Competing on Price – Utilities Using Pricing as a Competitive AdvantagePosted to Guidehouse
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- Jan 31, 2020 7:00 pm GMT
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For decades, the utility industry has billed customers using rates based on well-intentioned commonly accepted principles (e.g., the Bonbright principles for rate design). During this time, many trends have developed that challenge this traditional approach:
- Deregulation and disaggregation of the value chain
- Incentive and outcome-based regulation
- Competitive offerings to customers based on cost savings off utility rates
- Shift toward higher fixed components of utility cost structures
- Transformation of pricing in other industries (unlimited plans and subscriptions)
Traditional rate design can create opportunities for competitors to offer customers services with lower costs, arbitraging the rate structure and raising the average costs for remaining utility customers. The fundamental issue is that the rates are based on the average costs for aggregated products and services and customer groups. Further, additional policy mandates applied to utilities encourage technology use, enable and fund social justice programs, and address reliability and safety issues inherent in the industry. These policies have created additional distortions in rate design that enable opportunities for some customers to gain, while the total cost is borne by all customers (e.g., including those customers that cannot participate in policy-mandated rate changes).
To remedy this situation, a new approach is needed; one that can be agreed on by regulators, policymakers, and utilities, and can continue to offer customer options and enable competition. The solution is easy: Eliminate the concept of rates and have utilities and all other stakeholders compete on price.
How can this approach be accomplished? Borrowing on the concepts of transparency, equity, sustainability, and access outlined in the Public Utilities Fortnightly article, “A Modern Rate Architecture for California's Future,” a new framework can be developed.
Herein referred to as the modern price design framework, we propose a new framework that establishes the following key components: product differentiation, customer segmentation, cost attribution, and incentive design. These components are linked and dependent on each other to facilitate a new pricing design structure.
Figure 1. Modern Price Design Framework
The first step is product differentiation, which requires the industry determines the products and services offered and identifies which of those offerings are standard and thus required versus those that are optional. Standard products and services can be offered by the utility or a third party but require certain credentials and requirements that are uniform to all suppliers. Optional offerings can be competitive and market-based. What options are offered, by whom, and at what price is at the discretion of the supplier and driven by the needs of the customer.
The next step is customer segmentation. Not all customers want the same products or level of services. The industry must accept that the traditional one-size-fits-all utility service is an antiquated and inefficient model. Customer segmentation allows for different pricing options based on how the customer wants to pay, not just the products they use.
Cost attribution follows product differentiation and customer segmentation. Understanding costs at the level of granularity needed for cost attribution is critical for not only utilities but also regulators and, ultimately, to achieve the goal of economic efficiency through market forces. By making known the costs of each product and service to targeted customer groups, utilities cannot game the market by setting certain prices below costs. Making these costs known to customers also ensures all costs for necessary services are covered and those services are accessible to all customers.
These first three steps feel familiar and consistent with most rate design principles. The flexibility and granularity of these steps is the necessary change.
The last step, incentive design, is perhaps the most critical. As noted, utilities are often tasked with implementing policy through rate design, restricting the utility’s options and often creating numerous opportunities for third-party entrants to arbitrage. This setup creates inefficiency and provides discounts to customers who can afford the time, energy, and financial resources (including credit) to participate in these options. As mentioned earlier, this system leaves remaining customers, who often can ill afford to take advantage of potential price cuts, pick up additional costs. Incentive design remedies this situation. Incentives can be positive, such as discounts or credits for change in behaviour or adoption of new technologies. Further, incentives can be additional or punitive charges, such as premiums for added services or fees for costly customer behaviour.
This last step is the most transformative, as the traditional rate approach buries and obfuscates incentives in the design and underlying analytics. By separating the incentives and making them clearer and more actionable, customers can make better decisions and regulators can see the response to their policies. Furthermore, coupling incentive design with product differentiation and customer segmentation leads to options targeted to specific customers and product offerings, enabling competition for customer choice while ensuring affordable access to standard services.
Following this new incentive price design framework will produce a modern pricing framework that results in utilities behaving more like competitive stakeholders in the value chain rather than protected monopolies or extinct establishments. By 2030, the term rate will likely be abolished from the industry lexicon and product pricing options will become the norm.
Utilities will then be open to creative pricing options such as subscriptions, premium pricing, and one-time payments. Subscriptions include a fixed charge price for a level of service, much like Netflix. It is a monthly payment for services, and customers have a choice about the subscription-level price based on the plan options they choose. For example, a customer could get a lower subscription payment if the customer employs energy efficiency measures, installs smart thermostats, or agrees to limitations of use during certain times of day or year.
Premium pricing requires the establishment of a base level of services for a base price with additional services added at premium rates or pay as you go. This structure is like current cable options and other series such as Amazon. Premium series could include access to a customer call center, billing and payment options (electronic versus paper billing), or payment for power during peak periods on peak days (e.g., peak day pricing).
Finally, one-time payments may become a key option, particularly for new customers. In this option, the customer pays for a lifetime of standard utility services in the price of a new home or in new connections (e.g., connection upgrades). As the industry encourages electrification and net-zero housing, this option offers customers a way of eliminating energy bills because the costs associated with on-demand energy and storage and access to the grid are paid for in the initial housing value and transferable with the house in subsequent sales.
None of these pricing options can come to full fruition unless the industry establishes a new pricing paradigm offered by the modern price design framework and embraces the modern rate architecture principles. Even without fully implementing all of the components of the new framework immediately, utilities can begin to be creative.
Consider, for example, the Pacific Gas and Electric Company’s new commercial electric vehicle rate. This rate offers customers access to low cost electricity during specified times of day, and customers pay a subscription rate based on connected load. This rate mimics phone and data plans and creates bill certainty and competitive pricing for electricity versus gasoline pricing. Further, and most important, the rate establishes a new, commercial EV customer class, allowing for accurate cost allocation to that class based on their costs (cost attribution), and enables the utility to offer a pricing option aligned with customer needs. This rate, recently approved, is a major step toward the implementation of the modern rate architecture and furthers progress toward utilities being able to compete on price.
In closing, a modern pricing framework is needed to fully enable competition. This framework must allow all market players to compete while ensuring all customers access to standard, necessary services. We propose that a framework that focuses on defining products, targeting customers, understanding costs, and designing prices that are understandable, actionable, and send clear signals is the future of rate design. Let’s eliminate the term rate from the industry’s lexicon and embrace a new customer-centric pricing paradigm that allows for regulatory processes to adapt and enable this new future.