Designing creative electricity tariffs

Background

In the UK, the majority of domestic electricity customers are on a standard variable tariffs: a contract which the customer can leave any time, with a single price for electricity used any time of day, which the utility can increase with 30 days notice.

A common variant of this is referred to as Economy7, in which there is a lower price for any electricity consumed in a 7 hour window, and a higher price for electricity used the other 17 hours. This tariff is particularly attractive for customers who have electric storage heaters which they can run at night.

Another way in which contracts commonly vary is by having fixed terms, typically 1 year but occasionally 2 years, in which the prices won’t increase. There is often an exit-fee for leaving a fixed term contract early. At the end of the fixed-term period a customer can revert to the standard variable tariff or agree another fixed term, both of which will involve a new price.

With the increased rollout of smart meters, which measure electricity consumption at half hourly level, there is now the possibility to create more innovative tariffs.

The Cost of Electricity Supply

Before we consider how to structure tariffs, it is worth taking a moment to understand how electricity suppliers pay for the electricity their customers use. After all, whatever tariff a supplier sets must aim to cover these costs (plus leave some margin for profit).

The simplest case is where domestic customers are paid for, by the supplier, based on their half hourly consumption. For these customers, the supplier pays whatever the wholesale system price is in each half hour, multiplied by whatever the customers have used. They also pay additional charges for distribution and transmission losses, for balancing, and for various environmental commitments.

Now, the wholesale system price is incredibly volatile (it fell to £-63/MWh on 26 Dec 2020, and rose to £4000/MWh on 8 Jan 2021), and most suppliers wouldn’t want to be exposed to it. As a result, most suppliers will ‘hedge’, or lock in, the price they pay, usually with a generator. They can do this years in advance, right through to the day. For example, a supplier might hedge the expected consumption when it agrees a fixed price with the customer, reducing their losses if system prices turn out higher than expected.

The challenge with hedging is that the suppliers don’t know how much their customers will use in advance. This forces them to estimate, and they are likely to underestimate in some periods (say when the weather was colder than predicted) and overestimate in others. What suppliers often do is to hedge an approximate volume initially, and then refine it as they get better estimates.

This way of paying for the electricity requires the supplier to know how much their customers used each half hour. For customers without smart meters (and even, for now, most domestic customers with smart meters), there is a complex process by which suppliers are settled based on deemed profiles, which are then adjusted. This goes some way to reducing the volume uncertainty for suppliers, but still leaves quite a bit. My hope is that as more customers get smart meters, these will largely disappear.

Now that we understand the costs, let’s turn to tariff design, first starting what I consider the purest tariff.

The ‘Purest’ Tariff

The purest tariff I can think of involves just charging the customer based on their half hourly consumption, at the system price, plus passing through the various other costs, and adding a small profit margin. This eliminates the need for the supplier to forecast consumption and hedge. A second advantage of this tariff would be that it would send a strong incentive to the customer to use less when the price was highest, reducing their average price.

Unfortunately, few customers are prepared to take on this level of risk. For example, if the system price was £4,000/MWh when you needed to cook dinner, that would translate to £4/kWh, even before system costs were added (compared with normal levels of around 15p/kWh). A second difficulty is that the system price isn’t known until afterwards. Customers would need a good way of forecasting in order to make the right decisions.

The closest thing to this tariff currently on offer to domestic customers is Octopus Energy’s Agile tariff. This product derives its prices from an auction that takes place each afternoon for each half hour the following day, effectively capturing the expected system price. Octopus also ‘cap’ the price at 35p/kWh, eliminating the fear of £4/kWh prices while still leaving plenty of incentive to reduce consumption. I love the Agile tariff, and save a lot by flexing my consumption to get the cheapest prices. If anything, I wish it was even purer, reflecting the full system price volatility.

However, I have to recognise that most customers would find Agile unpalatable. They wouldn’t want the stress of wondering when they can put the kettle on (an issue made worse when there are others in the household). They wouldn’t want the uncertainty of not knowing how prices might get in the coming months — even a period of low prices (such as seen in April 2020) can lead to disappointment when the prices return to normal levels. And many people like using electricity in the high price periods (typically 4–7pm on weekdays). I will consider these issues shortly.

However, I have recently discovered another problem with tariffs like this, that adjust to reflect prevailing market prices. At times when Agile prices are high, customers can see fixed tariffs which are lower, and feel compelled to switch. In many cases this is not rational, as they would then be locked into a fixed contract that is likely to be higher in the long run, even after Agile has returned to lower levels. However, in some cases fixed price tariffs may not lock in the customer, in which case the customer likely would be rational to switch until Agile prices return to lower levels. I would argue the issue here is not with the Agile prices, but with fixed contracts, which is my next topic for discussion.

Thoughts on fixed contracts

In many financial markets (for example mortgages) there are two distinct forms of contract: fixed and floating. The floating, or flexible, version fluctuates freely, ideally such that the contract could be ended at any time without either party being worse off. The fixed version would, on the other hand, generally leave one party worse off if the contract was ended early, often requiring fair compensation.

Domestic electricity contracts, however, don’t seem to work like this. Flexible electricity contracts don’t fluctuate nearly as much as wholesale prices: they often don’t even reflect the fact that wholesale prices are considerably higher in winter than summer. I believe this is due to customers disliking price increases, even if the prices had previously decreased. Fixed contracts, in turn, have moved away from charging disproportionate penalties for leaving, and now often don’t charge any penalties for customers that leave.

This state of affairs does seem to be what customers want, but I’m not so sure. Customers win by changing contracts part way through, for example, as soon as winter is over. This forces companies to ensure their fixed price is high enough to be profitable even over the winter months. This means that any customer that sticks with the contract for the full term will lose. If all companies slightly overcharge all year, there will be less incentive to break contracts, but this strategy is vulnerable to the entry of new tariffs like Agile.

One way for electricity companies to lessen the risk of customers leaving part way through contracts that are no longer good value, would be for them to shape the prices. For example, rather than charging the same price year round, they could charge a higher price in winter than summer. However, this would require effort to get customers used to this way of charging, and it is possible that many would resist. In addition, this would not eliminate the risk of customers leaving fixed contracts as a result of non-seasonal factors, for example, the reduced demand as a result of Covid made cheaper contracts available.

My preference would instead be to make fixed contracts fixed (with penalties), and flexible tariffs more market reflective — I believe this would be fairer. I’m currently in a minority with this opinion, but it will be interesting to see if this changes over time.

Static Time of Use tariffs

Economy 7 has been around for a long time, and in recent years other suppliers have tried other time-of-use tariffs. Bulb Energy have a smart tariff which charges a high price from 4–7pm, and a lower price the rest of the day. Octopus Energy have a range of tariffs aimed at EV owners, called Go Faster, that allow them 3, 4 or 5 hours of very cheap electricity and a higher price the rest of the time (though even the peak price on Go Faster is often cheaper than most standard contracts).

These tariffs, referred to as ‘static time of use’ as the prices and periods are known in advance, are a useful way of incentivising customers to shift their consumption to the times of day where it costs the supplier less (though this only works if the supplier is being settled based on actual half hour data). Some appliances can be specified to switch on at a given time of day, making this much easier than trying to switch them on and off according to a tariff like Agile which is different each day.

These tariffs also tend to be fixed for a year, which eliminates much of the uncertainty for customers, but introduces the risk of unfair pricing if there is no exit fee, as discussed in the previous section.

For customers even static time of use tariffs requires too much engagement. This is particularly the case where price changes occur during waking hours. For example, having a high price from 4–7pm might lead to anxiety if you or someone in the house has a cup of tea during that period.

A second disadvantage of static time of use tariffs is that their simplifications can distort markets. If the price drops at 7pm, and enough people switch on at that time, it can lead to higher prices at 7pm than before. Likewise, on sunny days in summer, we might prefer customers to use more during the day, but these tariffs may disincentivise it. There are often nights where the some half hours cost significantly less than others, and static time of use tariffs are unable to capture that benefit.

Another perceived disadvantage of time of use tariffs is that they allow customers with flexible consumption to pay less, which might ultimately increase the price that other customers pay. Given that home owners with EVs are likely to be the most flexible, and parents with young children may have least flexibility, this seems undesirable. I would prefer to find ways to reduce economic inequality that don’t conflict with the incentive to use electricity at the optimal times, however I appreciate that this is politically easier said than done.

Reducing Tariff Uncertainty

One of the key concerns with a tariff like Agile is that it leaves customers exposed to a lot of uncertainty. Prices can spike for certain half hours. The whole day can be much higher than expected. And prices can gradually increase over time. Many customers would be willing to pay a premium in order to reduce their uncertainty.

The challenge here is to reduce tariff uncertainty without distorting the incentive to use electricity at the optimal times. For example, I’m sure most Octopus Agile customers are grateful for the 35p/kWh cap, yet that price is still sends a strong incentive to reduce consumption. Some customer might be happy for there to be a minimum , or ‘floor’ price, in return for a lower price at other times. However, many Agile customers adore their ‘plunge’ prices, when prices go negative.

Some people have suggested we might create a hybrid tariff. For example, if a tariff promised four hours each night at 5p/kWh (giving you certainty for charging the car), set the price at 30p/kWh from 4–7pm, and allowed it to vary the rest of the day. This type of deal might prove popular with some customers. However, the more that elements of a deal are fixed, the less incentive there is to flex consumption, and the more reason there is to switch tariffs the moment it is no longer good value (as discussed above), perhaps requiring exit fees.

I also wonder, whether half hourly caps are the right way to go. If a customer pays a higher price than expected for one half hour, and a lower price for another half hour, do they really need compensation? I thought about designing a version of Agile that replaced the 35p/kWh cap with a promise that you would never pay more than 30p/kWh for electricity used from 4–7pm, on average over a month. But I must admit this is more complicated to understand and manage, which might leave customers less trusting.

Appliance Specific Tariffs

One area where I think there is considerable potential is for customers to be offered a tariff for the electricity consumption from a specific appliance. For example, you could be offered a lower tariff for any electricity consumed by your electric vehicle, which could be assumed to primarily be used overnight, and a regular tariff for the rest of your consumption.

This would work quite easily if both tariffs were from the same supplier — they would just need to be able to measure your consumption from the appliance in question. They is some risk that you might game tariffs — for example, having one heater on a fixed tariff and a second heater on flexible —but this is already a risk for customers with electricity and gas. Splitting tariffs could also with with consumption for the specified device from a different supplier, so long as both suppliers could agree on the split.

Where I believe this approach makes most sense is when the supplier can control the device, for example choosing when to charge the car. There would need to be a contract, for example, that the car had to be 80% charged by 7am, but this would allow a supplier to minimise its own cost. The supplier could also offer short term flexibility resource to the grid, for example switching off charging for 2 minutes during a short lull in the wind. I don’t underestimate the challenge of specifying the contract and letting customers build confidence that they weren’t being cheated, but this does seem to offer the potential for gain.

Combining Import with Export

So far I have just been talking about buying electricity from the grid, however customers with PV (solar panels) and batteries may also export to the grid. In future there will also the potential to discharge from your car’s battery (Vehicle 2 Grid), which may sometimes be worthwhile.

It is possible to buy from the grid on a pass-through tariff (say Octopus Agile), and sell to the grid on a pass-through tariff (Octopus Agile Export). These tariffs aren’t identical, as you incur network and system charges on purchases, but you don’t receive them back on exports. For example, Octopus tends to pay customers half as much for electricity exported as they would charge for purchases. (For what it is worth, I’d prefer this margin to be reduced, as discussed in this post).

Where suppliers reduce the uncertainty for customers, things can get distorted. Even with Octopus Agile, putting the 35p/kWh cap on imports but not exports means there are times when the export price exceeds the import price. This technically gives a customer a reason to buy power from the grid and sell it straight back — hardly an efficient outcome. Where one or both of the tariffs are fixed, the customer may use their battery to optimise the tariffs, which may be quite different from optimising overall cost. I believe that over time, suppliers will take into account their customers’ ability to export when setting fixed tariffs.

Conclusion

To wrap up what has ended up being a long post, I expect there to be substantial changes to electricity tariffs in future.

I expect it will be possible to get tariffs that always reflect the true cost, similar to Agile but perhaps being even more market reflective. Only a small minority of customers would want this level of dynamism, but they will form the basis to compare other tariffs.

I then expect to see specific tariffs for appliances with large consumption or flexibility. Using these would allow customers to save on their overall bill, and open up the door for further optimisation by the supplier.

I expect most customers to have a fixed or static time-of-use tariff to cover all other consumption. While I think there will still be a preference for the simplicity of a single tariff, in many cases there will be substantial savings to be had by using a time-of-use tariff, especially where the customer hasn’t carved off significant appliances onto separate contracts.

And finally, I expect the fixed periods to be more firmly enforced, with penalties for breaking. And I expect contracts that are fixed for less than a year (or not fixed at all) to more accurately reflect seasonality and changing markets. This isn’t necessarily what customers would like, but I suspect that otherwise suppliers would suffer too much from detrimental customer switching.

All up, I expect it to offer a way for customers to avoid what could otherwise be considerable cost increases as the industry transitions to a green energy system, while also being an exciting time for the energy industry.