When restaurants charge you more at dinner than at lunch, is that a form of “price discrimination”? Not necessarily. If the restaurant serves a full house every night, but sees only a few tables filled at lunchtime, it can resort to what is called “peak-load pricing” during the evening.
Peak-load pricing is the type of price strategy that promotes efficiency while ensuring that a service provider doesn’t sell at a loss. When you pay for a restaurant visit, you pay for the food cost as well as the rent of the restaurant. If the restaurant is not so packed at dinnertime, the owner can shrink the size of leasing space. As that is not the case, the marginal cost of serving customers during dinnertime is higher than that in lunchtime.
Peak-load pricing is often misconstrued, especially by those who don’t know much about the concept of “cost” in economics. A fresh example is the new pricing scheme launched by CLP (0002.HK) this month. With smart meters installed to record usage by the hour, CLP would test higher fees for peak-time electricity usage.
The one-year ‘Smart Energy Programme’, featuring experimentation with differential pricing for the first time in Hong Kong’s electricity sector, has received huge criticism from the public and press. As an advocate of peak-load pricing in energy sector, my arguments can be found in an article I wrote as far back as four years ago.
I learnt power market economics from Professor Arnold Harberger, who had taught at the University of Chicago. According to him, power market pricing analysis is merely based on the price theory in economics, with thoughts centered on whether a product or service is priced at its marginal cost.
Marginal cost is the amount of resource that the society forgoes in exchange for an extra unit of product or service (electricity in this case). In general, the marginal cost of producing electricity comprises cost of fuel, human resources, etc. However, taking the huge fixed cost in investing infrastructure into account, its marginal cost is always lower than the average cost of production. Many believe that growth in production volume will continue to drive down the marginal cost of electricity, displaying the characteristic of “natural monopoly”.
If a government regulator forces a monopolist to set its price at marginal cost, it cannot cover the average cost and the monopolist will suffer losses. But if there is no regulation on pricing, the monopolist will tend to charge customers more than the marginal cost, resulting in a deadweight loss for the society.
In this case, Prof. Harberger suggested that peak-load pricing should be adopted. Power companies can charge more for electricity usage during periods of high demand or full capacity. This pricing will not only satisfy different degrees of power demand during different hours, but will also help power companies retrieve fixed costs in infrastructure investment.
One point to add after four years is that charging users a single uniform price regardless of the difference in their demand, is indeed fleecing off-peak users while compensating intensive users.
It is economically illogical to discredit CLP for using energy saving as an excuse to boost profit. Firstly, when the assets of power companies are bound in the short term, the companies’ profit is restrained under the Scheme of Control Agreement (SCA), regardless of different pricing scheme. Besides, with the SCA currently providing for 9.99 percent permitted rate of return on average net fixed assets, controlling new power plant investment yields similar result as holding back the tariff growth. And one of the goals of the new pricing scheme is to reduce electricity usage during peak hours, thereby moderating the need for investing in new plants.
By adopting peak-load pricing, users are encouraged to install home battery units for energy storage, which is another underappreciated long-term benefit of the new pricing system. Residential battery storage practice would also narrow the difference between energy usage in peak and off-peak hours, so as to promote renewable power generation in Hong Kong.
Experimental analysis is required to determine the operational details about the Smart Energy Programme, such as the extra fee for electricity usage in peak-hours. In countries that launched similar projects previously, users in general pay double at peak hours than that in off-peak hours.
This article appeared in the Hong Kong Economic Journal on June 20
Translation by Ben Ng
[Chinese version 中文版]
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