacity, saved variable cost of ‘meals’ no longer applicable on domestic flights], car rentals [depreciation], clothes [new ‘collections’ degrade value of old ones], web services [capacity not used is like airplane seats, but there are some saved variable costs], etc. Water [utility] is different – it can be stored usually without loss of value.
    But electricity largely MUST be used when produced. So if utilities were to offer ‘negative’ rates at trough-hours many retail and even industrial customers would use that capacity, and storage [with its costs that eventually get passed on to users] would be less needed. If stores offered discounts at late-night [because electricity is cheaper or even negative] I would expect many shoppers around.

    Dynamic pricing [surge included] would be fine provided there was some advance notice –

    Few of us thought negative interest rates were likely until they started happening. The only problem is a side effect might be ‘people’ putting ‘cash in the mattress’ in in a safe deposit box; and the attendant crimes as cash-carrying citizens are mugged.
    Negative interest rates not good.
    Negative electricity prices good.

  6. I think there is additional complexity about how consumers use electricity that should be pointed out. Individual electric users are engaging in dozens of transactions to “buy” electricity every hour of varying amounts and for varying amounts of time which has no analog in the rest of the world, only water comes close. Because of this, I believe that consumers need to pay for essentially two separate services. The first is the option for the consumer to look to the grid supply electricity to meet the instantaneous needs that nearly all first world electric consumers expect. The second is the amount of energy itself that meets those instantaneous needs. In my mind this is an argument against an NEM structure that includes those costs associated with providing the platform to even use electricity that a user does not provide – costs that should be socialized and applied without discrimination. But, the set of costs associated with energy itself should have a rate structure most efficiently accounts for the variable nature of the product.

  7. Another example for Net Metering could be a sale or return deal. For example, in the UK some supermarket chains will sell you a large number of cases of wine (e.g. for a family party) and you can sell them back to the supermarket at the same price without challenge, but I recognise it isn’t the same

  8. Excellent article. Unfortunately the CPUC has a huge mess by using just about every one of those devices in its attempts to satisfy an ungainly number of competing and contradictory policy goals. And it has also mostly failed.

    • And the goals compete and contradict in different ways at different times. Players in “real markets” are more likely to have consistent objectives.

  9. The only analogy I can think of for net metering is the skate and cleat exchanges that I recall existed in my town when I was a child. Children outgrow their hockey skates and soccer cleats faster than they can wear them out. The Parent-Teacher Association or some other charitable organization in my town operated an exchange at the start of each athletic season so that parents would be able to buy used equipment and sell their own used equipment. I do not recall how the pricing worked, for I was a child. The analogy to net metering is that families could bring in their old skates whether they wanted other skates or not. Families could have net-negative or net-positive transactions depending on their own supplies and needs.

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