Solutions to California’s Energy Crisis: Real-Time Pricing

byFrank Wolak

Chairman, Market Surveillance Committee

March 17, 2001

Real-time pricing for all customers as soon as possibleRequires real-time metering technologyCommercial and industrial consumers--large saving per customerResidential and small business--large savings in aggregate

All customers have opportunity to reduce energy bill if they respond to pricesNo need to consume less energy, could consume moreExample: Two periods, two prices: $10/MWh and $100/MWhConsumer purchase 1/2 MWh in each period, Total bill is $55Consumer shifts 1/4 MWh from high price to low price periodTotal bill becomes, $32.50

Suppose consumer is currently paying $20/MWhPay this consumer $15/month for taking on real-time price riskIf price-responsive, then bill is $17.50 = $32.50 - $15.00If not price-responsive, then bill is $40.00 = $55 - $15.00

Solutions to current problem at State Level

Real-time pricing is feasible for all large commercial and industrial customers by this summer

For all customers with peak demand above 200 KWState must act fast through an emergency orderCan set different monthly payments for taking of real-time price risk

Set payment for each type of customer to create potential for lower bill if customer is price responsiveResearch results from other markets can be very useful (UK experience described later in slides)

Real-time pricing creates win-win situationCalifornia taxpayers pay less for electricityCalifornia consumers pay less for electricity

Consider example from previous slideWithout real-time pricing, consumer pays $20 and California taxpayers pay $35 = $55 - $20 = Wholesale energy purchases - revenues collected from consumerWith real-time pricing, consumer pays $17.50 and California taxpayers pays $15 to consumer to take on real-time price risk

Solutions to current problem at State Level

Why real-time pricing makes sense?Safe to assume that retail revenues plus payments by State government must exceed wholesale purchase costs

Two groups pay for wholesale purchasesCalifornia taxpayersCalifornia ratepayersVirtually every California resident is member of both groups

Without real-time pricing, even with single State buyer there still no price elasticity in aggregate demand and high spot price remains

Increased tax revenues must be collected from California consumersNo way for taxpayer to avoid paying higher wholesale price for powerCalifornia taxpayers pay large blue box on next slide

With real-time pricing, all customers have opportunity to reduce their total payments and wholesale energy prices through there actions

California taxpayers pay smaller green box on next slideCalifornia consumers purchase less electricity

Solutions to current problem at State Level

Tax Revenue Payments

Real-Time Pricing versus Tax Revenue Financing

Price

Quantity

Supply

QID

Inelastic Demand

PID

PPR

Pretail

QPR

Price Responsive Demand

Why real-time pricing makes sense?Significant commitment to real-time pricing for this summer and next summer will allow to state to obtain lower prices in forward contract negotiations

Generators will recognize that effects shown on previous slide will operate to reduce spot prices and demand, particularly during high load periods

This implies that spot market prices will be lower this summer and next summer than they would be in the absence of significant real-time pricing

The lower spot prices that will result from a significant commitment by the state to real-time pricing will create a lower opportunity cost to a generator signing a forward contract for the next two years

Consequently, generators will be more likely to sign forward contracts for the next two years at lower prices than they would in the absence of a large commitment by the state to real-time pricing

This is major benefit to immediate and significant commitment by the state toreal-time pricing

Solutions to current problem at State Level

Real-Time Pricing not Time-of-Use Pricing

Time-of-use pricing does not create win-win situation for California taxpayers and consumers

Time-of-use pricing provides limited signals to consumers to respond to real-time wholesale prices

Time-of-use pricing creates the same basic incentives as current rate-freeze billing scheme

Time-of-use pricing may not yield lower average spot electricity prices or increase incentives for generators to sign low-priced forward contracts

Time-of-use pricing creates similar incentives to those from load-profile billing

Residential electricity pricing Load-profile billing• Can only measure total monthly consumption of electricity

• Representative load shape used to compute weighted-average energy price for month

• Monthly bill = (monthly consumption) x (monthly weighted-average energy price)

• Demand reduction when hourly energy price is $0/MWh leads to same monthly savings as same demand reduction when hourly price is $250/MWh.

• Want consumer to realize maximum benefit from reducing consumption when wholesale price is highest– Real-time pricing is the only way to guarantee this will occur

– With time-of-use pricing limited or no incentive for this to occur

Limited Benefits of Restructuring Without Involving Demand

• US has privately-owned, profit-maximizing firms facing cost-of-service price regulation or incentive regulation plan– Detailed prudence review of investment– Hard to argue there are large deviations from

minimum cost production– Vertically integrated ownership and centralized

dispatch should be able to improve on bid-based dispatch on true production cost basis

Markets use prices to allocate scarce resources

• Competitive market should be able to get by with lower level of capacity and serve same customers– This implies lower capacity costs for market at

large– If dispatch costs are close to the same, then

average price in competitive market should be less than average price in regulated market

• A necessary condition for this to occur is a sufficient number of price-responsive consumers

Optimal Capacity Choice Under Regulation versus Competition

Kreg >> Kcomp

Example--US Airline Industry

• Load Factors = (Seats Filled)/(Seats Total), – In regulated regime highest load factors

approximately 55% in 1976– Currently Load Factors are close to 73%

• This increased capacity utilization rate allows real average fare per passenger-mile to be significantly less than under regulated regime

• Regime works because of large number of sophisticated price-responsive consumers.

Real-time pricing contracts• All England and Wales retail customers have option to

purchase hourly consumption according to hourly pool price plus transmission charge

• Many large industrial customers purchase according to this pool price contract

• “Estimating the Customer-Level Demand for Electricity Under Real-Time Market Prices” Patrick and Wolak

• Estimate half-hourly price responsiveness of a sample of large industrial and commercial customers in England and Wales– Significant price response from all classes of industrial

customers--water suppliers, industrial process plants, retail stores

– Even with a small fraction of these customers bidding into demand side of pool, market power can be mitigated.

Market Power Problems withoutPrice-Responsive Demand

Price

Qd

Quantity

1 2 3 4 5

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76 8 109

Qd(p)