“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.
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?
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.
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.
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.
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.
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 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.