Electricity Markets Regulation - Lesson 8 - Pricing


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Once the revenue requirements are established they should be converted into tariff systems. This session explains the major economic principles of electricity pricing and the general pricing models using average and marginal costs. Moreover the session explores the major pricing models for the electricity activities including: generation, transmission, distribution and retail activities.

* Pricing principles : economic efficiency - cost recovery
* General pricing models : average cost pricing - marginal cost pricing
* Cost allocation issue
* Pricing for different activities in the electricity industry : generation pricing - transmission pricing - distribution pricing - retail supply pricing

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Electricity Markets Regulation - Lesson 8 - Pricing

  1. 1. Training on Regulation A webinar for the European Copper Institute Webinar 8: Electricity Pricing Dr. Konstantin Petrov / Dr. Daniel Grote 9.2.2010
  2. 2. Agenda 08/02/2010 b) Marginal cost pricing a) Average cost pricing 2. General pricing models 3. Cost allocation issue 1. Pricing principles 4. International Examples
  3. 3. <ul><li>1. Pricing Principles </li></ul>08/02/2010
  4. 4. 1. Pricing principles Allocative efficiency and cost recovery <ul><li>Allocative efficiency </li></ul><ul><ul><li>Efficient distribution of productive resources among alternative uses so as to produce the optimal mix of output </li></ul></ul><ul><ul><li>An efficient pricing should signal to users the marginal costs that they impose on the regulated company </li></ul></ul><ul><li>Cost recovery </li></ul><ul><ul><li>Regulated companies should be able recover their reasonable O&M costs and capital costs (including an adequate rate of return) through electricity tariffs </li></ul></ul><ul><ul><li>A lack of adequate revenues may endanger financial viability, discourage investments and cause reduction of quality of supply </li></ul></ul>08/02/2010
  5. 5. 1. Pricing principles Further principles <ul><li>Efficient Regulation </li></ul><ul><ul><li>Pricing methodology should encourage efficient operation by regulated service provider </li></ul></ul><ul><ul><li>Minimise costs of service provider of complying with regulation </li></ul></ul><ul><ul><li>Minimise costs to regulator of administering regulation </li></ul></ul><ul><li>Transparency and Simplicity </li></ul><ul><ul><li>Regulated charges should be understandable and transparent </li></ul></ul><ul><ul><li>Transparency encourage general acceptance by users and the general public </li></ul></ul><ul><ul><li>Clear and explicit pricing rules reduce administrative burden and risks of potential disputes </li></ul></ul><ul><li>Non-Discrimination </li></ul><ul><ul><li>Level playing field for all service users </li></ul></ul><ul><ul><li>Treating all users equally irrespective of size, ownership or other factors </li></ul></ul><ul><ul><li>all users face same methodology for calculating charges (not necessarily same level) </li></ul></ul>08/02/2010
  6. 6. 1. Pricing principles Further principles <ul><li>Social Affordability and Political Acceptance </li></ul><ul><ul><li>Not a normative economic principle but often highly important in the practice </li></ul></ul><ul><ul><li>Move to cost reflective prices in many cases hampered by cross-subsidies between customer groups (e.g. large to small consumers, urban to rural areas) and direct subsidies, both aiming to low end-user prices for specific customers </li></ul></ul><ul><ul><li>Reasons for such distortions may be social affordability (support to low-income consumers), but also political populism or pre-election campaigns </li></ul></ul><ul><ul><li>Ideally social objectives should not be pursued at rate-making level but outside of the price-making schemes (e.g. through vouchers, direct cash subsidies or the inclusion of energy costs in transfers through the social security schemes) </li></ul></ul><ul><li>Macroeconomic Constraints </li></ul><ul><ul><li>Inflation control, GDP growth requirement, unemployment minimisation etc. may also hamper implementation of cost reflective pricing models </li></ul></ul>08/02/2010
  7. 7. <ul><li>2. General Pricing Models </li></ul>08/02/2010
  8. 8. 2. General pricing models Pricing of unregulated (natural) monopoly 08/02/2010 <ul><li>Economies of scale, economies of scope, high initial (sunk) costs, high fixed costs (e.g. transmission, distribution) </li></ul><ul><li>Single firm can produce output at lower per-unit cost than two or more firms </li></ul><ul><li>Price is affected by the output of the company </li></ul><ul><li>If unregulated, monopoly firm will charge a price where marginal revenue equal marginal cost </li></ul><ul><li>Company achieves maximum profit </li></ul><ul><li>Output will be lower and customers will be charged higher prices than under conditions of perfect competition </li></ul><ul><li> allocative inefficiency </li></ul><ul><li>Prices above marginal cost and welfare loss </li></ul><ul><li>Consumers forced to consume more costly substitutes or less useful products </li></ul>welfare loss of unregulated monopoly Costs and Revenue Quantity Demand long-run average cost Marginal revenue Marginal cost Unregulated monopoly price Unregulated monopoly output profit of unregulatedmonopoly Unregulated monopoly
  9. 9. 2. General pricing models Marginal cost pricing 08/02/2010 <ul><li>Prices are set equal to marginal costs by the regulator, as would be achieved by the market under perfect competition </li></ul><ul><li> allocative efficiency </li></ul><ul><li>Marginal costs measure the additional (incremental) cost incurred to transmit, distribute, generate or supply one additional kW or kWh </li></ul><ul><li>In natural monopolies with large economies of scale marginal cost pricing results in a financial loss for the firm </li></ul><ul><li>Financial loss may be covered using several schemes: budget subsidies, fix tariff component, tariff upscale keeping marginal cost proportions, Ramsey-Boiteux pricing </li></ul>Costs and Revenue Quantity Demand long-run average cost Marginal revenue Marginal cost Marginal cost output Marginal cost price financial loss under marginal cost pricing Marginal cost pricing
  10. 10. 2. General pricing models Average cost pricing 08/02/2010 <ul><li>Prices are set by the regulator so that they cover the average costs (at the intersection of the long-run average cost curve and demand) </li></ul><ul><li>Cost includes also the allowed return to of the company’s investors </li></ul><ul><li>Average costs allocate the total costs of transmission or distribution to the total units (energy or demand) transmitted or distributed </li></ul>welfare loss under AC pricing Costs and Revenue Quantity Demand long-run average cost Marginal revenue Marginal cost Average cost pricing Average cost price Average cost output no economic profit
  11. 11. 2. General pricing models Marginal Cost (MC) pricing vs. Average Cost (AC) pricing 08/02/2010 Marginal Cost Pricing Average Cost Pricing Allocative Efficiency High Relatively low (not optimal), size of in-efficiencies depend on elasticity of demand Cost Recovery Company not financially viable, adjustments needed to MC tariffs (government subsidies) Ensures financial viability of regulated firm, cost recovery results automatically from the cost allocation, eliminates economic profits provides ‘fair’ rate of return Efficient Regulation Depends on the regulatory role in the tariff setting process. Administration and compliance cost of MC pricing may be relatively high Depends on the regulatory role in the tariff setting process Transparency and Simplicity Low – MC pricing concepts may apply sophisticated modelling High – AC pricing easily understood by users Non-Discrimination High – but also depends on adjustments for cost recovery Variable – depends on the rules for cost allocation and tariff setting Implementation in Practice Used to provide short and long-term locational signals, may require sophisticated modelling Usually used with energy and demand charges differentiated by voltage level
  12. 12. <ul><li>3. Cost Allocation </li></ul>08/02/2010
  13. 13. 3. Cost allocation Tariff design issues 08/02/2010 Possible levels of differentiation of tariffs Time-of-use Fixed and variable elements Uniform charges (postage stamp) Locational charges Voltage level Two-/ multi-part tariffs Peak load pricing Energy, demand (capacity) charge Generation – load split Charges for connection, network, meter etc. Payment liability Type of service Geography Household, commercial, industrial,… Type of customer
  14. 14. 3. Cost allocation Locational signals (transmission networks and energy markets) 08/02/2010 <ul><li>Uniform prices for the whole transmission or differentiation by voltage levels </li></ul><ul><li>Examples: applied at transmission infrastructure level Germany, France, Spain, Netherlands </li></ul><ul><li>Geographical price differentiation and establishment of pricing zone </li></ul><ul><li>The price differences are driven by congestion, marginal transmission losses and generation prices </li></ul><ul><li>Examples: applied for transmission infrastructure (UK, Australia) and energy market (NordPool) </li></ul><ul><li>Market clearing prices calculated for every node of the transmission network, locational marginal pricing </li></ul><ul><li>The price differences are driven by congestion, marginal transmission losses and generation prices </li></ul><ul><li>Examples: applied for energy market PJM, New York, New England, New Zealand </li></ul>Postage Stamps Zonal prices Nodal prices
  15. 15. 3. Cost allocation Locational signals 08/02/2010 <ul><li>Predictable/Stable </li></ul><ul><li>Simple to calculate </li></ul><ul><li>Cost-reflectivity distorted </li></ul><ul><li>Distorted economic signals for efficient network usage </li></ul><ul><li>Compromise between uniform and nodal prices </li></ul><ul><li>Efficiency incentives depend on the specific details of the regime </li></ul><ul><li>Provide incentives for </li></ul><ul><ul><ul><li>efficient usage of the network </li></ul></ul></ul><ul><ul><ul><li>investment and location of new generation / consumers </li></ul></ul></ul><ul><li>Can be volatile, difficult to predict </li></ul><ul><ul><li>Complex calculation </li></ul></ul>Uniform prices Zonal prices Nodal prices
  16. 16. 3. Cost allocation <ul><li>Power generation and power consumption take place on all voltage levels </li></ul><ul><li>Large power plants feed-in at (extra) high voltage, large industrial plants take out at (extra) high voltage </li></ul><ul><li>Small renewable power plants (wind, solar power) generally feed-in at medium and lower voltage, private household and small commercial customers take out at low voltage </li></ul><ul><li>How to allocate network costs among network users of different voltage levels? </li></ul>Cost allocation among voltage levels 08/02/2010 Typical Tariff Design Principles <ul><ul><li>Connection charge individualised </li></ul></ul><ul><ul><li>Network charges independent on the transaction, and based on the voltage level of connection </li></ul></ul><ul><ul><li>Network users bear the costs of voltage levels of their connection and upwards </li></ul></ul><ul><ul><li>Cost cascading between voltage levels using energy and demand balance </li></ul></ul><ul><ul><li>Tariff structure usually include demand and energy charges </li></ul></ul>Extra high voltage High voltage Medium voltage Low voltage
  17. 17. 3. Cost allocation Example: Distribution Pricing Optional Connection cost Depreciation Return on assets Operation and maintenance Purchased losses Transmission services Ancillary services Energy dependent costs Network 1 - 110 kV Network 2 - 35 kV Network 3 – 6 /10 kV Network 4 – 0,4 kV Network 1 Network 2 Network 3 Network 4 Metering / Billing Connection Connection Network costs Cost types Demand dependent costs Network 1 - 110 kV Network 2 - 35 kV Network 3 – 6 /10 kV Network 4 – 0,4 kV Metering / Billing Cost centres Customer tariffs Energy charge Demand charge Energy charge Energy charge Demand charge Energy charge Demand charge Use of network charge
  18. 18. 3. Cost allocation Peak load pricing 08/02/2010 <ul><li>Capacity need determined by peak demand </li></ul><ul><li>Peak capacities only utilised during a short period of time, excess capacities off-peak </li></ul><ul><li>Uniform prices do not encourage optimal capacity utilisation </li></ul><ul><li>To reflect higher demand, firm charges higher prices (equal to long-run marginal costs) during peak-load hours </li></ul><ul><li>To utilise capacities at lower demand, firm charges lower prices (equal to short-run marginal costs) during off-peak hours </li></ul><ul><li>Adjustment of marginal cost charges should be made to ensure cost recovery where needed </li></ul>Peak price Peak output Price Peak demand Short-run marginal cost Off-peak demand Long-run marginal cost Off-peak output Off-peak price Quantity Uniform-price
  19. 19. 3. Cost allocation Energy vs. demand (capacity) charge 08/02/2010 <ul><li>follows equity objectives </li></ul><ul><li>considers the fact that network is used also in off-peak periods </li></ul><ul><li>reflects the network planning process (peak demand relevant for network design, hence causality between demand and cost) </li></ul><ul><li>compatible with peak load pricing: system value higher in the peak demand periods </li></ul>Energy charge Demand (capacity) charge <ul><li>allocates sunk cost to energy quantities and dilute/distort signals </li></ul><ul><li>may affect negatively energy consumption and network usage </li></ul><ul><li>may undermine causality principles </li></ul><ul><li>complete payment liability in one (or small number of periods) time period </li></ul><ul><li>may discourage network usage </li></ul><ul><li>network is used not only in peak hours </li></ul><ul><li>may lead to substantial differences in payments in case of different load profiles </li></ul>Pros Cons Practical solution: energy / demand split <ul><li>Network costs are determined by the capacity needed to cover the system’s peak load as well as by the actual energy consumed by customers </li></ul><ul><li>Network tariffs can be structured as demand (capacity) or energy charge accordingly </li></ul>
  20. 20. 3. Cost allocation Energy vs. demand (capacity) charge 08/02/2010 Source: ETSO 2009 Energy and capacity related elements of transmission network charges in Europe in 2008
  21. 21. 3. Cost allocation Payment liability (generation – load split) 08/02/2010 <ul><li>Generators require a reliable transmission grid in order to feed in any electricity </li></ul><ul><li>Reliable transmission and distribution network services are also important for customers (load) </li></ul><ul><li>Network capacity and network usage depend on size and location of electricity injected by generators as well as electricity taken out by load </li></ul><ul><li>Network costs can either be charged to generators or to load or both (joint liability) </li></ul>Sharing of transmission network operator charges in Europe in 2008 Source: ETSO 2009
  22. 22. 4. International Experience 08/02/2010
  23. 23. Transmission Pricing – European Examples Germany: - Demand and energy charge by voltage levels - Payment liability : L Great Britain: - Locational charges (ICRP) - Payment liability : G&L Ukraine: - Single energy charge - Payment liability : L Norway: - Locational charges (SRMC) - Payment liability: G&L Spain: - Energy and demand charge - Payment liability : L Ireland: - Locational charges for G (reversed MW-miles) - Payment liability : G&L Greece: - Zonal charges - Payment liability : G&L
  24. 24. Distribution Pricing – European Examples Germany: - Demand and energy charge by voltage level - Payment liability : L Great Britain: - Standing, demand and energy charge - Based on LRMC (LRAIC) Portugal: - Demand and energy charge by voltage level - Payment liability: L Czech Republic: - Demand and energy charge by voltage level - Payment liability : L Austria: - Demand, energy and standing charge by voltage level - Time-of-use energy charge (peak / off-peak period) - Separate charge for network losses
  25. 25. End of Webinar 8 <ul><ul><ul><li>KEMA Consulting GmbH </li></ul></ul></ul><ul><ul><ul><li>Kurt-Schumacher-Str. 8, 53113 Bonn </li></ul></ul></ul><ul><ul><ul><li>Tel. +49 (228) 44 690 00 Fax +49 (228) 44 690 99 </li></ul></ul></ul><ul><ul><ul><li>Dr. Konstantin Petrov </li></ul></ul></ul><ul><ul><ul><li>Managing Consultant </li></ul></ul></ul><ul><ul><ul><li>Mobil +49 173 515 1946 E-mail: konstantin.petrov@kema.com </li></ul></ul></ul>