California
Experiments with New Ways of Pricing Electricity
By Ahmad Faruqui, PhD
Danville, California
In 1998, California restructured
its power market, hoping to reduce its electricity
prices that were 50 percent higher than the US
average. The administration of then Governor Pete
Wilson wished to promote job creation in the state,
by reversing the flight of industry to other states.
The state had been hit hard by the recession of
1991 and the cutbacks in defense spending that
had ensued following the end of the Gulf War.
Much to everyone’s surprise, the restructuring
experiment ended in failure just two years later.
As wholesale prices shot through the roof, the
power market experienced a “melt down.”
Blackouts were frequent. Since retail rates had
been frozen under the restructuring plan, the
investor-owned utilities would lose money every
month, since they had been forced into the unenviable
position of “buying high and selling low.”
This ultimately impaired their credit worthiness
and forced Governor Gray Davis into the power
business.
The state signed long-term contracts with unregulated
power producers. While this eliminated the near
term threat of blackouts, it proved to be an expensive
mistake as it converted California’s long-standing
budget surplus into a large deficit. Not too long
afterwards, Arnold Schwarzenegger replaced Gray
Davis as the state’s governor in a recall
election, reflecting voter anger at Davis.
The failure of California’s market restructuring
program dealt a body blow to power market restructuring
efforts worldwide. Seeking to contain the problem,
the World Bank, which had long been a proponent
of introducing competition into power markets
by restructuring them, issued a policy paper stating
that the problem lay not with market restructuring
but with California’s specific market design.
This design, among other failings, had disconnected
the demand side of the market from the supply
side by eliminating pricing flexibility in retail
markets. In other words, there was no “demand
response” in the markets, giving a free
rein to unregulated power producers to charge
high prices.
Five years ago this month, California experienced
unusually hot weather conditions. This happened
at a time of diminished hydro supplies in the
Pacific Northwest, which provided a quarter of
California’s electricity. Both events coincided
with a surge in the price of natural gas, which
fueled three quarters of California’s power
plants, creating what was appropriately termed
a “perfect storm” in the electricity
market. Against this backdrop, wholesale prices
rose ten fold and stayed high for several months.
Electricity costs are highest during hot summer
afternoons when central air conditioners raised
power demand to peak levels. But even were it
legally feasible, there was no way to send retail
electricity customers higher prices during those
times, since traditional electric meters cannot
measure electricity consumption by time of day.
Ironically, the digital revolution that was spawned
in California’s Silicon Valley bypassed
these meters, which continued to embody 50-year
old technology. Peak load pricing would have given
customers an incentive to lower loads during peak
times that, in turn, would have reduced prices
in wholesale markets. However, peak load pricing
requires the installation of digital interval
meters. By refusing to change its meters, the
state ended up paying several times more for procuring
expensive power.
In the aftermath of the crisis, the state was
forced to raise retail rates for most customers,
the very opposite of the intent of restructuring.
Large residential customers ended up seeing their
electric bills rise by upwards of 30 percent.
However, since they had no economic incentive
to use less power during peak times, the state
funded a very expensive advertising program called
“Flex Your Power” that asked them
to voluntarily reduce power demand during peak
times. In addition, through emergency legislation,
it decided to spend $34 million on the installation
of digital meters on all large commercial and
industrial customers.
California also began to assess the potential
for reducing peak loads in smaller commercial
and industrial customers and, most notably, in
residential customers. Since it was not clear
whether such customers would be able to reduce
peak loads, it initiated a scientifically-designed
social experiment with some 2,500 customers.
The experiment ran from July 2003 and December
2004 and its report (which I co-authored) has
been released recently. It quantifies the impact
of several new rates, including a critical-peak
pricing (CPP) rate. The CPP rate, while featuring
the same average price annually as the standard
rate, has higher prices during the peak period
and lower prices during the off-peak period. The
peak period runs from 2 to 7 in the afternoon
on non-holiday weekdays and features prices that
are about twice as high as the standard rate.
All other hours are off-peak and feature prices
that are lower than the standard rate. On 15 critical
days, the peak price was raised so it was five
times higher than the standard rate, to simulate
market conditions that might be encountered during
a crisis.
The study found that residential customers in
California reduced peak period energy use by about
14 percent in response to a CPP rate. Impacts
on peak-period energy use on critical days did
not differ significantly across the summers of
2003 and 2004. However, impacts were higher during
the hot summer months of July through September
than during the milder summer months of May, June
and October. Winter impacts were lower than summer
impacts. Impacts were lower during the milder
winter months of November, March and April than
during the colder months of December, January
and February.
Prior to the experiment, some experts had argued
that there would be a degradation of demand response
if multiple critical days were called in a row.
The experimental results showed that this did
not occur. There was also a question about whether
technologies such as smart thermostats (that automatically
raise the temperature setting when prices rise)
enhanced impacts. The experiment found this was
indeed the case. Reductions in peak loads exceeded
25 percent for customers that were given enabling
technology.
These new experimental results are being used
by California’s three investor-owned utilities
to develop business cases for advanced metering
infrastructure that is estimated to cost several
billion dollars for their 10 million residential
customers. The California Public Utilities Commission
is in the process of reviewing the business cases
and is expected to announce a final decision later
in the year.
Consistent with the state’s reputation as
a global bellwether, California’s pricing
experiment and the utility business cases are
being studied intently around the world. So, while
its grand experiment with market restructuring
did not succeed, the Golden State’s well-designed
experiment with electricity pricing is on track
for success.
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