No more detours due to dynamic pricing

How consumers benefit from paying real time market prices

Renewable power generation promises to resolve some of the issues of the climate crisis, but in turn, also creates new challenges. In the old times with mostly conventional power sources, energy generation and consumption were able to align themselves quite neatly, as furnaces could be turned up or down depending on the respective consumption patterns. Times of excess power or a lack of power were dealt with through pricing incentives.

Cheaper night tariffs and more expensive peak hours acted as the gatekeepers on both pricing ends. But now as renewable energy sources like wind and solar can’t be “turned up” to meet the actual demand, this way must be reconsidered. As the efficiency of renewable energy sources is steadily increasing and governments are strongly promoting them, they will deliver a higher share in total energy generation, which will lead to an even bigger fluctuation.

Decentralization is one way to deal with this issue; having the generation of energy physically close to its consumption helps to avoid major grid imbalances. But energy supply can only be decentralized so much. An additional way to close the gap between consumption and generation is to give energy suppliers tools to read customer consumption in real-time, making use of a combination of smart meters and direct incentives via dynamic pricing contracts. But what’s in it for end consumers?

EU Directive

Starting in 2018, an overhaul of the rules for the EU electricity market was agreed upon not only to enhance cross-border electricity trade, but also to introduce dynamic pricing to address the difficult task of integrating renewable energy. What followed was the new EU directive, "Dynamic electricity price contracts", which forces each EU state to implement dynamic pricing into national law by 2025. 

The directive defines a dynamic pricing contract as “a contract between a supplier and a final customer that reflects the price variation in the spot markets, including Day-Ahead and Intraday markets”. The law entitles end users to be offered at least one contract that includes the dynamic pricing of their electricity usage and forces energy companies with more than 200,000 clients to offer at least one dynamic pricing option. Widespread use of this method would not only have a positive impact on energy efficiency and lower emissions, but it also would make the EU’s electricity market a more competitive and consumer-oriented environment.

Dynamic pricing

Dynamic pricing is needed to steer consumption behavior to align with actual energy generation. Achieving this will benefit both the electricity providers and consumers. By providing consumers with dynamic price signals, energy providers encourage customers to use power during sunny or windy periods, away from typical system peak hours. This will potentially reduce the need for investing in additional generation, distribution, and related expenses. To do so, dispatchable energy must be held in reserve for times of low wind or solar energy generation. It is widely discussed if offering dynamic pricing should be made an obligation for energy suppliers. The liberal approach would be to still let companies have a free hand in designing offers for consumers. On the other hand, offering dynamic pricing contracts should generally be in the best interest of retailers, as it gives them a chance to reduce their hedging and sourcing costs.

"The more prices and pricing periods correspond to the prices on wholesale markets, in a timeframe that provides incentives to shape energy consumption behaviors according to the way wholesale prices evolve, the more ‘dynamic’ they are." (Source: Dynamic pricing in electricity supply (A EURELECTRIC position paper, p.2)

From a customer’s perspective, dynamic pricing is not that controversial, as they will be able to reduce their electricity bills by managing and adjusting their consumption in response to price signals. At the beginning of 2019, dynamic pricing contracts were available in seven EU Member States. Today, most dynamic pricing contracts are signed by businesses, but also many residential customers are picking up on the immediate direct cost savings.

Different types of dynamic pricing

All companies in the retail energy sector basically have a limited range of options for their business plans. But one factor where they differentiate from each other is how they design their pricing. Looking closer, retailers effectively pass through the charges for network, taxes, and levies. This leaves them to only be creative when it comes to designing the pricing of the energy component. On the other hand, a customer, of course, would want to have a diversified price list so they can choose an optimal plan that exploits price volatility while taking into account their flexibility potential and minimizing risk. The two different categories for pricing offers are basic fixed-priced and dynamic pricing offers:

The plan that most customers are familiar with is a basic fixed-priced offer. It provides a predefined price of the energy component for a defined period of time, independent from actual changes in the market price that effectively isolates consumers from price variations. As this kind of offer gives end users a clear idea of what their electricity bill is made up of, it is becoming increasingly popular among household consumers but lacks the cost benefits that a dynamic pricing contract has to offer.

With dynamic electricity pricing, some of the wholesale price volatility is passed on to end customers, and prices are linked to the actual or at least anticipated changes to wholesale prices. In competitive markets, this marginal cost of every energy unit generated surfaces as short-term spot prices and long-term forward prices. 

The most common dynamic pricing plan is time-of-use pricing (ToU). Here customers simply get billed the cost per kWh, which is determined by the time when electricity is consumed. Splitting the day into several predefined periods, like day and night, on-peak and off-peak gives customers the opportunity to benefit from the most prevalent patterns.

Critical peak pricing (CPP) is basically a ToU plan with an added top-up rate for certain days where electricity prices are substantially higher compared to the average prices and aims to reduce load during the relatively few, very expensive hours. Key elements in CPP are the time window over the peak price period and the degree of price differentiations between the peak and off-peak times, but when it comes to ‘dynamic’ there is still room for improvement.

The most immediate and state-of-the-art dynamic pricing is real-time pricing (RTP). Here wholesale electricity prices are directly passed through to end-users and the calculation of the bills is based on reading consumption at the smart meter at least hourly. The supplier can only count on billing a thin but fixed margin on every unit of electricity delivered.

Having more control over the electricity bill, it is no wonder that dynamic pricing including real-time spot-based pricing has been commonly adopted by industrial customers. But in several countries, household and small commercial customers have only been offered simplified forms of ToU and CPP. So far, only Nordic, Estonian and Spanish residential consumers have access to real-time pricing.

Smart meter technology

A smart meter is an intelligent electricity meter. It communicates electricity consumption throughout the day via a communication link to the respective network operator and can also limit or shut off the power supply remotely. This technology makes dynamic pricing contracts possible, which results in lower customer billings.

Relying on smart meters, which allow reading of consumption in specific time intervals according to electricity market intervals (15-60 min), you can have all the benefits of dynamic pricing. If metered individual consumption load curves based on smart meter readings are used, retail and wholesale markets can be better linked, thus enabling consumers to be more active and to value their flexibility. Generally, the deployment of smart meters will promote innovative pricing beyond the existing ToU and CPP tariffs.

Challenges in the way

As dynamic pricing is the economically most viable option it should be low effort to bring forward a wide implementation, but as it always is with innovative products, there are some boulders still in the way:

First of all, consumers need to be well-informed, and the dynamic pricing plans need to be well-designed and easy to use. The exposure to price volatility needs to be transparent, so consumers may adapt to potentially significant price increases. This can happen in the case of real-time pricing with a direct exposition to spot prices, where one day of energy consumption may cost more than the rest of the year.

If cases like these are avoided, there are still ways the performance can be poor and savings are not achieved, as the ‘energy component’ only represents one-third of the average EU retail consumers’ bill. With the remaining 2/3 of the bill being regulated charges, an increasing tax burden and other policy costs could weaken the benefits of dynamic pricing, creating incentives to switch to other forms of energy. This could also harm decarbonization goals. But it could also be that prices in the wholesale market are simply not volatile enough. 

Another reason why the progress of dynamic pricing could slow down is that model regions like the Nordic countries have specific consumption patterns (higher than average consumption and exceptional consumption in winter) that go particularly well with dynamic pricing. In France for example, most business clients operate electrical devices for both indoor heating and water heating. In other countries, it will depend on how well residential consumers will take up electrical heat pumps and electric vehicles. These technologies are key to operating dynamic pricing profitably, as they are able to provide a considerable shiftable load potential. 

Innovation in household technology can make dynamic pricing tariffs more attractive to end-users with the use of smart devices. By automating the process, these devices allow capturing more potential savings and spare end-users the trouble of actively monitoring and responding to changes in tariffs.

Thanks to these innovations and the development of efficient wholesale markets, electricity retailers have the possibility to provide final customers with a wider variety of pricing offers. With this, end users can optimize their electricity bills and also tap into potential reward schemes as flexibility providers. We’ll be curious which will be the next countries to offer dynamic pricing contracts to all end-users, which subsequent potential use cases could emerge from this, and of course, how the energy industry will adapt to these changes.