The Price of the Month. Success or Failure?

04/2010: Green Electricity starting at 5,53 cent/kWh

Posted in Pricing by Jouko Riihimäki on 1.4.2010

General information on the electricity markets

The Finnish electricity markets were reformed and opened for competition from 1995 onwards, when the Electricity Market Act (386/1995) became effective. Opening the markets has been gradual and today all consumers of electricity can acquire their electricity freely from any supplier they wish. The electricity market reform reduced the obstacles for competition and removed unnecessary regulation in those areas where competition was possible, i.e. production, sales and foreign trade. However, the reform set clear rules on electrical power networks, which are monopolies by nature.

General information on electricity pricing

The electrical bill consists of 1. electrical energy or electricity sales (about 38 %), 2. transmission of electrical energy (about 37 %) and 3. taxes (about 25 %). Various factors determined by the markets affect the price of electrical energy, such as production costs and stock prices. The only portion of the electric bill that the suppliers can compete on is the share of electrical energy, or sales. The local electrical power network company is responsible for the transmission of electrical energy, and therefore the transmission price cannot be put out to tender. In terms of the household price of electricity, the general price level in Finland in 2008 was low (12.73 cents per kWh) compared to other European countries. The lowest price was found in Bulgaria 8.23 (-35 % vs. Finland) and the highest in Denmark 27.85 (+119 % vs. Finland). This article focuses on the pricing of household electrical energy. Due to the nature of the industry and the product itself, the basic pricing of electricity is mostly Cost Based Pricing.

General information on green electricity

According to Wikipedia, sustainable (green) electricity is a common name for electricity produced with forms of energy which are renewable and either zero or only minimally polluting. Ground heat, wind power, solar energy and tidal power stations are included in this group, as well as bio fuels, bio gas and small-scale water power, sometimes even waste incineration. According to Statistics Finland, the share of sustainable energy of all energy consumption reached a new record in 2008, up to 28 per cent of total energy consumption. The pricing of sustainable electricity is in part Value Based Pricing. This is supported by a survey of Taloustutkimus on March 20th 2010; according to the survey, two out of three (66 %) citizens of the 14 municipalities in the Helsinki area, as well as the citizens in the Raseborg area and Sipoo, are willing to pay for replacement (renewable) energy, even if it meant higher taxes or increase in electric bills. This article uses the terms sustainable (green) energy and renewable energy as synonymous.

Key questions in pricing of sustainable electricity are:

1. What are the selection criteria for electrical energy in terms of households (formation of price)?
2. How much does sustainable electricity cost compared to other electricity?
3. From households’ point of view, is sustainable electricity a consumer product?
4. Have the sustainable choices of households affected electricity production?
5. How should the sustainable electricity product and related services and pricing be developed?

Consumers can affect the price of electrical energy in their bill, as well as total amount of the bill, via the following factors: 1. the amount of used electricity, 2. the manner and time of using electrical energy, 3. the supplier of electrical energy and the product itself and 4. the term of the electricity contract. The sustainability of the electricity product only consists of the manner of electricity production but consumers may affect the environment-friendliness of electricity in other ways, as well: by saving energy on a general level, focusing the use of energy on weekends and evenings/nights and by using various energy-efficient products (such as washers, televisions, etc.). In terms of these factors, sustainable electricity and other electricity do not differ from each other.

The Energy Market Authority maintains current records of electrical energy prices. The table below is based on an annual consumption of 10.000 kWh in the Helsinki city center (zip code 00100). The table includes 20 of the most economical reference products. Renewable electricity is marked in green in the picture.

According to this price comparison, almost half of them are produced via renewable production methods (8/20). Thus we can conclude that sustainable electricity does not have to be any more expensive than other electricity. Thanks to free competition, households can choose any supplier they wish for their sustainable electricity, at a competitive price.

Next, I will answer the third question. According to the Vihreä Lanka website (March 9th 2010), State Secretary Raimo Sailas from the Ministry of Finance criticized sustainable energy in the latest Energia magazine. “Dear people, do not believe the advertisers of sustainable energy. It is the one and the same thing coming out of the cable”, Sailas says. Basically the statement refers to the consumers not being able to affect they will be the ones using the sustainable electricity. First, let us examine the value chain of electricity:

1. The sources and production of electrical energy (free competition)
2. Area network – Transmission of electricity from production to the main grid (monopoly)
3. Main grid – Transmission of electricity within the main grid (monopoly)
4. Area network – Transmission of electricity from the main grid to the place of use (monopoly)
5. Consumption of electricity

Sustainable electricity applies to the beginning of the value chain but it is marketed as a separate consumer product at the end of the chain. The problem with sustainable electricity is the fact that, due to the nature of the product, it cannot be “earmarked” in the value chain all the way to its usage. This means that, with their choices, the consumers affect the share of sustainable electricity in the electrical power networks, and not directly the sustainability of their personal electricity. Therefore your personal choice will affect the sustainability of electricity used by others (societal product). Thus selling and pricing sustainable electricity as a separate consumer product is somewhat misleading. This is also supported by the observation of Suvi Salmela in her 2004 pro gradu thesis, stating that consumers may have trouble understanding the principles of electricity contracts and distribution of electrical energy in the liberated electricity markets. Many of the interviewees were unaware of the fact that when consumers pay for sustainable energy, they still receive the same electricity as other customers and that the electricity is still distributed via the local distributor of electrical energy.

My personal evaluation takes the special nature of the electricity markets into consideration. Operation in the electricity markets is long-term and capital-intensive. Electricity is a commodity product, without which the society cannot function. In addition, energy production is based on electricity contracts, against which the suppliers supply electricity to the markets. Therefore contracts (including households) are an important part of the operating logic of the electricity markets. Contracts can thus be used to affect the method of production and guide it toward more sustainable alternatives. By choosing sustainable electricity, to some extent the households also make the choice for other households. As proof of the change and effect, the share of sustainable energy sources has grown significantly in the 21st century: over 20 % growth from the year 2000 to year 2008. At the same time, the share of household customers with environmentally friendly eco-energy has taken a strong turn upward. However, when looking at these numbers, it must be taken into consideration that the electricity used by households and agriculture only forms about 25 % of total consumption according to Statistics Finland.

To conclude, the pricing of sustainable electricity is reasonable when the nature of the industry is considered. Households have the option of choosing sustainable electricity without paying for it significantly over the average price level in the markets. In addition, these choices affect the way the markets operate. Here I disagree with State Secretary Raimo Sailas, who would not give households any chances of affecting the sustainability of electricity production methods.

Although households have not been very active in making electricity suppliers compete with each other, there is plenty of up-to-date price information publicly and easily available. This means that the inactiveness of households is not caused by lack of availability and transparency of price information. In addition, it is fairly easy and quick to switch electricity suppliers. The inactiveness of households has given electrical energy suppliers an excellent chance to make money with electricity products (including sustainable electricity) via simple and continuous notifications of increases in price. The bases for these increases often remain unclear to households. To this extent, the pricing mechanisms of suppliers to current customers are strongly based on the operating methods of the monopoly era. This traditional pricing of electrical energy is also supported by the regional monopoly status of electricity transmission.

Pricing Stars (1-5):

Developing pricing

Since electricity as a product does not vary much from the perspective of household usage, the pricing will remain based mainly on costs in the future as well. The demand for cost-efficiency for many actors is essential. This also applies to the production and pricing of sustainable electricity. New production methods require long-term investments and this can be seen in the price of electrical energy.

However, sustainable electricity should be seen as a bundled service instead of a simple choice of production method and sources. From the point of view of households, it must be highlighted that personal behavior will affect the sustainability of electricity in an effective way in the future as well. For this purpose, up-to-date reporting and invoicing tools for electrical energy would support the monitoring and efficiency of household electricity usage. There is no information or certifications available for the personal energy-efficiency and environment-friendliness of suppliers. Based on the current information, it is hard to say whether sustainable electricity is better produced in local electrical companies or farther in efficient production plants. This would be a perfect opportunity to develop a clear sustainability index for suppliers, including the efficiency of production processes, location of production plants, etc. The picture below indicates all factors affecting the selection of sustainable electricity, all the way from the core to supplementary services. The pricing of products and services could be developed on these bases as well. In addition, the use of loyalty based pricing should be considered.

Jouko Riihimäki, M.Sc, CPP Certified Pricing Professional

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