On the Inequity of Flat-rate Electricity Tariffs.

Author:Simshauser, Paul


In Australia, residential electricity prices are structured as conventional two-part tariffs comprising a fixed charge and a 'flat-rate' variable energy charge. The origin of the two-part tariff can be traced back to the electricity supply industry in 1892. The design by Hopkinson (1892) reflected the atypical cost characteristics of power systems--a non-storable commodity with a cost structure overwhelmingly driven by periodic demand rather than annual energy demand. Expected peak loads during extreme weather 'critical event' days drive system capacity, and capital-intensive capacity costs (as opposed to system marginal running costs) dominate the cost structure of electricity supply. The fixed and sunk capital costs of an electricity distribution system will typically comprise 70-80% of the total network cost structure. The Australian east coast generation fleet has a similar cost structure. The two-part tariff was theoretically designed to capture these characteristics and originally comprised a demand charge (expressed in dollars per kilowatt or $/kW) reflecting peak capacity utilised by a customer, and a variable energy charge (expressed in cents per kilowatt hour or c/kWh) reflecting the real-time marginal running costs of the power system. There was a difficulty with implementing the theoretically optimal two-part tariff, however. Power system peak load typically occurs on 12-15 critical event days each year and in order to levy a demand charge, measurement of coincident customer peak load is necessary. For most of the past 120 years, meter technology has been a limiting factor--for households it was simply uneconomic to install two meters and so a surrogate demand charge would be required (i.e. a fixed charge). To be clear, most households in Australia still have a mechanical meter which requires a meter reader to physically inspect and record metered electricity use.

In Australia, the fixed charge is levied on a uniform basis and therefore involves an arbitrary, and by implication inequitable, allocation of fixed costs. A uniform fixed charge bears some relationship with direct connection costs, but no relationship with household peak loads during critical events. Moreover, in Australia the fixed charge has become a surprisingly small component of the two-part tariff. Given the nature and cost of the network, this aggravates the inequity of existing tariff structures relative to the cost of supply.

The purpose of this article is to analyse efficiency gains and inter- and intra-segment wealth transfers arising from existing flat-rate tariffs in the context of a power system experiencing sub-optimal load growth. (1) We do this by contrasting the existing flat rate with the more cost-reflective Time-of-Use and Critical Peak Prices. We should emphasize that we do not attempt to redress the optimal level or structure of the fixed charge. Nor do we contemplate other tariff designs such as one dominated by a demand charge--an alternate solution which is at least as valid. (2) Instead, in this article we focus on analysing inequities that exist by assessing the changes arising from a more cost-reflective time-differentiated structure and build on the applied analysis contained in Simshauser and Downer (2012).

Our analysis makes use of AGL Energy's SAP HANA, an ultra-high speed in-memory computing appliance which enables us to work rapidly with a truly vast data set. Our modelling incorporates 2.8 billion meter reads from 160,000 smart meter customers from Victoria (i.e. 17,520 meter reads for each customer, representing a full year of half-hourly consumption data). Approximately 6000 of these households were matched with AGL Energy's online household survey (one of Australia's largest ongoing household surveys with more than 70,000 entries (3)). This combination of data sources enables us to analyse inter- and intra-segment wealth transfers. By specifying a set of broadly representative household cohorts, our analysis of tariff reform should be of interest to the electricity industry, consumer groups and policymakers.

We have structured our article as follows. In Section I, we review the relevant literature while in Section II we provide an overview of default electricity tariffs. In Section III, we present average daily load shapes for five different household cohorts. Section IV outlines our tariff model and pricing structures while Section V reviews model results. Our policy implications and concluding remarks follow.


    The two-part tariff was developed by electrical engineers in the 1890s--initially by Hopkinson (1892). The two-part tariff represented the means by which to charge electricity consumers in a fair, efficient and equitable basis--reflecting meticulous engineering cost analyses undertaken by these early power system engineers. From an applied perspective Wright (1896) from the United Kingdom and Greene (1896) from the United States demonstrated in considerable detail that the primary cost driver of their respective 'central' power systems was not variable production costs, but rather, the cost of installing and maintaining the capacity required to meet aggregate peak load. (4) Based on these principles, early tariff engineers concluded electricity prices should take the form of a 'two-part tariff' comprising a demand charge according to customer peak load ($/kW), and a variable energy charge based on the volume consumed (c/kWh). (5) In a practical sense the limiting factor at the time (and for the ensuing century or more) was the cost and availability of interval metering. Given this data constraint, at the residential level the substitute for the demand charge would be the 'fixed charge'. Early applications of the residential fixed charge for electricity supply were driven by demographic indices. In England for example, the fixed charge was linked to the number of bedrooms or the rateable value of the property in question (Lewis, 1941). The fixed charge would be adopted by the electricity industry around the world and in time the two-part tariff would be extended to other industries such as gas supply, water supply, telecommunications, rail transport, the taxi industry and so on.

    Contemporary applications of the two-part tariff in the Australian electricity supply industry are dominated by the variable charge. That is, over time, the uniform fixed charge element of the two-part tariff has decayed considerably. (6) As our data later reveals, the fixed charge currently comprises 10% of the overall tariff structure for an average customer. For a power system experiencing rapid underlying energy growth (e.g. due to rising appliance use such as air-conditioners), a two-part tariff structure dominated by a 'flat rate' variable charge could be argued as desirable against a range of tariff design criteria. (7) But in a system experiencing sharply rising peak load growth, declining underlying energy demand, or both, a two-part tariff with the structure dominated by a flat rate variable charge does present certain difficulties. Above all, it can become unstable and risks inducing an inefficient allocation of resources, thereby violating other elements of conventional tariff design criteria (see for example Boiteux & Stasi, 1952; Bonbright, 1961). This was the primary theoretical motivation of Hopkinson (1892) and the applied findings in both Wright (1896) and Greene (1896) because at the time, these power systems were experiencing sharp and unsustainable growth in system peak load.

    A key issue for the electricity industry and for policymakers is that with flat rate tariffs and periodic demand, the value of peak energy is under-priced while the value of off-peak energy is overpriced. (8) The absence of widespread time-differentiated pricing has been persistently identified as a problem facing the efficiency of electricity systems by energy economists dating at least as far back as Boituex (1949), Dessus (1949), Houthakker (1951), Steiner (1957), Nelson (1964), Turvey (1964), Joskow (1976), Crew & Kleindorfer (1976), and Wenders (1976).

    More than a century has passed since the ideal theoretical tariff structure was specified (see Hopkinson, 1892; Greene; 1896; Wright, 1896), and more than half a century has passed since energy economists generalised and optimised the principles for mass market application (see Lewis, 1941; Boiteux, 1949; Houthakker, 1951; Boiteux & Stasi, 1952). Only recently, however, have smart meters become economically viable at the household level. In the case of Victoria, at the time of writing a mandated network monopoly roll-out of smart meters was in its final stages. The deregulation of metering services has also become a key thematic in other regions of Australia. (9) These developments raise the prospect of meaningful electricity tariff reform, and the potential to substantially reduce inter- and intra-segment cross subsidies.

    Faruqui & Malko (1983), Borenstein & Holland (2005), Faruqui (2010a, 2010b), Faruqui & Sergici (2010, 2013), Faruqui, Sergici & Sharif (2010), Wood & Faruqui (2010), Faruqui & Palmer (2011), Simshauser & Downer (2012), Borenstein (2013), Procter (2013), Nelson & Orton (2013), Energex & Ergon (2014), Horowitz & Lave (2014), Fenwick et al. (2014) and others have all demonstrated that with the availability of smart meters, time-of-use tariff structures are capable of correcting market inefficiencies and inequities. (10) Furthermore, the literature on price discrimination (11), which is well summarised by Armstrong (2006, 2008), notes that as firms in competitive markets access more ornate tariff structures, it has the effect of amplifying competition because they equip themselves with a new arsenal of weapons to attack competitors to gain market share, which in the end enhances consumer welfare. The combination of smart meters, time-differentiated structures and non-linear pricing more generally will...

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