Pricing designs in retail electricity: How to get out of price wars and get into profitability

In electricity’s own real-time game of Price Wars, retail pricing is considered the necessary evil–the Darth Vader, if you will–of competitive markets. “How low can you go?” is all too often the dubious basis upon which retail prices are set. But when prices are set so low that companies can’t seem to eek out a reasonable profit–both the customer and the supplier lose the retail battle.


Dr. Faruqui
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As area manager of retail and power markets at the Palo Alto, Calif.-based Electric Power Research Institute (EPRI), Dr. Ahmad Faruqui believes he has an answer to retail’s pricing problem. For years Dr. Faruqui has studied how energy service providers can develop a menu of profitable products for the retail market and led EPRI professionals in assessing successful business planning, financial analysis, risk management and marketing strategy and tactics in energy.

In the past, Dr. Faruqui has held senior consulting positions in various firms and helped clients in the United States and Canada improve their profitability by strategic pricing and marketing, forecasting market demand, and designing new products and services. He has also advised government agencies on industry restructuring and energy efficiency issues in California, Hawaii and Minnesota as well as several foreign countries. Dr. Faruqui has authored more than 100 papers on energy issues and is the co-editor of two books: Customer Choice: Finding Value in Retail Electricity Markets and Pricing Electricity in Competitive Markets.

EL&P: How important is an optimal pricing design to bottom-line profitability in electricity?

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Dr. Faruqui: I can tell you that inappropriate pricing in energy is the primary cause of energy companies losing money, because prices have been set too low. The prices don’t cover fixed costs and certainly not variable costs. For example, Montana Power in California offered an 8 percent discount off the power exchange price and signed up many users, like the California Manufacturer’s Association. Within one year, Montana Power was pulling out of the market. They had the generation, but chose retail and dropped the price too low. Other companies like PG&E Energy Services and New Energy Ventures also dropped their prices too low in the battle to acquire market share. That’s cutthroat pricing, good for customers initially, but not in the long run, because the price is not sustainable. All of those providers lost in large measure due to cutthroat pricing-and in their zeal to acquire market share, used pricing based upon a perceived market leader benchmark price. (See Figure 1)

After more than two years of losses, Enron Energy Services is now in the black. They turned the corner in the last quarter of ’99. Their secret appears to be risk-based pricing and bundling of commodity energy with value-added services.

Even though pricing is relegated to a “third front” role, often after downsizing and marketing, one recent study by McKinsey & Company showed that pricing has significant effects on company profitability–a one percent improvement in pricing can boost profitability by 11 percent; whereas increased sales of one percent increased profits by 3.3 percent, and the reduction of variable costs impacted profits by 7.8 percent.

EL&P: In your opinion, what does the power sector do right/wrong in addressing and implementing pricing designs?

Dr. Faruqui: I see a fundamental weakness of design. It’s a conceptual weakness where prices do not even reflect the basic cost of supplying the customers, the break-even price. ESPs [energy service providers] don’t know the customer load shape, so most make faulty assumptions and use load profiles with huge margins of errors. In order to price accurately, they need to know several other factors such as the price elasticity of demand by time of day, volatilities in load shapes and wholesale price forecasts, and correlations between loads and prices. Most pricing software being used in the industry today allows for no volatilities, correlations or elasticities, and thus are error prone. Lastly, ESPs do a poor job of projecting how many utility customers are going to switch, and under what terms and conditions.

EL&P: You’ve said that immature “first generation” pricing designs, based on price-war rates, have resulted in “Pyrrhic victories” and caused a “massive erosion of shareholder value for both winners and losers” in energy. How can the industry best mature in its pricing schemes?

Dr. Faruqui: I believe there are several “generations” companies go through in pricing. In the first generation, the company is anxious to sell the product and get customers. It’s the “I’ll price it as low as anybody else’s and if my brand name is not well-known, then I’ll price it even lower” stage. Unfortunately, this pricing is unsustainable over the long haul, since it does not address time-of-use or risk-based characteristics of electricity pricing or value-added services. In the second generation, companies realize they don’t want to keep on losing money and can’t make it up on volume. Some companies may now need a product differentiator, in our power business that means real-time pricing with a cap, flat price, real-time pricing without a cap, etc.

The third generation pricing design arises from a supplier’s recognition that anyone with risk-based products needs to expand with bundling non-energy products and services. Enron is a primary example of this. They’re really the only company who’s successfully used all three designs, the first, second and third generation, now. Some of the factors impacting a company’s movement into successive generations include the maturity of the player, imposed regulatory rules, and the financial base of the company–or the depth of the war chest which affords more staying power and long-term strategic goals for absorbing short-term losses.

EL&P: Please explain the differences, drawbacks and opportunities between cost of service, customer value, risk-based and pricing to match the competition pricing designs.

Dr. Faruqui: Well, we have years and years of experience in cost-based pricing, so we can do it pretty well. But the customer doesn’t care what it costs the company to produce the commodity. Like an airline, all of the seats have the same cost, yet there are different prices for the business and leisure traveler seats based on customer value. So customer value is price based upon what the customer will pay. In energy, we’re hearing lots of cries now on price discrimination; the mere mention of the term just freezes people in their tracks. Yet it’s only valid when customers don’t have a choice, then it could be considered price gouging. Risk-based pricing recognizes volatility. A customer who wants a “flip the switch” price can pay more, but has no quantity restrictions and imposes a greater risk to the supplier. But there’s only one positive to match the competition pricing: It keeps you in the business of getting customers. It makes you look at power as an undifferentiated commodity and doesn’t recognize the need for value-added products. It always results in a price war.

In my opinion, it’s best to offer a menu of risk-based prices, differentiated by market segment, and optionally configured with value-added features. No one can offer the product at a huge premium without offering specialized products and services. The savvy ESP will roll out a menu of pricing designs ranging from flip the switch, fixed bill (or “all-you-can-eat”), time-of-use, two-part real-time, spot and cap and spot, that offer various levels of risk to both the supplier and the customer. (See Figure 2)


Figure 2: A continuum of risk-differentiated products
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Figure 2: Flip-the-switch products (guaranteed pricing products with no quantity restrictions); Time-of-Use (TOU) and seasonal products (building block combinations of guaranteed price contracts for time/seasonal periods); Two-Part Real-Time Pricing (RTP) products (combination of a forward contract and a balancing contract for incremental or decremental load priced at wholesale spot with a mark up/down [i.e. bid-ask spread] ); Spot + Cap product (spot price with a price cap, or maximum price set, and limits the retail customer’s exposure to high retail spot prices); and Spot products (the retail customer sees a price that is directly related to the wholseale spot price). The fixed bill is a product where the customer’s bill is invariant of usage; also known as “all-you-can-eat” pricing. It is typically a take-or-pay forward contract with a guaranteed price contract for additional usage; while it may eliminate a customer’s bill uncertainty, it holds quantity risk.

EL&P: What are some of the more noteworthy “lessons learned” in the past few years in retail competitive markets?

Dr. Faruqui: You don’t have to be a fan of Arnold Toynbee to subscribe to the notion that history repeats itself in cycles. It’s human nature to repeat mistakes. Germany now is in a price war where rates are 40-50 percent discounted, as utilities are grappling to become the biggest company. Many people thought that electricity would merely become a cutthroat-priced commodity, and that has been shown to be incorrect. A problem we have in energy is that marketing people are close to the customer and know best what the customer wants, yet they continue to be alienated from the pricing people.

EL&P: In your opinion, what are some of the barriers in retail markets and how have they affected current and future pricing structures?

Dr. Faruqui: A significant barrier to competitive markets has been the availability of appropriate metering technology. We need cost-effective hourly metering. Our technology is surprisingly behind the times.

Another barrier to competition are the Byzantine “Rules of the Game,” that have been adopted in a quilt-work fashion across the nation. For example, California’s provisions regarding a four-year retail price freeze, stranded cost recovery and customer transition costs have placed a significant impediment to open competition and market innovation in product design. The technology barrier in metering also applies to pricing software, which needs to recognize volatility and elasticity.

EL&P: Concerning pricing, what future trends and opportunities do you see in the next three to five years?

Dr. Faruqui: One of the key opportunities in pricing and marketing is augmenting pricing with enabling technology, like time-flexible technologies. For instance, a thermal energy storage facility could run its chillers during the hot afternoon (when power is most expensive), but super cool its water coolers during off-peak times at night. In other words, companies could change their processes to be less consumptive in on-peak energy times, or release their own power during on-peak times and buy during off-peak. It’s energy efficiency in a time-varying sense. It might require a change in machinery and processes, but when customers and ESPs see the very real benefits of real-time pricing, they’ll make the necessary investments. But so far, it’s not so much the technology, as the lack and availability of real-time pricing data and pricing software that’s proven an impediment.

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