ELECTRICITY TARIFFS IN A LOW CARBON WORLD

 

We can start from a few basic principles and realities.

 

1.     Spot markets as conceived in the UK are increasingly irrelevant and/or dysfunctional. Originally conceived to replicate the optimisation of the merit order of fossil plant, and designed by the operators of such plant, they provided price signals consistent with efficient operation of an existing collection of generating plant. The provision of signals for inducing the right quantities and types of investment were always more problematic and for some time spot markets have increasingly been seen as wholly inadequate for this purpose. However we now need to recognise that with low carbon systems based around renewables, nuclear and storage, they will increasingly be irrelevant even in the first function, that of price signals that result in efficient least cost operations.

 

2.     What should really matter to us is not pricing structures in the wholesale market per se –  more or less a legacy structure of institutional arrangements in need of serious reform - but the nature of the tariffs that get passed through to final consumers. We should try to follow the general economic principle that the structure of tariffs needs to reflect the structure of costs. Failure to do this almost invariably results in major economic distortions that come back to bite us, through adverse selection and other unintended incentives and consequences. Current and recent institutional and structures and regulatory approaches have not encouraged more cost reflective tariffs.

 

3.     Reliability planning is fundamental, particularly as electricity expands into heating and transport (EVs), where the security/reliability requirements are very different from those of “traditional” load. The old VOLL approach is no longer appropriate since we really need very different types and definitions of reliability in the new world. Addressing reliability questions, in terms of what we are prepared to pay for, is essential.

 

4.     At least for domestic and smaller consumers, politically the most important category, a very high proportion of costs rests in the provision and operation of transmission and distribution. These are network costs which are essentially fixed costs that do not vary much (on a long term basis) with the volume of throughput. These are however recovered, typically, by averaging over kWh supplied. This method is widely accepted as “fair” and equitable, but will inevitably produce some major distortions. Other approaches are possible which are more economically efficient and can do a better job on redistribution objectives. 

 

5.     Metering, communications, control and information technologies allow for a range of feasible tariff options that would have been unthinkable a few decades ago. These include supplier managed loads, choice over reliability standards, and charging by type of use, as well as more familiar ToD pricing and load management techniques. These are of much greater significance in a low carbon world when there is less flexibility in generation and therefore there has to be more flexibility in either consumption or storage.

 

6.     There have been particular concerns expressed that prices can be set by, for example, very high spot prices dictated by the marginal (gas) plant when gas prices are high, even though most of the power may be coming from low cost renewables. The analogous situations in traditional “vertically integrated” power systems arise when incremental growth is met through different generation technologies, and it can work both ways. For example load growth in some countries can exhaust cheap hydro, and utilities, if they can price at long run incremental  cost (LRMC), can then enjoy a potentially large economic rent from their legacy plant. Legacy costs or surpluses (as an offset) can of course be put with other fixed costs if it is decreed that they have to be recovered from consumers.

 

7.     Economic efficiency and the requirement for adequate revenue generation are clearly not the only considerations. Political acceptability and distributional issues are also key. There are no trivially easy solutions but there is a lot that can be done to improve matters in the future.

 

8.     My idealised solutions rest heavily on technical  assumptions about metering, communications and control systems, but might include some combination and selection from the following:

 

·      Recovery of far more of fixed cost through other “distributional” means, eg via linkin standing charges to property values (cf water), more use of rising block tariffs, and type of use tariffs. 

·      In addition to the above means, price inelastic EV charging might legitimately be expected, as a premium use, to carry a higher burden of infrastructure cost than price elastic and politically sensitive heating load, where we need low unit rates to encourage a switch to heat pumps.

·      Recognition that it is really only the “traditional” loads that need the instantaneous supply response that underlies the VOLL approach, and also dominates conventional definitions of reliability. We need different conceptions and definitions of supply reliability especially in systems that rely on storage. 

·      Consumers will place different values on reliability depending on the application, and this needs to be reflected in reliability planning and in tariffs.

·      Consumer options to designate certain uses as “supplier managed”, with an appropriate tariff incentive for a lower unit rate.

·      Differentiated reliability standards for different uses, with selected uses (eg lights, TV, computer) always the most reliable; default to this standard for less vital services available at a premium.

·      Various methods for reflecting periods of “system stress” into tariffs - eg the French “red light” approach.

·      Continued development of possible time of day or seasonal pricing.