I recently came across an interesting paper with a novel argument for demand pricing. In a previous post I explained why peak demand drives network costs. Because we mostly have flat tariffs in Australia we have the situation of cross subsidy whereby people with ‘flat’ demand profiles subsidise those with ‘peaky’ demand profiles. Consider this example.
From a policy point of view there is nothing wrong with cross subsidy per se, but it is important to know who are the winners and losers in the transfer of costs. If the flatter demand belongs to lower income consumers and peaky demand belongs to higher income consumers then flat tariffs subsidise the rich and transfers demand costs to the poor. If this is the case then it is hard to argue that a flat tariff structure is fair.
To test this there are a number of factors that I have considered:
- How should ‘peakiness’ be measured?
- Is there an inherent link between ‘peakiness’ and household income?
- Therefore is a flat tariff fair or unfair, based on who is being cross-subsidised?
What I would like to do here is present a detailed analysis but I cannot do this because most of the data I have is highly confidential and there is a paucity of public data available. What I can do is share some general observations based on my experience across a number of jurisdictions and my general approach.
The standard measure of peakiness is load factor: for a given period this is the maximum demand measure divided by the average. This gives a measure of peak relative to the underlying demand. In the example above the ‘peaky’ profile is about 3% peakier than the flat profile. But another measure is the actual range in demand between the peaky profile and the flat profile. In the same example we get a 60% difference between the peaky and flat profiles.
What I have noticed is that if we look at load factor this is more or less uncorrelated with household income if I remove controlled load (the rationale is that controlled load is off peak anyway and controlled by the distributor, not the consumer). If I look at the range in demand between the trough and the peak, we get a reasonably strong correlation with income. But we also have a correlation between income and total consumption, so range could just be a function of total consumption? That is, if you use more then the variation between your peaks and troughs are also going to be larger.
So what are the conclusions?
Firstly, I can’t find any evidence that demand pricing will inherently transfer costs from wealthy households to poor households. Wealthy households by virtue of their greater consumption contribute more to peak demand even though they are not inherently peakier in their usage profile. From my analysis I can’t say that poor households are inherently flatter in demand and therefore subsidise richer households, but what I can say is that given an equivalent household income, flatter demand households do indeed subsidise peak use households under a flat tariff structure and that demand pricing such as a properly designed time of use tariff could remove this cross subsidy.