September 2008

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Ahmad FaruquiEMAIL INTERVIEW  Ahmad Faruqui & Ken Sinclair

Ahmad Faruqui, Ph. D.
The Brattle Group

Dr. Faruqui is one of the nation’s leading experts on the design and evaluation of innovative pricing, demand response, and energy efficiency programs. He has helped design, implement, monitor and evaluate innovative rates throughout the United States, Canada, Asia and the Middle East and was one of the architects and evaluators of California’s award-winning dynamic pricing pilot. Additionally, he has helped evaluate new market designs for improving economic efficiency and in both regulated and competitive settings. He has also helped develop new products that harness the commercial opportunities created by these market designs. He has experience in developing and evaluating a variety of new products, including pricing and non-pricing based ones, to promote demand response. He has also worked with clients in forecasting energy consumption, peak demand and hourly load profiles.  During the past two decades, he has consulted with more than 50 electric and gas utilities, research organizations, government agencies, trade associations, law firms and the World Bank.

Dynamic Pricing

Dynamic Pricing minimizes the use of expensive peaking capacity which sits idle most of the time but whose costs have to be recovered from customers year round.

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Sinclair:  What is Dynamic Pricing?

Faruqui: It is a method of pricing electricity that is both more efficient and equitable than the existing tariff. Dynamic Pricing minimizes the use of expensive peaking capacity which sits idle most of the time but whose costs have to be recovered from customers year round. Just consider this fact: for the typical electric utility, upwards of ten percent of the system peak load resides in just one percent of the hours of the year. For some utilities in the New England area, the figure is as high as eighteen percent. Dynamic pricing also eliminates subsidies that exist between customers who contribute heavily to peak load and those who don’t.

Sinclair:  If dynamic pricing is such a good thing, what is holding it back?

Faruqui: The biggest single barrier is the existing tariff, which averages costs across customers and hours and fully hedges the suppliers against price and volume risk. Regulators and utilities are reluctant to touch it since it has been around for a hundred years. Thus we have this tragedy where customers who are willing to buy fully unhedged (real time pricing) or partially unhedged (critical peak pricing) products end up paying more for power than they want to pay. What we need today is a choice of pricing products, each with varying amounts of hedging built into it. It is possible to get this choice today (or in the near future) because the whole nation is moving to upgrade its metering infrastructure.

Sinclair:  What is the status of dynamic pricing?

Faruqui: It's coming since it has become very expensive to build new power plants and the associated transmission and distribution infrastructure. Fuel costs are rising as well. A few years ago, experts estimated the cost of new peaking capacity at $52/kW-year. The current estimate is north of a hundred dollars with some pegging it at $150/kW-year. Just a five percent drop in North American peak demand (estimated by NERC this summer at 836,000 MW) carries a present value of $77 billion at a capacity value of $104/kW-year. Thus, more and more utilities and commissions are investigating its potential benefits. The state of California has recently issued a decision that will make dynamic pricing the “default” pricing mechanism in a couple of years. It is a landmark decision that is being studied throughout the length and breadth of the North American continent.

Sinclair:  Will customers respond to dynamic pricing?

Faruqui: Yes, but not every customer will respond. Experiments carried out across the globe show that a sufficient number will respond to make it worthwhile. We have surveyed the evidence from the most recent 15 pricing experiments in Australia, Canada, France and the US and found that you can expect peak demand during the top one percent of the hours to drop by 10-15 percent even without enabling technologies such as price-sensitive thermostats and appliances. And if you add enabling technologies to the equation, you can expect to see demand drop by twice as much. Details are available at the Social Sciences Research Network1.

Sinclair:  But are these experimental results valid? Don’t they suffer from self-selection bias?

Faruqui: Most of the experiments are of high quality. Some, like California's Statewide Pricing Pilot, were carried out under very stringent oversight by state-mandated working groups. The participants were chosen randomly and their usage profiles were compared with those of randomly chosen control groups before dynamic prices were sent out to make sure that the “treatment” and control groups were balanced. In other words, the generally accepted principles of experimental design were followed. Thus, the results are valid and robust. It would be unfortunate if they were not used to inform regulatory policy about dynamic pricing and advanced metering infrastructure.

Sinclair:  OK, if we accept them as valid in the short term, how do we know that demand response from dynamic pricing will persist in the long run?

Faruqui: In the long run, we should expect to see even better results, as customers make use of enabling technologies to automate response. As more customers use the enabling technologies, their cost will come down and more customers will use them. It is possible to imagine a future where every building and appliance will have these features built into it. Just about all these technologies are based on solid state electronics so I am quite optimistic that their costs will decline in line with Moore’s Law. In the past few years alone, we have seen the cost of smart thermostats for residential applications come down from $300 to $100.

Reliable Controls Sinclair:  Some consumer advocates are concerned that dynamic prices will simply make prices more volatile without offering any commensurate benefits. How do you answer that criticism?

Faruqui:  Of course, if all that dynamic prices did was to make your prices more volatile, you would have to be a remarkable individual to want them. That is not how things work. In most cases, dynamic prices will be revenue neutral to the standard tariff. Thus, half of the customer load will immediately benefit by transferring over to dynamic pricing. The other half would benefit by lowering its peak usage. And the first half would save even more by also lowering its peak usage. In the 21st century, when people are very conscious of their carbon footprint, we should not underestimate the creativity of customers, especially those who are powered by digital technology. There is no reason to protect customers from lower prices, which is essentially what some of the advocates seem to be doing, inadvertently.

Sinclair:  Do you anticipate a paradigm shift in how electricity is priced?

Faruqui: Yes, in the not too distant future, we will see dynamic pricing rates being designed to be revenue neutral on a risk-adjusted basis. I.e., when customers are willing to take some of the price risk, they will be credited for the insurance premium that their suppliers no longer need to buy. This insurance premium can range from three to thirty percent of the cost of power. By crediting customers for this risk premium, rates will be lowered and this will vastly expand the appeal of dynamic pricing.

Sinclair:  One final question. Should dynamic pricing be an option or the default pricing design?

Faruqui: It should be the default pricing design. Otherwise most customers won’t try it out. Years of research in behavioral economics bears this out. When few customers take dynamic pricing, we –society as a whole –will be denied the benefits of demand response and additional peaking plants will have to be built. When it is offered as a default, it should be accompanied by a menu of alternatives. Risk-averse customers should be able to opt-out to progressively higher amounts of hedging built into them that would be more expensive on an average price basis. When customers are able to choose the product that best matches their risk tolerance levels, economic efficiency will be maximized.

Please plan to visit the DR-Expo in Toronto October 6-7.  Ahmad Faruqui will deliver the keynote presentation and be leading the business track on DR in North America.



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