Electricity Markets Regulation - Lesson 8 - Pricing

Experience you can trust.http://www.leonardo-energy.org/training-module-electricity-market-regulation-final-session-8

Training on Regulation

A webinar for the European Copper Institute

Webinar 8: Electricity PricingDr. Konstantin Petrov / Dr. Daniel Grote

9.2.2010

http://www.leonardo-energy.org/training-module-electricity-market-regulation-final-session-8

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Agenda

b) Marginal cost pricing a) Average cost pricing

2. General pricing models

3. Cost allocation issue

1. Pricing principles

4. International Examples


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1. Pricing Principles

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1. Pricing principlesAllocative efficiency and cost recovery

Allocative efficiency Efficient distribution of productive resources among alternative uses so as to produce

the optimal mix of output

An efficient pricing should signal to users the marginal costs that they impose on the

regulated company

Cost recovery Regulated companies should be able recover their reasonable O&M costs and capital

costs (including an adequate rate of return) through electricity tariffs

A lack of adequate revenues may endanger financial viability, discourage investments

and cause reduction of quality of supply

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1. Pricing principlesFurther principles

Efficient Regulation– Pricing methodology should encourage efficient operation by regulated service

provider

– Minimise costs of service provider of complying with regulation

– Minimise costs to regulator of administering regulation Transparency and Simplicity

– Regulated charges should be understandable and transparent

– Transparency encourage general acceptance by users and the general public

– Clear and explicit pricing rules reduce administrative burden and risks of potential

disputes Non-Discrimination

– Level playing field for all service users

– Treating all users equally irrespective of size, ownership or other factors

– all users face same methodology for calculating charges (not necessarily same level)

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1. Pricing principlesFurther principles

Social Affordability and Political Acceptance– Not a normative economic principle but often highly important in the practice

– 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

– Reasons for such distortions may be social affordability (support to low-income

consumers), but also political populism or pre-election campaigns

– 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) Macroeconomic Constraints

– Inflation control, GDP growth requirement, unemployment minimisation etc. may also

hamper implementation of cost reflective pricing models

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2. General Pricing Models

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2. General pricing modelsPricing of unregulated (natural) monopoly

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Costs and Revenue

Quantity

Demand

long-run average cost

Marginal revenue

Marginal cost

Unregulated monopoly

price

Unregulated monopoly

output

profit of unregulatedmonopoly

Unregulated monopoly– Economies of scale, economies of scope,

high initial (sunk) costs, high fixed costs (e.g. transmission, distribution)

– Single firm can produce output at lower per-unit cost than two or more firms

– Price is affected by the output of the company – If unregulated, monopoly firm will charge a

price where marginal revenue equal marginal cost

– Company achieves maximum profit – Output will be lower and customers will be

charged higher prices than under conditions of perfect competition allocative inefficiency

– Prices above marginal cost and welfare loss– Consumers forced to consume more costly

substitutes or less useful products

welfare loss of unregulated monopoly


2. General pricing modelsMarginal cost pricing

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– Prices are set equal to marginal costs by the regulator, as would be achieved by the market under perfect competition allocative efficiency

– Marginal costs measure the additional (incremental) cost incurred to transmit, distribute, generate or supply one additional kW or kWh

– In natural monopolies with large economies of scale marginal cost pricing results in a financial loss for the firm

– Financial loss may be covered using several schemes: budget subsidies, fix tariff component, tariff upscale keeping marginal cost proportions, Ramsey-Boiteux pricing

Costs and Revenue

Quantity

Demand


Marginal revenue

Marginal cost

Marginal cost output

Marginal cost price

financial loss under marginal

cost pricing

Marginal cost pricing


2. General pricing modelsAverage cost pricing

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– 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)

– Cost includes also the allowed return to of the company’s investors

– Average costs allocate the total costs of transmission or distribution to the total units (energy or demand) transmitted or distributed

Costs and Revenue

Quantity

Demand


Marginal revenue

Marginal cost

Average cost pricing

Average cost price

Average cost

output

no economic

profit

welfare loss under AC pricing


2. General pricing modelsMarginal Cost (MC) pricing vs. Average Cost (AC) pricing

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Marginal Cost Pricing Average Cost PricingAllocative Efficiency High Relatively low (not optimal), size of in-

efficiencies depend on elasticity of demand

Cost RecoveryCompany 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 modellingUsually used with energy and demand charges differentiated by voltage level


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3. Cost Allocation

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3. Cost allocationTariff design issues

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Possible levels of differentiation of tariffs

Time-of-useFixed 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 serviceGeography

Household, commercial, industrial,…

Type of customer


3. Cost allocationLocational signals (transmission networks and energy markets)

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– Uniform prices for the whole transmission or differentiation by voltage levels

– Examples: applied at transmission infrastructure level Germany, France, Spain, Netherlands

– Geographical price differentiation and establishment of pricing zone

– The price differences are driven by congestion, marginal transmission losses and generation prices

– Examples: applied for transmission infrastructure (UK, Australia) and energy market (NordPool)

– Market clearing prices calculated for every node of the transmission network, locational marginal pricing

– The price differences are driven by congestion, marginal transmission losses and generation prices

– Examples: applied for energy market PJM, New York, New England, New Zealand

Postage Stamps Zonal prices Nodal prices


3. Cost allocationLocational signals

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– Predictable/Stable

– Simple to calculate

– Cost-reflectivity distorted

– Distorted economic signals for efficient network usage

– Compromise between uniform and nodal prices

– Efficiency incentives depend on the specific details of the regime

– Provide incentives for

efficient usage of the network

investment and location of new generation / consumers

– Can be volatile, difficult to predict

– Complex calculation

Uniform prices Zonal prices Nodal prices


– Power generation and power consumption take place on all voltage levels– Large power plants feed-in at (extra) high voltage, large industrial plants take out at (extra) high voltage– 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– How to allocate network costs among network users of different voltage levels?

3. Cost allocationCost allocation among voltage levels

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Typical Tariff Design Principles

– Connection charge individualised– Network charges independent on the

transaction, and based on the voltage level of connection

– Network users bear the costs of voltage levels of their connection and upwards

– Cost cascading between voltage levels using energy and demand balance

– Tariff structure usually include demand and energy charges

Extra high voltage

High voltage

Medium voltage

Low voltage


3. Cost allocation

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

Demanddependent 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

Example: Distribution Pricing


3. Cost allocationPeak load pricing

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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

– Capacity need determined by peak demand

– Peak capacities only utilised during a short period of time, excess capacities off-peak

– Uniform prices do not encourage optimal capacity utilisation

– To reflect higher demand, firm charges higher prices (equal to long-run marginal costs) during peak-load hours

– To utilise capacities at lower demand, firm charges lower prices (equal to short-run marginal costs) during off-peak hours

– Adjustment of marginal cost charges should be made to ensure cost recovery where needed


3. Cost allocationEnergy vs. demand (capacity) charge

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– follows equity objectives – considers the fact that network is used also

in off-peak periods

– reflects the network planning process (peak demand relevant for network design, hence causality between demand and cost)

– compatible with peak load pricing: system value higher in the peak demand periods

Energy chargeDemand (capacity) charge

– allocates sunk cost to energy quantities and dilute/distort signals

– may affect negatively energy consumption and network usage

– may undermine causality principles

– complete payment liability in one (or small number of periods) time period

– may discourage network usage – network is used not only in peak hours– may lead to substantial differences in

payments in case of different load profiles

Pros

Cons

Practical solution: energy / demand split

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

Network tariffs can be structured as demand (capacity) or energy charge accordingly


3. Cost allocationEnergy vs. demand (capacity) charge

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Source: ETSO 2009

Energy and capacity related elements of transmission network charges in Europe in 2008


3. Cost allocationPayment liability (generation – load split)

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Generators require a reliable transmission grid in order to feed in any electricity Reliable transmission and distribution network services are also important for customers

(load) Network capacity and network usage depend on size and location of electricity injected by

generators as well as electricity taken out by load Network costs can either be charged to generators or to load or both (joint liability)

Sharing of transmission network operator charges in Europe in 2008

Source: ETSO 2009


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4. International Experience

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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


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

Experience you can trust.http://www.leonardo-energy.org/training-module-electricity-market-regulation-final-session-8

End of Webinar 8

KEMA Consulting GmbHKurt-Schumacher-Str. 8, 53113 BonnTel. +49 (228) 44 690 00Fax +49 (228) 44 690 99

Dr. Konstantin PetrovManaging ConsultantMobil +49 173 515 1946 E-mail: [email protected]

Electricity Markets Regulation - Lesson 8 - Pricing

Technology

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