Saturday, 24 May 2014

Is the marginal cost of electricity falling? Some evidence from recent two-part pricing changes

There's some interesting things going on in electricity prices at the moment. On the one hand, we have the Statistics New Zealand showing that costs of electricity generation are rising, and that these costs are being passed onto commercial customers in the form of higher spot prices of electricity (see for example here: "...higher costs to generate electricity because of low hydro-lake levels and more expensive thermal generation...").

On the other hand, back in March my electricity retailer changed their pricing plans. Since these pricing plans are an example of two-part pricing and we have recently covered pricing strategy in ECON100, I thought this was a timely opportunity to blog about this. It also gives us a clue as to what is happening to marginal cost for the retailer.

Two-part pricing occurs when the supplier splits the price into two parts (no surprises there!): (1) an up-front fee that gives the consumer the right to purchase; and (2) a separate price per unit of the good or service. Many goods and services are sold with two-part pricing, including telephone services (monthly fee plus cost per call), some theme parks (cost for entry, plus cost for each ride), golf (club membership, plus green fees), and electricity. The two parts of the electricity price are the Daily Fixed Charge (which is a fixed amount per day connected to the electricity network), and the price per unit of electricity (measured in kWh).

Suppliers use two-part pricing in order to increase profits. This is how it works in theory. In the diagram below, the 'traditional' profit-maximising firm will maximise its profits by selecting the price where marginal revenue is exactly equal to marginal revenue. This occurs at the quantity QM, and the per-unit price PM. At this price-quantity combination, consumers receives a surplus (the difference between what they were willing to pay and what they actually pay) equal to the area ABC. Producer surplus (profit contribution) is equal to the area CBDF.

Using two-part pricing, the firm could instead charge a fixed fee equal to exactly ABC for the consumers to have the right to purchase, and a per-unit price of PM, and the consumers would be still willing to buy QM of the product. In this case, there would no longer be a consumer surplus (because this is offset by the fixed fee), and producer surplus would increase to ABDF.

However, the firm could do even better than this. If they instead reduced the per-unit price to PS and increased the fixed fee to be equal to the area AEF, the consumer would be willing to purchase the quantity QS. There would still be no consumer surplus, but producer surplus would be the entire area AEF. Importantly, the optimal per-unit price is equal to marginal cost.

Now, think about what happens if the marginal costs of production fall. Consumer surplus increases, so the optimal size of the fixed fee increases, while the optimal per-unit price decreases.

Now, back to the change in electricity prices. From the letter I received from Genesis in March:
...Your bill reflects a variety of costs, including generation and transmission costs, metering charges and our own business costs... We have recently reviewed our electricity prices in your area and from 6 April 2014 your electricity prices... will change. The weighting of the two components of your pricing plan has also changed. The daily fixed charge (the fixed cost of supplying energy to your property) and the variable change (the cost of electricity you use) have been aligned to better reflect the cost structure used by your network company...
The pricing changes in the letter refer to a 76.9% increase in the Daily Fixed Charge, and decreases in the per-unit charge of between 7.7% and 15.3% (depending on pricing plan). Assuming that Genesis is pricing effectively, then the increase in fixed fee and reduction in the per-unit charge are consistent with a reducing marginal cost of electricity.

Of course, there are alternative explanations. First, perhaps Genesis weren't pricing in isolation but were engaged in a strategic pricing battle with other firms. There is competition among the different retail electricity suppliers, after all. Where firms set similar per-unit charges, they might compete in terms of the fixed fee, driving the fee downwards (until it barely covers the fixed costs of transmission of electricity, maintenance of lines, etc.). This lowers profits. However, competitive pressures as an explanation seems unlikely. For the fixed fee to rise, that would suggest that price competition between the firms has decreased. I would argue that competition is no less now that it was before (in fact it might be more competitive now due to the likes of PowerSwitch) - so why raise the Daily Fixed Charge now?

Second, perhaps Genesis deliberately under-priced the potential fixed fee (but not due to competitive reasons). One potential problem with two-part pricing is if you have heterogeneous demand and you set the fixed fee too high, low demand customers opt out of purchasing from you. So, maybe Genesis intentionally under-estimated the fixed fee in order not to drive customers away. However, again this seems unlikely. They've suddenly raised the Daily Fixed Charge now - did they hugely misinterpret the potential fixed fee before and now suddenly realised that customers wouldn't leave in droves if they raised the fee?

Third, electricity transmission prices are regulated in New Zealand, and electricity transmission charges are fixed costs that make up part of the Daily Fixed Charge. So maybe the Commerce Commission allowed a substantial increase in transmission charges recently? I can't see anything on the Commerce Commission website to suggest they have made a recent change.

So, perhaps that just leaves lower marginal costs of production as an explanation?

One last point: Why aren't the Greens jumping on this change in pricing plans? Surely Genesis isn't alone in making this change (see the point on competitive pressures above)? This change in pricing strategy may have a negative environmental impact. With lower marginal costs, the per-unit price falls and consumers purchase more. Given that New Zealand's marginal electricity production is thermal generation (as I understand it hydro, geothermal, wind, etc. are "always on", so if additional peak load generation is needed it is coal/gas generation), so if retail electricity consumers are purchasing more electricity doesn't that mean more carbon emissions? Having said that, residential consumers make up only about a third of electricity demand in New Zealand (see here - a really useful primer on the electricity sector in New Zealand), so maybe it's not a big deal?

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