Cost reflective pricing: Not so simple in practice

Current trends in technology and consumer choices have resulted in changes to who is imposing the costs on networks and generators in the grid, and who is paying. We are in a transformation that, according to many, makes network tariff reform essential. So the Council of Australian Governments (COAG) and the Australian Energy Market Commission (AEMC) are keen to ensure that network charges are fair, sustainable and reward customers for efficient choices.

In 2014, the AEMC made a rule requiring regulated network companies to structure their prices to better reflect the consumption choices of individual consumers[i]. Under the new rule the desire was that network prices will reflect the costs of providing the electricity to consumers with different patterns of consumption over time[ii]. This means the users that are creating the costs on the system should pay for those costs – causer pays principle.

Cost reflective pricing is a widely held pricing principle based on the idea that the most efficient allocation of resources occurs when consumers pay the full cost of the goods that they consume.  While it sounds good in theory, it’s not so appealing or simple in practice.  Energy pricing policy requires judgements be made on where the economic efficiencies and the societal benefits intersect.  Exercising this judgement generates significant debate.

User pays and the ability to pay

The cost reflective pricing principle most often loses its appeal where it stands in opposition to the ability to pay principle. In practice this conflict explains why cost reflectivity in network pricing is such a difficult principle to implement.

Balancing societal access to an essential service is complex. The conventional wisdom is that cost reflective network tariffs unravel cross subsidies, and that cross subsidies are universally a bad thing. Genuinely cost reflective tariffs are very complex and go beyond demand and time of usage. Unravelling cross subsidies must be done carefully, considering the complexities, fairness and political acceptability of the proposals.

Retailers and consumer groups know that getting customers to opt-in to cost reflective (flexible) pricing in Victoria, where it currently exists, has proved largely futile. So in the absence of voluntary participation, the AEMC has created a compliance obligation for networks to implement cost reflective tariffs, albeit in the face of stiff consumer resistance. What the AEMC has done, as required by COAG, is to quietly give practical effect to assigning cost reflective tariffs to customers.

This approach of changing the rules up the supply chain and having the effect trickle down to end users through retailers, has now become the default for network tariff reform. What remains apparent is that in the absence of consumer support, customers and retailers have not been brought on the journey.

In New South Wales the journey has gotten tougher. Proposed tariff changes by the two Greater Metropolitan Sydney electricity distributors (Ausgrid and Endeavour Energy) will introduce new demand tariffs; tariffs that ratchet up to a new level each time a residence reaches a new maximum demand. This change is designed to provide incentives to consumers to curtail demand, relieving pressure on parts of the distribution system. Of course, it also implies some pain for those who do not respond.

According to the AEMC, these changes put consumers at the centre of future energy decision-making and gives them clearer choices. But for this to happen, the customer needs the information in time to respond.

Energy Consumers Australia’s Lynne Gallagher describes it as “being pulled over for speeding when you can only see the speedometer reading of the day before as you travel – you can’t see what is happening in real time”. This consumer concern is unsurprising. Products and services that enable customers to make real time of their energy consumption data and better monitor and manage their energy still do not have significant consumer uptake.

New technologies, old problems, new (and not so new) ideas

Network congestion is an old problem, it is also a localised problem. The application of time of use or demand tariffs over an entire network, as is proposed in the various tariff structure statements, will penalise customers in network locations where there is no congestion challenge, creating costs for these customers even when they are not contributing to the actual problem and providing them with no commensurate network benefits. These tariffs are not a new idea, and may lock in poorly designed tariffs that send the wrong investment signals[iii]. Developing an efficient, incentive-based network regulation framework is key, but to achieve this the framework should incentivise the use of spare network capacity where it exists. Underutilisation is also inefficient.

What might meaningful tariff reform look like? 

Tariff reform may require thinking differently about cost reflectivity and cross subsidy. In Canada, the Ontario Energy Board (OEB) is changing how distribution rates will be billed for residential customers.

Currently in the OEB, as in Australia, distribution rates are a blend of fixed and volumetric rates. Over the next three to seven years, distribution rates in the OEB will gradually change so that all residential customers will be billed an all-fixed monthly distribution charge. This change recognises that network costs are largely fixed, and that the customer contribution to those fixed costs could be allocated more equitably[iv].  This is also a mandatory tariff reassignment, which is the only way to keep network revenues whole. There is no opt out. And of course this will have an impact on customer bills. The change has been developed in consultation with the community.

The OEB's policy to move to fixed distribution rates for residential customers is in their assessment a fairer and more transparent way to recover the costs related to distribution[v].  In assessing the customer bill impact, the OEB has determined that most customers will not see a significant change in the distribution charge component of their bill - but it is a fact that customers who use very little electricity will see an increase on their bill, while customers who use a lot of electricity will see a decrease on their bill.

In a world with the costs of DER, EVs, the phase out of natural gas for heating, and the disturbance of people going off-grid[vi] - the OEB’s approach may signal part of the future for network pricing. It also gives an approach where networks and retailers can more easily collaborate to address distribution issues. Importantly, no customer is made unattractive as a proposition to a retailer by their network tariff assignment.

The OEB plan is not the only approach. Meaningful tariff reform could be targeted more locally to prevent inefficient underutilisation and address real congestion points with accuracy. This could include local tariff structures with options for demand response (rewards) and automated load management (technology), directed at appliances such as air conditioners, pool pumps, and hot water. Distributors could work in conjunction with retailers in providing a lower price to consumers in targeted areas who opt in to these programs. While more complex than the OEB plan, this would still be preferable to the mandatory distribution tariff assignment of demand or time of use tariffs. This is especially true where demand or time of use tariffs are introduced regardless of the local system necessity, either at the point of meter upgrade or by regulatory action.

Tariff structures with options at a localised level, in conjunction with or on behalf of distribution networks, would enable retailers to make a clearer and more compelling case for change and would likely resonate with consumers[vii]. 

We’ve been here before

Nationally network tariffs are in various stages of assessment for the upcoming reset and networks are feeling the pressure to address cost reflectivity, as they are required to do by the AEMC rule. We should be concerned that this may turn into more of a compliance activity and less of an efficiency one.

Developing an efficient, incentive-based network regulation framework is important to all who bear the costs of providing the network, ultimately end users. To achieve this, the framework should incentivise effective utilisation of network capacity, remembering that underutilised capacity is also economically inefficient. Under the changes, network tariffs are supposed to be designed to better signal the costs of providing the electricity to consumers with different patterns of consumption in advance.

Experience indicates that consumption patterns can represent a problem for efficient investment.  The air conditioning boom of the 1990s and the subsequent network upgrade costs to accommodate the higher peak demand they created are best avoided. The only thing we do not know is whether signalling the costs to consumers in advance via cost reflective network tariffs in the 90s, via a causer pays approach, would have prevented the network problems created by air conditioning or influenced how consumers use them.  The same might be said today for solar.

Networks or regulators might say that nothing stops a retailer from solving the problem of maximum demand or other cost reflective type network tariffs in the current suite of proposals for the customer. By solving, we assume this means shielding the consumer from the price signal. But that’s avoiding the issue; Poorly designed tariffs are like a car manufacturer (distribution network) insisting on supplying a car with a specification (provided by a regulator) that nobody wants, and suggesting the dealership (retailer) is the reason it doesn’t sell. So we all end up driving a Trabant[viii].

As dealing with passive solar exports has shown, where congestion or other network inefficiencies is a problem, there are alternative and sometimes better tools that are technology based that exist to provide more precise solutions for local problems, such as technical standards for inverters.

And as Ontario has shown, there is absolutely more than one way to look at cross subsidy and cost reflectivity than we are seeing proposed under the current rules. It just depends on where we realistically judge the economic efficiencies and the societal benefits to intersect.

[i] AEMC News Release, New Rules for Cost Reflective Network Prices, December 2014. https://www.aemc.gov.au/news-centre/media-releases/new-rules-for-cost-reflective-network-prices

[ii] Ibid

[iii] PIAC Response to the AEMC’s approach paper on the Electricity Network Economic Regulatory Framework Review February 2017, p 4 https://www.aemc.gov.au/sites/default/files/content/4a3bd520-2894-495e-a01e-bf69ee38e346/MarketReview-Submission-EPR0050-Public-Interest-Advocacy-Centre-1702.pdf

[iv] Social Efficiency occurs when goods and services are optimally distributed within an economy, also taking externalities into account.  In most cases, this requires some form of taxation to achieve, and who gets taxed is a vexing question.  Arguably in the OEB case the tax has shifted from higher users to lower users. This does not necessarily reflect a shift from the disadvantaged to the advantaged, as studies have shown that hardship customers generally have higher levels of consumption than either concession card holders or average consumers.  See http://agl2017.reportonline.com.au/sites/agl2017.reportonline.com.au/files/social_economic_inclusion_report.pdf

[v] Moving to fixed Distribution Rates, Hydro One, https://www.hydroone.com/rates-and-billing/rates-and-charges/fixed-distribution-rates

[vi] Blackout - how is energy-rich Australia running out of electricity? Going off grid. Matthew Warren. Affirm Press 2019.

[vii] SAPN’s Flexible Load Strategy and Energex air conditioning rewards are both innovative programs to help manage peak demand.  Whilst they could be improved to address both energy and network peak where these are not coincidental, they represent a good starting point for discussion.

[viii] https://en.wikipedia.org/wiki/Trabant