Industry 101 | Electricity Market Dynamics: Retail Market
This post is part of our Industry 101 Series, an ongoing campaign to provide a foundation of knowledge about our unique industry. To learn more about this campaign, please click here.
3.1 RETAIL MARKET
Electricity goes through a complex delivery system before the end user is able to consume it. Traditionally, the U.S. uses a vertically integrated monopoly where the utility company is responsible for all aspects of the energy services, from generation to the electric system operations. This utility model could be an investor-owned utility, municipal and public utility district, or a rural electric co-op. Because of the lack of competition, government imposed cost regulations exist to protect the end user. However, the electric marketplace is also evolving, and the once dominating business model of government regulated monopolies is shifting toward a business model that fosters competition. This change will allow for cheaper, more reliable service. It also encourages innovation in the marketplace. Since the market is changing, the set of rules defined by regulators must change as well in order to adapt to this new competitive market.
3.1.1 INDUSTRIAL AND COMMERCIAL PRICING IN DEREGULATED MARKETS
In contrast to the regulated market where prices are set by regulations, market-based electricity prices fluctuate based on the perception of the supply and demand. These prices are determined in two ways. A common place for short-term transaction is the Intercontinental Exchange (ICE). ICE was founded to facilitate the purchase and sale of energy commodities. For long-term transactions, bilateral trading is a common method to buy and sell energy. Under mutually agreeable terms for a certain period of time, an agreement is created between the willing buyer and willing seller to exchange electricity, rights to generate, etc. These types of arrangements are necessary to create a stable energy market essential to perform long-term planning and optimal investment decisions. A competitive market requires price transparency, which means that all the parties involved have access to the information about the market price at a specific location. To ensure the integrity of these indexes, the Federal Energy Regulatory Commission (FERC) monitors the market and penalizes any entity that manipulates it.
Like any marketplace, business activities are dictated by the end user; the utility is no different. To be better served, the utility places the end user into different customer classes.
The main categories include residential, commercial, and industrial. Customers are grouped into categories based on their individual consumption, which will be similar in any one group. A similar rate class which is the price per Kilowatt hours will be applied to each customer category. So why does the unit price differ greatly based on the customer category? Let’s look at this chart. Notice the consumption of the different customer classes is fairly similar. However, the number of customers per category is dramatically different. As a result, we can conclude that commercial customers consume more than residential customers, and the industrial customers consume the highest amount of energy, which explains why utilities provide electricity at a cheaper rate for higher energy consumers. Since electricity cannot easily be stored, the utilities biggest challenge is to meet customers’ demand throughout the day. It is critical for utilities to understand its customers’ usage patterns to optimize its electric delivery system. In a regulated market, the price of energy is usually stable since they are set by regulations. However, many markets are becoming deregulated. In such markets, the pricing is dictated by the perception of supply and demand.
As mentioned earlier, the vertically integrated monopoly allows the utility to be in control of all the sectors. In a deregulated market, the sectors that could be open to competition are generation, wholesale trading, and retail sales. Retail sales refers to the transaction between the energy supplier and the end user. Since the retail market is open to competition, customers may choose between the main energy supplier and different competitive suppliers versus a single provider in a regulated market. In a competitive retail market, energy retailers could offer alternative energy sources such as renewable energies, and programs to incentivize customers to switch to more energy efficient supplies. These opportunities allow for customer freedom of choice based on their individual needs and preferences. The retail markets are regulated at the state level, and the public utility commission (PUC) is responsible for regulating the distribution cost, the rate of return for the use, and maintenance of the distribution system. In addition, the PUC is responsible for approving any alternative energy supplier before they are allowed to sell their generated energy.
3.1.2 RATE CASE PROCESS AND PUC’S ROLE
The utility industry is a good example of a natural monopoly. A large investment is required to produce a unit of output, and larger operations tend to decrease the price per unit. Historically, only few were able to survive the market, or even enter it, which led to an energy industry controlled by monopolies. Regulations were put in place in order to protect consumers from unfair prices. The public utility commission (PUC) was created to regulate the rates and services provided by the utilities. Its main goal is minimizing the cost for its customers, ensuring reliable service, and encouraging innovation within the services provided.
Setting the rates the utility is allowed to charge the end-user requires going through a regulatory process called rate case. By law, this process must be completed within 275 days. The formal process starts with the initial filing, which is usually initiated by a regulated entity. This document describes the reason behind the requested increase. A member of the PUC staff reviews the submitted document and investigates the facts. As part of the investigation, the staff assesses the quality of service provided, reviews the plant infrastructure, the taken safety measures, and the financial records. Following his investigation, the staff files a report that includes his feedback on the rate case. Within thirty days of receiving the rate case judgement, the filing entity is able to file for an objection against the staff’s report if they disagree with the outcome. The commission would then schedule hearings for the case. Its main purpose is to provide all the evidence to support all the parties’ positions. Supporting evidence would include testimonies by witnesses and written documents. After each testimony, the interested parties have the opportunity to argue their case. At the end of the hearing, the administrative law judge or the commissioner drafts an educated decision based on all the facts presented during the hearing. This document is not yet final, and the commission is responsible for making that final decision. In the real world, changes are made to the draft several times based on the different feedback from the commission. The draft decision becomes the final decision once the majority of the commissioners vote to support it. It is important to note that even a final decision could be reviewed by the commission that issued it. If any of the involved parties believe that the decision made does not align with the facts, a request for a review is made either through a petition or a request for a rehearing. The final component of the regulator process is the creation of tariffs. These are a set of rules that define the relationship between the utilities and their customers. These documents are written by the regulated entities and approved by the PUC. They include the terms of services and rates based on each customer class.
3.1.3 DEMAND RESPONSE PROGRAM
Traditionally in the utility market, energy supply is built based on the forecasted demand. Factors such as demographics, customer classes, and the business activities come into play in order to predict the supply and demand. However, it is important to mention that the key driver to increase capacity is to meet the customers’ peak demand. Even though peak demand occurs for only a few hours a day, the utility must meet the market’s peak demand as electricity outages are unacceptable. As part of the movement toward a deregulated market, competition is pushing energy suppliers to find innovative ways to lower the cost. Demand response programs where introduced by utilities to better manage the supply and demand. These programs allow customers to have an active role in the electric grid operation by shifting their energy consumption to a time of the day where the rates are lower.
Because supply and demand change drastically over time, the energy price is very volatile. By lowering the market peak demand, the utility is able to reduce the cost of energy, which in return benefits the end user. Based on the utility’s offerings, customers could participate in different demand response programs. The most popular programs are time-based rate programs:
- Time-of-Use Pricing: Typically applies a different rate over a few hour blocks. An example would be a higher rate during peak hours.
- Real-Time Pricing: Usually a supply rate by the hour. Customers subscribed to this program pay the corresponding wholesale hourly market price of electricity. Usually the utility company provides the hourly rate the previous day to allow its customers to determine the best time to use major appliances such as the dishwasher, washer, and dryer.
- Variable-Peak Pricing: A hybrid of time-of-use and real-time pricing. The different periods for pricing are defined in advance. For example, on peak is defined as six hours for summer weekday afternoons, and off peak is all other hours in the summer months. The price established for the on peak period varies by utility and market conditions.
- Critical-Peak Pricing: When utilities observe or anticipate high wholesale market prices or power system emergency conditions, they may call critical events during a specified time period (e.g. 3 pm – 6 pm on a hot summer weekday), the price for electricity during these time periods is substantially raised. Two variants of this type of rate design exist: in one, the time and duration of the price increase are predetermined when events are identified, and in the other, the time and duration of the price increase may vary based on the electric grid’s need to have loads reduced.
- Critical-Peak Rebates: When utilities observe or anticipate high wholesale market prices or power system emergency conditions, they may identify critical events during pre-specified time periods, e.g. 3 pm – 6 pm on summer weekday afternoons. The price for electricity during these time periods remains the same, but the customer is refunded at a single, predetermined value for any reduction in consumption relative to what the utility deemed the customer was expected to consume.
Other programs include:
- Direct-Load Program: HVAC systems account for a big portion of energy consumption. This type of program allows the utilities to turn on and off certain appliances during peak demand using remote appliance control. Load management saves money for both the utilities and its customers by reducing the energy generation and limiting the amount of energy purchased on the open market during peak periods.
We are witnessing a major shift in the energy industry where certain aspects of the vertically integrated monopoly are becoming obsolete. The energy industry is shifting from centralized electric generation to a more distributed system, where more end users are able to generate their own electricity.
If you enjoyed this article, click here to start from the beginning of our Industry 101 Series.
Or to continue your journey, click here to access the next installment of our Industry 101 guide.
Here is a list of relevant reading material our expert identified as sources for additional information: