Energy Economics 21 Ž1999.

213 ᎐ 223

Pricing of electricity tariffs in competitive markets
Jussi KeppoU , Mika Rasanen ¨¨ 1
Helsinki Energy, Kampinkuja 2, PL 469, 00101 Helsinki, Finland

Abstract In many countries electricity supply business has been opened for competition. In this paper we analyze the problem of pricing of electricity tariffs in these open markets, when both the customers’ electricity consumption and the market price are stochastic processes. Specifically, we focus on regular tariff contracts which do not have explicit amounts of consumption units defined in the contracts. Therefore the valuation process of these contracts differs from the valuation of electricity futures and options. The results show that the more there is uncertainty about the customer’s consumption, the higher the fixed charge of the tariff contract should be. Finally, we analyze the indication of our results to the different methods for estimating the customer’s consumption in the competitive markets. Since the consumption uncertainties enter into the tariff prices, the analysis indicates that the deterministic standard load curves do not provide efficient methods for evaluating the customers’ consumption in competitive markets. ᮊ 1999 Elsevier Science B.V. All rights reserved. JEL classifications: D4; L94
Keywords: Electricity pricing; Stochastic demand; Competitive markets; Tariff design

1. Introduction The Scandinavian countries provide the first multinational electricity markets, where traders can buy and sell electricity between nations. In this market area each
U

Corresponding author. Present address: Department of Statistics, Columbia University, New York, NY 10027, USA. Tel.: q1 212 854 3652; fax: q1 212 663 2454; e-mail: jkeppo@stat.columbia.edu 1 Present address: Cap Gemini, Management Consulting, Nuttymaentie 9, FIN-02200, Espoo, Finland. ¨ ˆ E-mail: Mika.Rasanen@capgemini.fi 0140-9883r99r$ - see front matter ᮊ 1999 Elsevier Science B.V. All rights reserved. PII: S 0 1 4 0 - 9 8 8 3 Ž 9 9 . 0 0 0 0 5 - 5

g. Ž1995. The competition in the supply business requires that distribution networks and national grids must have equal pricing principles for each operator in the market. Chao Ž1983.. his annual electricity bill should be at least US$5000 to make it profitable for her to enter into the competitive markets. Keppo.. For example. Specifically. the energy measurement devices are quite expensive. and Rasanen et al. In UK and New Zealand. the price and customer’s consumption processes are stochastic processes by their nature. In each of the countries having free markets. i. reporting services. Unfortunately.. Sweden and Finland followed this trend in 1995 when markets were opened for large and medium scale customers. This is beyond the electricity bill of an average household without electricity space heating Žsee. Therefore. billing services Žsupply and transmission. the energy measurement interval is 1 h. which is scaled according to the customers past total annual or monthly billing measurements. Both. and Rasanen et al.g. In this paper we consider the pricing of the electricity supply tariffs in the competitive markets. To solve this measurement problem and to ¨¨ give all customers a possibility to benefit from the free markets. For different statistical approaches for building the standard load profiles see.. 1997. Taylor and Lester Ž1975.. The price process is observed from the electricity exchange places. The pricing of distribution services is not considered. e.. For a different analysis of consumption processes see.g. the regulated distribution companies are responsible for the customers’ energy measurements. the time span is 30 min. e.e. Brown and Johnson Ž1969. Ž1996. M. since in the pure competition it should not affect customers’ electricity supply contract decision. In the valuation of tariffs we assume that the additional services. It would be simple for free competition. in Finland the annual hourly measurement cost per customer was approximately US$500 at the end of 1996. etc. In 1997 all customers were allowed to enter into the free markets. e. In Norway the markets were opened to all customers in 1993. Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 individual customer can buy electricity from any company providing electricity supply services. the customers with small consumption are associated to a single standard load profile.214 J. In our analysis. In Scandinavia. Thus. an alternative to the hourly or half-hourly measurements has been discussed. since each supplier must have a balance between his sales and supply contracts. The use of this standard load profile based ¨¨ . if all customers in the market had measurement devices that collected these hourly or half-hourly energy measurements. the UK and New Zealand have already opened their supply business for full competition. In addition to the Scandinavian countries. In Norway for example.. we focus on regular tariff contracts which do not have the explicit amount of consumption units defined in the contracts. If a customer had 10% lower bills in the free market than with his local supplier.. Bartels et al. Rasanen et al. they are added into the fixed charge of the tariff. Ž1992. ¨¨ The measurement of customer’s consumption is one of the main issues in the competitive markets. the price of the supply service is derived from the customer’s hourly electricity consumption and the hourly energy price processes. are constants. Bunn and Farmer Ž1985. the governments regulate the distribution business in all of the above countries at the moment..

the market price of risk is liable to enter into the pricing of the tariff. The market consists of a set of customers. The main results of this paper are summarized in Section 5. electricity future prices can be obtained from the electricity exchange market places. In Scandinavia. Energy is bought for consumption and it can not be considered as a tradable asset. A numerical example shows how the model is applied in practice in Section 4. Methods to improve the standard load profiles are also discussed. Therefore. etc. ELEX. e. However. there are no standard instruments for the money amount. the dynamics of the money amounts are different. This kind of market exists in Scandinavian countries.␶ x. Because different customers have different consumption behaviors. and the number of elements in M is n m . We assume that a single customer will consume electricity in the future according to a given stochastic consumption model and we price the energy options on that amount of money.J. Therefore. The stochastic processes for the money amount that the customer spends on consumption of electricity as well the dynamics for future prices are derived. where electricity producers and suppliers trade electricity 24 h each day in a year. a single customer is interested only in the amount of money that she will spend in her electricity consumption.1. 2. Instead of assuming that the variable underlying in the tariff design process is the money amount. Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 215 method is also under parliamentarian discussion in Finland and in the UK. The main contribution of this paper is that it develops a tariff pricing method that takes into account both the price and the consumption uncertainties. The pricing rules are summarized in Section 3. M. This money amount is a stochastic variable that depends on the electricity price and the amount of consumption at each moment of time. Most of the electricity contracts in an electricity supplier’s contract portfolio are these kinds of tariff-contracts. we present a general analysis. where the electricity future contracts are traded. M . The proposed methods have already been implemented as a part of the contract portfolio management system in Helsinki energy.g. Consumption and market price models 2. Each customer m g M has consumption qm(t) at time . which covers both standard load profiles and hourlyrhalf-hourly measurement. The paper is divided as follows: Section 2 introduces the price and consumption models used in the paper. These processes are then applied in the pricing problem. We show how to evaluate this price of risk by using the futures prices on the money amount that the customer will spend on consumption of electricity.. we use the future price. In our pricing model. Price and consumption processes We consider an electricity market where energy instruments are traded continuously within a time horizon w0. NordPool. Keppo.

␣ q mŽ t .␶ x . dzŽ t . the price process and the consumption processes can be correlated. mg M Ý qmŽ t . and Ž3. s W Ž t . mean that uncertainty in electricity price and in a single customer’s consumption is generated from the n m q 1 Brownian motion processes. Assumption A2 means that there are no opportunities for risk-less profits in the market. Ž1. Assumption A1: The stochastic ¨ ariables of the market follow an Ito ˆ stochastic differential equation: d x Ž t . t . where W is the energy price.␶ x ª R and e:R = w0. M... is a standard Brownian motion on the probability space Ž ⍀ . Keppo. The following assumptions characterize our electricity markets.. Brown and Sibley. For electricity price Eq. Valuation of consumption patterns and future price dynamics Here. ␣ w Ž t . we derive the value process of the consumption pattern corresponding to a single customer and the process of the future prices on the value of customer’s consumption pattern. Ž1. and P is a probability measure on F. The first general analysis where the electricity consumption and price processes are divided into correlated and non-correlated processes can be found from Chao Ž1983. and it says that there are n m q 1 independent Brownian motions in the electricity markets.. is d qm Ž t . d t q e Ž x . Ž1. dzŽ t .␶ x ª R n mq1 are gi¨ en functions that satisfy Lipschitz and growth conditions on x and zŽ t .. s qm Ž t .216 J. The total consumption at time t is probabilistic structure of the markets. Ž2. and for the consumption of m g M Eq. If there exists such risk-less trading opportunities. uncorrelated or partially correlated. the greed traders and customers will collect those instruments out from the market Žsee. Here ⍀ is a set. d t q W Ž t . d t q qm Ž t . e q mŽ t . F . Assumption A1 guarantees the existence and uniqueness of the solution to Eq.␶ x. F . t .g. Ž2. F is a ␴-algebra of subsets of ⍀ . P . Ž3. along with the standard filtration Ä Ft : t g w0. e. P . 2. e w Ž t . Assumption A2: There is no arbitrage. Ž1.2. s ␣ Ž x . dzŽ t . Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 t g w0. That is. In describing the where ␣ : R = w0. The value of the consumption pattern at time t g w0. becomes dW Ž t . Eqs. 1986. we will refer to an underlying probability space Ž ⍀ .␶ x4 .

t g w 0.T . the value of the customer’s consumption pattern g m Ž t . since Et w WmŽ t . q ␣ q mŽ t . s W Ž t . Lemma 2: The process of the future price is gi¨ en by dWm Ž t . Q.J. for all m g M . Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 217 means the amount of money that the customer spends on the consumption of electricity at time t. x Et w qm Ž T .T . s W Ž t . we get Eq.T .␶ x where WmŽ t .␶ x Ž4. for all m g M .T x . the future price of the value of the customer’s consumption pattern is given a follows: Wm Ž t . In our market. t g w 0. Typical contracts in these electricity exchanges are futures or bundles of futures where the amount of energy and future price per energy unit is fixed. e w Ž t . ½H t T ␣ w Ž y . With the above assumption. Øksendal Ž1995. Ј d t qg m Ž t .x and Wm Ž t .E.T . If assumption A3 is not valid. r x Et w qmŽT . Ž4. qmŽT .T . s qm Ž t . T g w 0. t g w 0..␶ x Ž6. there are huge amounts of future contracts continuously traded in exchange places.g. s g m Ž t . dzŽ t .␶ x where eЈ means the transpose of e. e q mŽ t . and Eq. T g w 0. a supplier calls these bundles to fill her supply contracts and a producer puts this type of bundles to keep her production as optimal and stable as possible.x s expwyŽT y t . W Ž t . for all m g M . ␣ w Ž t .exp Ž7.. s exp w y Ž T y t .W ŽT . dzŽ t . Ј d t q W Ž t .T x . Proof: Using Ito’s ˆ lemma. Lemma 1: The ¨ alue process of the consumption pattern for the customer m g M is d g m Ž t . q e W Ž t . where r is the constant instantaneous discount rate and Et is the conditional expectation operator with respect to P . Ž5. e. q e w Ž y . see. M. t g w 0. Before we derive the process for the future prices we must make sure that there exists this kind of contracts in our electricity market.D. it can be replaced by the valuation of the future contracts. Assumption A3: There are future contracts on the ¨ alue of consumption patterns. x for all m g M . Normally. The assumption of the constant discount rate is made to simplify the model. r Ž t . is Ft-measurable. we avoid a pricing model where there is a market price for the risk parameter. y e w Ž t . That is. Ј y r d y 5 . In a competitive electricity market. Ž5. r x Et w g m Ž T . Keppo. e w Ž t . e q mŽ t . e q mŽ y . q e q mŽ t .

Ј y r d y 5 Ž 10. 5 Ž9. give Wm Ž t . Therefore.. A possible solution to above problem is to set standard ¨¨ profiles proportional to some stochastic external factors. Ž7. Ž6. ½H t T Ž . q e w Ž y . and Ž9. e q mŽ y . smaller than forecast errors based on standard load profiles Žsee Rasanen et al..D. Ž7.e w Ž t . M.. says that the stochastic process for the future price follows Ito ˆ process. If standard load profiles are used for approximating customer’s electricity consumption. Keppo.. which is based on standard pricing of contingent claims. Ht 5 e H t T qm Ž8. y e w Ž t . q e q mŽ y .e q mŽ t . 1996. This is a contradiction. ␣ q mŽ y . in general. e w Ž y . d y e w Ž y . dzŽ y . y 1 2 e qm y e qm y Ј d y q Ž y . Pricing of tariffs This section considers the valuation of tariffs for a single customer’s consumption pattern. exp 1 2 T ½H t T ␣ w Ž y . exp y q and qm Ž T .T . q e q mŽ y .e. 1995. ¨¨ 3. Ј e w Ž y . Ž .T . s g m Ž t . and Lemma 1 we get g m Ž T . exp ½H t T ␣ w Ž y . This result is simple to explain: the more there is uncertainty about the customer’s hourly consumption pattern the higher the future price will be. i. e q mŽ y . this means the customers having a predictable consumption will have lower prices than customers having an unpredictable consumption behavior. q e w Ž y . By using Ito’s ˆ lemma. we get Eq. Eq. Eqs. In Scandinavian countries this factor is typically outdoor temperature ŽRasanen et al.Ј is the conditional variance of Wm Ž t . q e q mŽ y .Јx and W Ž t . s W Ž t ... q ␣ q mŽ y . since with the absolute forecast error of the customer’s consumption based on actual measurements are. That is. Ž3. the consumption pattern is fixed. dzŽ y . Q.E.218 J. s qm Ž t . where the conditional expected change is W Ž t . In practice. 2 e w Ž t .. . Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 Proof: From Eq.w r Ž t . the consumption pattern affects only to the expected drift of the future price and the volatility of the future price is the same as the volatility of the electricity price. Ž8. the customers having an associated standard load profiles must obtain lower prices than similar customers with hourlyrhalf-hourly measurements.

t g w 0. Øksendal.␶ x Ž 12. Theorem 1 is a pricing rule only for one energy call option.T . Given A2 there exists equivalent martingale probabilities for WmŽ t . d˜ zmŽ t . incomplete. for all m g M . fixed charge as the premium of the option..D.T .␶ x Ž 13 . s dzŽ t .g. Proof: Lemma 2 and Eq. Hull.. P Proof: Given A2. e w Ž t . and r y e w Ž t .g. However. 1995. since detailed analysis of contingent claims valuation can be found. Q. s exp Ž t y T . P ˜m is an equivalent martingale where ˜ z m is a Brownian motion on Ž ⍀ .g. where the energy charge is considered as a strike price. For the more detailed proof and the use of equivalent martingale measures see. where r f is the instantaneous risk-free rate at time t and it is assumed to be constant. The value of an electricity call option can now be calculated as the price of regular call options Žsee.x is calculated by using Lemma 3. Lemma 3: The process of the future price under the equi¨ alent martingale measure is gi¨ en by dWm Ž t . M. Ž12. e. x Cm Ž t . Using Girsanov’s Theorem Žsee. if Eq. and the future price as an underlying asset. ˜m . Ž1992. i..␶ x.J. q n m for all m g M Ž 11 . 1993. a pricing rule for an option to buy at time T one energy unit at a given energy charge corresponding . F . T g w 0. e. give Eq. Ž13.T . P measure. Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 219 the presentation will be brief. we get d˜ z m Ž t .T x .T x .g. Ž11. the market may be ˜m is used only with m g M. Keppo. and Heath et al. Because there may be many different equivalent martingale measures. e.e. e. Q. r f E for all m g M . Harrison and Kreps Ž1979. T g w 0..E.E.D. s W Ž t . Theorem 1: The time t T-maturity arbitrage-free price of a electricity call option Cm for customer m g M is ˜tm w Cm Ž T . does not hold there exists arbitrage opportunities.e q mŽ t . Duffie Ž1992.T .Ј s e w Ž t . there is no arbitrage because P and the customers can not take advantage of the diverging pricing functions in the economy.T .n m for all m g M and t g w0. We can state the following theorem.. ˜tm is the conditional expectation with respect to the risk-neutral probability measure E ˜m . and E ˜tm w CmŽT . t g w 0. Harrison and Pliska Ž1981..

The standard deviation is assumed to be equal to 0.. . Et w qm Ž y . x where ln w Wm Ž t .e. is cumulative normal distribution and X Ž t . and Figs. T g w 0. y . i.2 during the time interval. By using Eqs. That is. The expected electricity price is shown in Fig. Since the tariff contracts are portfolios of call options. we get that the value of the tariff for customer’s consumption pattern is D Ž t . the energy price. M. In this model. 2. r s r f s 5% Žannual. Ž14. Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 to customer m g M. The current date is 1 January 1998 and the time interval is divided into 1-h periods. x d y for all m g M . 2 and 3 we can calculate the value of the tariff.220 J. Typically tariffs are understood as a portfolio of different maturity options each of which are priced according to Theorem 1. s exp Ž t y T . rX Ž T .T . we get Cm Ž t .T x . Ž6. 3 illustrates the value of electricity call options with different maturities when the energy charge is fixed at the level of US$1. 4. y X Ž T . e w Ž y .T . we analyze the case of Scandinavian markets. Fig. Keppo. i. By using the model of Black Ž1976.Ž15. the value of the tariff is high when the value of the electricity price is high.T . r f w Wm Ž t . x q 1 2 Ž 15 . The uncertainties of price and consumption are perfectly correlated in this example. continuous-time. d1 s Ht e T w Ž y . Јd y d 2 s d1 y (H t T e w Ž y . Јd y where N ŽЈ. s Ht C T m Ž t .␶ x Ž 14. is the strike price. e w Ž y . e w Ž y . N Ž d1 . N Ž d 2 . The pricing interval is from 1 January to 29 January 1998.T . t g w 0. Јd y (H t T e w Ž y . at time t. The expected consumption of the customer is shown in Fig.8.e. and the electricity price and the consumption of a representative customer are assumed to be distributed according to lognormal distributions. Numerical example In this section we illustrate our tariff-pricing model with a hypothetical numerical example. The standard deviation of the predicted consumption is assumed to be equal to 150 at each hour. 1. from Eq.

the value of the tariff is US$732. Ž10.J. . which is US$952. That is approximately 30% increase in the fixed charge of the tariff. In a case of deterministic consumption process. Summary In this paper we have derived a pricing model for tariffs on the value of customer’s electricity consumption pattern in the competitive electricity supply Fig. 5. Expected electricity price. 2. show the tariff with the consumption risks is more expensive than the corresponding deterministic case. Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 221 Fig. Expected consumption pattern of the customer. Keppo. and Ž13. As Eqs. M. In this example the difference is US$220. 1.

. The analysis also offers a framework for understanding the net risks corresponding to the tariffs portfolios for different customer groups. Black. An end-use electricity load simulation model. Dynamic Asset Pricing Theory.. Keppo. R. Brown. Rasanen ¨ ¨ r Energy Economics 21 (1999) 213 ᎐ 223 Fig. Garben. H.8. 179 ᎐ 190. Lumsdaine. Utilities Policy January. 1986. 59. D. The main result of this study shows that the more there is uncertainty in the customer’s electricity consumption pattern. F. since they do not include consumption risks. Duffie. The price of electricity call options with different maturities Ženergy charge US$1. R.. Public utility pricing and output under risk. Johnson. Econ. Princeton University Press. 3. Wiley. Sibley. The analysis indicates that deterministic standard load profiles as such cannot be applied in competitive supply business. New York. However. Chao. J. M. we use the future price of the customer’s electricity consumption pattern value instead of using directly the consumption pattern value. usually there does not exist such future contracts and these hypothetical securities have to be priced before the valuation model can be used. S. 4. Farmer. Peak load pricing and capacity planning with demand and supply uncertainty.. Cambridge University Press. M. In order to obtain a risk neutral probability distribution for the future prices. A customer’s consumption affects the prices in the tariffs only through the future price. D.222 J. Fin. Comparative Models for Electric Load Forecasting. 1992. 1985. Rev. Bunn. In this valuation model. D. M. The pricing of commodity contracts. . Therefore the customers associated with standard load profiles will face lower prices than similar customers having hourly or half-hourly measurement device installed. 71 ᎐ 82. Brown. 1969. 167 ᎐ 179. Bell J... Econ.... 1983.. G. 3. Princeton. Econ. Am. D. Chichester. the higher the fixed charge of the tariff must be. markets. E. Fiebig. The Theory of Public Utility Pricing.. References Bartels.. 119 ᎐ 128. 1992. we apply equivalent martingale measure. 1976...

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