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1, FEBRUARY 2007

A Model for Efficient Consumer Pricing

Schemes in Electricity Markets
Emre Çelebi and J. David Fuller

Abstract—Suppliers in competitive electricity markets regularly scheme, more than one price is fixed in advance of use, and
respond to prices that change hour by hour or even more fre- the different prices apply during different predefined intervals
quently, but most consumers respond to price changes on a very of the week. TOU pricing can reduce the inefficiency of single
different time scale, i.e., they observe and respond to changes in
price as reflected on their monthly bills. In this paper, we examine pricing while being more practical, for most consumers, than
mixed complementarity programming models of equilibrium the real-time pricing of the wholesale market.
that can bridge the speed of response gap between suppliers and This paper develops a computable equilibrium model to esti-
consumers yet adhere to the principle of marginal cost pricing mate ex ante TOU prices while adhering as closely as possible
of electricity. We develop a computable equilibrium model to to the marginal cost principle, given that consumers can respond
estimate ex ante time-of-use (TOU) prices for a retail electricity
market. It is intended that the proposed models would be useful to changes in price no more frequently than the billing cycle al-
1) for jurisdictions (e.g., Ontario) where consumers’ prices are lows (e.g., monthly) while marginal costs of production change
regulated, but suppliers offer into a competitive market, 2) for much more rapidly (e.g., hourly). The supply side of the model
forecasting forward prices in unregulated markets, and 3) in is deliberately simplified here, in order to focus on how to rec-
evaluation and welfare analysis of the policies regarding regulated oncile the differing time scales of responses of producers and
TOU pricing compared to regulated single pricing.
consumers to changing prices. With added realism on the supply
Index Terms—Electricity markets, equilibrium modeling, mixed side, the ex ante prices could be used by a regulator to set the
complementarity problem, regulated pricing, time-of-use (TOU) TOU prices. Another use of the model would be to forecast the
TOU prices in a market in which the regulator does not set the
prices, but it only defines the different intervals of the week for
I. INTRODUCTION the different prices.
This model is significantly different from any other pricing
model for electricity markets, because of the consideration of
ANY electric power markets worldwide have been expe-
M riencing dramatic changes due to the restructuring of the
industry. The retail market is often regulated and the consumers
the time-differentiated pricing concept in an optimization and
equilibrium framework. Other models have either ignored the
demand response to changing prices, or, at the other extreme,
pay a single price for electricity, whereas the wholesale market they assumed that the full demand response occurred within one
is open to competition where suppliers may receive a price that hour.
varies hourly or more frequently. This paper also shows how to conduct a welfare analysis, to
The price in the wholesale market is very volatile and compare the TOU pricing with a single pricing variant of the
time-varying as opposed to the price in the retail market model.
where it has usually been fixed by regulatory bodies. The most This paper is organized as follows. Section II is an overview
common retail pricing practice all over the world before dereg- of time-varying electricity pricing schemes, followed by a
ulation and even after deregulation is a single price, fixed for at background on equilibrium modeling and welfare analysis.
least several months. Customers are billed on their cumulative In Section III, the TOU computable equilibrium model and
consumption over a period such as a month. Therefore, con- its underlying assumptions are introduced. Section IV is an
sumers are protected from the price changes in the wholesale illustrative numerical example, followed by extensions of the
market that occur in real time. Single pricing blends the costs of model (single pricing model, welfare analysis). This paper
producing electricity in peak and off-peak periods (which have concludes with Section V, in which the results are summarized
different marginal costs) into a single price, which causes the and directions for future research are suggested.
off-peak users to subsidize the consumption of peak users [1].
This indeed makes consumers insensitive to real-time electricity II. BACKGROUND
prices and uninterested in cutting power usage during price
A. Background on Time-Varying Electricity Pricing
spikes in wholesale markets. In a time-of-use (TOU) pricing
Economic theory dictates that efficient pricing is achieved
Manuscript received March 24, 2006; revised August 4, 2006. This work was
when electricity is priced at the marginal cost of supplying the
supported in part by the Natural Sciences and Engineering Council of Canada. last increment of electricity demand, and a perfectly competi-
Paper no. TPWRS-00160-2006. tive market can provide this. The literature on real-time “mar-
The authors are with the Department of Management Sciences, University ginal cost pricing” in electricity markets is now vast (see the
of Waterloo, Waterloo, ON N2L 3G1, Canada (e-mail:; seminal work by Schweppe et al. [2]). However, the time-dif-
Digital Object Identifier 10.1109/TPWRS.2006.888956 ferentiated pricing concept started earlier with studies on “peak
0885-8950/$25.00 © 2007 IEEE

load pricing” [3]–[11]. Peak loads and their pricing have been markets minus the transportation costs). Takayama and Judge
a concern because of the capacity requirements for these loads. [23] extended Samuelson’s spatial equilibrium model using a
In peak load pricing, high marginal cost of electricity during the “quasi welfare function” with linear price-dependent demand
periods of the peak load is reflected in consumer prices, e.g., by and supply functions and proposed a quadratic programming
TOU pricing. In TOU pricing, both prices and time periods are algorithm to obtain the equilibrium solution.
known ex ante and are fixed for some duration (e.g., a season). However, if the demand functions are not symmetric, or in
In contrast, in real-time pricing (RTP), generally prices change other words, integrability conditions (see [23]) are not satisfied,
on an hourly basis and are fixed and known only on a day-ahead a quasi welfare function cannot be constructed. For example,
or hour-ahead basis. RTP reflects the wholesale prices, weather in a multi-commodity model, cross price effects in demand can
conditions, generator failures, scarcity of generation, or other cause the integrability conditions to fail. Empirically estimated
contingencies that occur in a wholesale electricity market. demand functions are unlikely to satisfy these conditions. How-
The theoretical body of peak load pricing literature was not ever, complementarity problems overcome this shortcoming of
able to give practical answers to the problem, and so many optimization approaches; see Rutherford [24].
large-scale experiments have been conducted with TOU pricing Many researchers have devised algorithms to compute the
over the past three decades. Surveys of these experiments can equilibrium for non-integrable models, such as the PIES algo-
be found in [3] and [12]–[14]. These experiments collected data rithm [25], the decoupling algorithm [26], and algorithms for
that allow econometricians to estimate the parameters of elec- complementarity problems [27]–[30] or variational inequalities
tricity demand functions such as own and cross price elasticities, [31].
elasticities of substitution, and lag elasticities. Some countries If the model has symmetric demand, and therefore an objec-
even implemented TOU pricing on a national scale (see [3] and tive to maximize welfare (normally consumers’ plus producers’
[15] for an account). A more recent experiment for California surplus), a policy analyst can observe the change in surplus be-
(statewide pricing pilot) has shown that residential and small to tween two different runs of the equilibrium model.
medium commercial and industrial customers cut energy usage When the demand functions are not symmetric (non-in-
in peak periods in response to TOU prices [16]. tegrable), an approximation method that was introduced by
Patrick and Wolak [17] estimated some significant demand Arnold Harberger [32] can be used to estimate the change in
response for electricity by large- and medium-sized industrial consumers’ surplus. He used a Taylor series approximation
and commercial customers purchasing electricity according to for the change in total value for a single consumer. Change
the half-hourly real-time price from the England & Wales elec- in consumers’ surplus is then given by the expression below,
tricity market. Borenstein et al. [18] reported on some U.S. util- change in consumers’ total value minus change in consumers’
ities’ implementations of RTP for their medium/large industrial payments, summed over all commodities in the model.
and commercial customers that showed reduction in peak period Change in consumers’ surplus
energy use.
The main attraction of time-varying pricing (e.g., RTP, TOU)
is that it motivates customers to reduce their electricity con-
sumption in peak periods and shifts some to off-peak periods,
thereby reducing the total capacity requirement [4], [6], [12],
where is the previous equilibrium price, is the quantity
demanded in the previous equilibrium, is the change in
However, RTP has several drawbacks. It transfers the uncer-
prices, and is the change in quantities demanded.
tainty and volatility of prices to customers, and consequently,
On the other hand, change in producers’ surplus can be calcu-
this has failed to attract many customers [19]. Joskow and Tirole
lated by change in profits or, equivalently, change in suppliers’
[20] gave two main reasons why the final consumers may not
revenues minus change in suppliers’ costs.
react to real-time prices. First, the cost of monitoring and evalua-
tion of hourly prices and constantly optimizing the use of equip- III. PRICING MODEL
ment is enormous for small consumers. Second, most directed
interruptions (due to a shortage in supply) that can be controlled A. Supply and Demand Side
by the distribution network operator usually occur at the level This section presents a multi-period computable equilibrium
of zones, which means that individual small consumers cannot model for wholesale and retail electricity markets that seeks
sign up for interruptible supply contracts. TOU prices based on the principle of marginal cost pricing of
electricity. The model consists of two parts: the demand side
B. Background on Equilibrium Modeling and Welfare Analysis and the supply side.
A partial equilibrium model represents only a part of the The simple supply model minimizes the cost of hourly gen-
economy, with all other variables in other markets being treated eration by different technologies of production (e.g., nuclear,
constant. Thus, it is possible to model a particular market in hydro, coal, gas/oil, indexed by ) to meet given demands for
more detail than general equilibrium models [21]. the hours in different time blocks, such as off-peak, mid-peak,
Samuelson [22] was the first economist to formulate a and on-peak demand (indexed by ). System-wide cost mini-
partial equilibrium model as a mathematical programming mization results, in theory, when suppliers behave in a competi-
problem with the objective of maximizing “net social payoff” tive manner (no exercise of market power). Market power issues
(consumers’ plus producers’ surpluses in different regional may be addressed in future research.

The supply model can be extended to be more realistic as long The demand side is represented by demand equations that use
as it remains as a linear program or more generally as a convex the prices and lagged demand as independent variables, such
program, because in the overall equilibrium model, we use the that the reaction of demand to changes in price is a process in
Karush–Kuhn–Tucker (KKT) conditions of the supply model, time. Especially in energy markets, the adjustment to varying
and we need the KKT conditions to be necessary and sufficient. prices can occur after some periods rather than instantaneously.
For example, one could include a linearized dc power network, The response of the consumer is not at a point of time but rather
line limits, and ramping constraints. However, the problem be- distributed over time because of usage patterns (i.e., habits), im-
comes challenging if the supply side of the problem becomes perfect information about the market, and need for some unin-
non-convex, e.g., with binary variables to allow representation terruptible services that are supplied by energy used by stocks
of unit commitment, startup costs, minimum run, and minimum of equipment—e.g., refrigerators, lights, etc. [26]. A distributed
downtime. lag demand can represent this response process in time. One
The supply side of the model is formulated as in (1). form of a one commodity model is the geometric distributed lag
Parameters: (GDL) demand model with constant price elasticity
set of generation facilities:
set of demand blocks:
set of periods (months): (3)
set of hours in demand block
operating cost per unit of energy for facility in where is the demand of electricity in period is a con-
period ($/MWh) stant representing non-price effects (e.g., weather conditions,
discount factor ( : discount factor to the power of ) socio-demographic factors), is the price of electricity at pe-
energy demand for demand block in hour in riod is the lagged demand, is the constant price elas-
period (MWh) ticity, and is the lag elasticity. This demand model is widely
capacity of facility in period (MW) used in econometric studies and also in the model of this paper.
Decision Variables: the energy flowing from facility In a real-world application, a careful econometric study would
to demand block for hour in period (MWh) be needed, to establish the best functional form and its parame-
By taking natural logarithms of both sides of (3), we can get


Equation (4) can be extended to a multi-commodity case

subject to dual
where each commodity is the electricity demand in different
and times of day (e.g., demand blocks: on-peak, mid-peak, off-peak)

and (5)
and (1)
The objective function minimizes the discounted total oper- vector of the factors representing non-price effects
ating costs of all facilities (nuclear, hydro, coal, gas/oil) that in- at period ;
ject energy. The first set of constraints ensures that electricity vector of all demands for electricity in period (i.e.,
supply is sufficient to meet demand; at an optimal solution, these on-peak, mid-peak, off-peak demand);
constraints are binding equalities. The second set of constraints vector of all electricity prices in period (i.e., on-peak,
contains the capacity constraint for each generation facility; they mid-peak, off-peak prices);
are written in the “ ” form to ensure that the dual variables are square matrix of the constant price elasticities (i.e.,
nonnegative, in order to ease the interpretation of these duals. own-price and cross-price);
The dual variables have the interpretation of the discounted square diagonal matrix of the constant lag elasticities.
marginal cost of increasing the energy demand of the th block
for hour by a unit. Hence, they give the discounted marginal B. Estimation of Load Variation Within a Demand Block
cost of hourly energy demanded in the various demand blocks.
In this subsection, we explain the meaning and measurement
The dual variables can be interpreted as the discounted
of the parameters that link the different time scales of the supply
marginal cost of reducing the capacity of facility by a unit for
and demand sides of the model: fraction of total energy
demand block and hour , i.e., the “scarcity rent.” The KKT
demand during block of month that occurs during hour .
conditions for the supply side of the model are as follows:
When consumers pay the same price for energy at any hour
within a TOU block, it is reasonable to suppose that the demand
variations over hours within the block are related to non-price
and (2) causes, such as temperatures, natural lighting, daily meal sched-
and ules, and habits of all kinds that affect electricity usage. Such

non-price causes must necessarily be represented by parameters, hourly and monthly time scales. The last equation includes the
not variables to be solved for. We propose to measure the pat- factor in order to remove the discounting from the marginal
tern of variation in demand that has been observed in the recent cost, , before relating it to the consumer price at time , .
past and to assume that the same pattern (but not the absolute The fifth equation ensures that the demand variation within a
values) will repeat in the near future, i.e., within the model’s block follows the historical pattern. The fifth and sixth equations
time horizon. together ensure that the revenue requirement of suppliers for
Next, we explain how to calculate the values of for a demand block is met by revenue collected from consumers
specific block and month , from historical observations of
from one previous year. If several previous years’ observations
are available, then can be averaged over the values for all
these years.
Note that the fifth and the sixth sets of equations do not im-
First, define , the total energy demand in pose the historical shape of the entire month’s load duration
block , the th element of the vector , for the historical curve. The historical parameters impose the historical shape
month . The desired fractions are simply of the load duration curve within the hours of demand block ,
but if prices differ from historical ones, then the entire month’s
load duration curve of the solution can have a shape that is dif-
(6) ferent from the historical shape.
If TOU prices are required to be the same in all months, then
a variant of (7) can easily be defined: remove the month index
from price and replace the fifth and sixth conditions by ones
Note that . that sum over . See Section IV-B.
C. Mixed Complementarity Problem (MCP) Approach IV. COMPUTATIONAL RESULTS AND ANALYSES
The model proposed in this paper is represented and solved
A. Illustrative Example
by a mixed complementarity problem (MCP) approach [34].
In general, a mixed complementarity problem is defined as An illustrative example of (7) for the Ontario market is given
follows: in this section to clarify the structure and the solution method-
MCP: find such that ology of the process model. We illustrate by using a past pe-
(or in short form ) and where riod’s demand data for Ontario and find the TOU prices (ex post)
and are vector valued. This complementarity for the same period to validate the model. In real use, parameters
problem is “square” if there are as many individual conditions carefully estimated from historical data would be used to fore-
(equations) as variables. cast future TOU prices (ex ante). This example consists of four
The demand side (5) along with the supply side’s first-order periods (T1, T2, T3, T4), four types of generation facilities (nu-
optimality conditions (KKT conditions) as in (2) can be for- clear, hydro, coal, gas/oil), and three demand blocks (on-peak,
mulated as a mixed complementarity problem. The MCP is as mid-peak, and off-peak electricity).
follows: The data for GDL demand equations are taken in part from
MCP: Find that satisfy (7) at the Mountain and Lawson [35]. In their experiment, they main-
bottom of the page, where , and are the th ele- tained the homogeneity assumption,1 and also, they did not use
any lagged demand term. Therefore, we have inflated the own-
ments of vectors , and , respectively. Similarly,
and are the elements of matrices and , respectively. 1The homogeneity assumption is that the sum of own and cross price elastic-

The first three conditions are the supply-side KKT conditions, ities for demand block j equals 0. This implies the unrealistic result that there is
no demand response to price changes when there is a single price for all demand
and the fourth equation is the geometric distributed lag demand blocks; see (10) in Section IV-B. Therefore, we have inflated the Mountain and
equation. The last two equations are the connection between the Lawson [35] own-price elasticities for our illustration.




To estimate the parameters in the lagged demand model,

the historical regulated single retail price ($50/MWh), historical
demand data (demand blocks from April to August 2004), and
the elasticities of Table I are used. The following formula is used
to estimate the parameters:

2004 (T0) TO AUGUST 2004 (T4)

In this illustration, the marginal cost for different production

technologies is assumed to be constant for output between zero
and installed capacity. Operating cost (or marginal cost) of each
production technology is from [39] and is shown in Table III.
Since the cost information is kept confidential by firms and reg-
ulatory bodies, only crude estimates can be used. Actual costs
may be different. Nevertheless, these estimates can be used for
illustrative purposes. We have assumed slight changes in mar-
ginal costs over time merely to illustrate that the model allows
for this.
price elasticities by the short-run price elasticity of Ontario res- The discount factor is assumed to be one to simplify the il-
idential electricity demand from a study by Ryan et al. [36]. An lustration, but there is no difficulty to use a discount factor less
estimation of the lag elasticity is calculated from an econometric than one.
study by Gill and Maddala [37]. It is calculated as 0.452 for all Also, for simplicity, available capacities are assumed to be
demand blocks. Although this is acceptable for illustrative pur- fixed throughout the four months and presented in Table IV [38].
poses, the use of the model for policy purposes would require However, there is no harm to use changing capacities for each
careful econometric estimation of all elasticities. The elastici- period , to represent, e.g., planned shutdowns for maintenance.
ties are shown in Table I. Another major assumption is about the network structure.
The demand data are taken from Ontario’s Independent Elec- Transmission constraints such as line and voltage limits are ig-
tricity System Operator [38]: hourly demand data for the On- nored in our analyses. This means that there is a single price at
tario market for each month from April 2004 to August 2004. any given time, as is now the case in Ontario. Geographically
The demand data for each day are grouped into 9 h of off-peak, differentiated prices (i.e., nodal, zonal pricing) would require a
8 h of mid-peak, and 7 h of on-peak demand, in a day as in representation of the transmission network in the model.
the proposed Ontario TOU pricing scheme [1]. However, no The model is coded in GAMS and solved by the MCP solver,
weekend and weekday distinction is made, to simplify for il- PATH.3 Tables V and VI summarize the results.
lustrative purposes. Table II displays the derived data for each For some months, the TOU prices are exactly equal to the op-
demand block within each month. Note that the model requires erating cost of the generator that serves the last unit of energy
inputs of , T0 in Table II, which is the lagged demand data (i.e., the marginal cost of production in Table III), and for some
for the period T1. It also needs data derived by (6) from his- other months, it is the weighted average of the hourly prices
torical hourly demand data and Table II data (from period T1 to 3Note that the model can be decomposed into separate problems for each
period T4). period t, except for the demand equation, which depends on demand in period
2The relationship between the short-run price elasticity, b, and long-run price
t0 1. Given the first period’s lag demand data, MCP in period T1 can be solved
and variable values in period T1 can be used in period T2 to solve for MCP
elasticity, b
in period T2. Starting with the first period, this iterative procedure can reduce
computation time.
Another scheme to reduce the computation time would replace all days in
b = (b)=(1 0 e) : the model by a representative weekday and weekend day for the month. Such
schemes for computational efficiency may be important in future research, if
Using this relationship and b = 0:34 and b = 00 64, the lag elasticity,
: more realism is added to the supply side, e.g., network constraints, line limits,
e , is found as 0.45 for all demand blocks. or ramp limits.






single price multiplied by the total demand (i.e., sum of de-

mand blocks in all periods) is equal to the revenues collected
from hourly prices and demands over all hours, demand blocks,
and periods. Note that the single price is actually a weighted
average of all hourly prices

within a certain demand block. There is about 24% increase in

off-peak demand when compared to actual off-peak demand in (11)
2004 in Table II. The mid-peak and on-peak demands are also
increased by about 18% and 11%, respectively, when compared
to actual mid-peak and on-peak demands in Table II. This is ex- Note also that a model with different single prices in different
pected since the TOU prices are lower than the regulated single months would require only simple changes to (10): a month
price of $50/MWh in the April 2004 to August 2004 period. index, , on , and replacement of the single revenue balance
constraint by of them, one for each month. Such a model
B. Extensions: Single Pricing and Welfare Analysis would be useful for forecasting equilibrium prices in markets
like the previous one in Ontario, prior to consumer price regu-
Instead of TOU pricing, some consumers may prefer a single
lation, in which the consumer price in a month was the quantity
price, or regulatory bodies in electricity markets may choose
weighted average of the hourly wholesale price in the month.
to implement a single pricing scheme. In this case, consumers’
The single pricing model is solved with these modifications in
prices do not vary by time of day, and they may or may not vary
(10) using the same data and parameters from the TOU pricing
by month. We illustrate by showing how to model a single price
model in the previous section. Solution of the single pricing
that is the same at all times of day and in all months, which is
model for a four-month period is presented in Table VII.
similar to current price regulation in Ontario.
The single price was found to be $33.74/MWh. The differ-
It is easy to incorporate the revenue requirements of the sup-
ences between demand values from the single model and the
pliers or retailers in the model, by modifying the fourth and sixth
actual demand values from Table II are about 14% for all de-
sets of equations in (7) to reflect the revenue requirements of
mand blocks. This is again mainly due to the fact that the single
suppliers and retailers as follows:
price is lower than the regulated single price of $50/MWh in the
April 2004 to August 2004 period.
A comparative welfare analysis for TOU and single pricing
can be done. Table VIII compares the single and TOU pricing
and models’ equilibrium solutions for the four-month model.
Equilibrium TOU prices for the off-peak and mid-peak de-
mand blocks for the four-month model are lower than the equi-
librium single price, except for the mid-peak price in the last
period. TOU prices for on-peak demand blocks are higher than
The first equation is the geometric distributed lagged demand the single price except for the first on-peak TOU price, which
with the single price . The second equation ensures that the causes an increase in the on-peak demand for that period. Off-
revenue requirements of suppliers over all periods are met. The peak demands for the TOU scheme are about 9% higher than


that of the single pricing scheme. Similarly, mid-peak demands strategic interactions between competing firms can be analyzed,
for the TOU scheme have increased about 3%. However, the in order to explore the potential for large firms to “game” the
demand for on-peak hours is about 3% lower than the single market, in the context of a model that more realistically repre-
pricing model. Some amount of the on-peak demand is shifted sents consumers’ responses to changing prices (see [40] and ref-
to off-peak and mid-peak hours. More accurately, this can be at- erences therein for a review of these models). Also, a more real-
tributed partially to a shift in consumption from on-peak hours istic model can be built by introducing a linearized dc network,
to off-peak and mid-peak hours and partially to a reduction line limits, and ramp limits. Moreover, stochastic components
in consumption at on-peak hours. This was expected, because such as generator failures, weather conditions, and other factors
many studies have reported findings that show either a shift in can be examined. This would allow a regulatory body to im-
consumption from peak hours to off-peak hours or a demand plement a critical peak pricing (CPP) scheme, i.e., a traditional
reduction in peak hours. Total demand for all periods has in- TOU pricing scheme that is in effect all year except for 50–100
creased almost 3%. This can be attributed to lower prices for critical peak hours, the timing of which is unknown and where
the off-peak and mid-peak hours that cause an increase in total a much higher price is in effect for the on-peak and mid-peak
demand that cannot be offset by the decreases in on-peak hours. periods (where customers are informed hours or a day ahead
The welfare effects of TOU pricing on consumers and sup- before the critical peak hours).
pliers can be examined by using Harberger’s approximation.
Table IX summarizes the welfare analysis after the implemen-
tation of TOU prices.
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