A new approach to congestion pricing in electricity markets: Improving user pays pricing incentives

- We evaluate the economic efficiency of existing electricity pricing methodologies.
- We find that average cost pricing and 'time-of-use' (ToU) pricing are not efficient.
- As an alternative, we propose a new efficient methodology for electricity pricing.
- Our new methodology is based upon demand variability and capacity utilisation.
- Demand variability is measured by calculating the first derivative of demand.

Electricity pricing has traditionally been based on average cost pricing where consumers pay a 'flat' tariff based upon the average cost of production and transportation of electricity. The introduction of new 'smart' meters allows electricity providers to differentiate tariffs on the basis of time. Utilising congestion pricing theory, the energy industry has embraced 'time-of-use' (ToU) tariffs with a view to more efficiently pricing electricity. This paper demonstrates that pricing as a function of demand variability (reflecting capacity utilisation) is a more appropriate alternative to existing ToU tariffs for more efficiently allocating costs to end users. We call this new alternative pricing model 'first derivative ratio' FDR pricing. This new approach to congestion pricing could be applied to markets other than electricity, such as road transportation.