Equity versus efficiency in utility pricing

Designing a system that only really works for the top 10% can be a somewhat risky enterprise.

On July 14th 1789, King Louis XVI wrote in his diary one single word – “nothing” – to describe the results of his day's hunting. Earlier that day, the Bastille had been stormed.  The King had no inkling as to what was coming, either in the lead up or even on the day of the event.  His ignorance of what would be his downfall is not an isolated example. History shows us countless examples where an awareness of the drivers, passion and resolve of an active proletariat came too late.  Is there a lesson here for today’s utilities, as the gap between rich and poor in many societies grows ever wider?

Inequality hurts people and economies

Inequality is now firmly on the international agenda – not esoterically or through academic discussions of philosophy but through the emerging presence of political involvement by those who have less. The rationale for this is twofold. 

Firstly, it’s acknowledged that inequality is bad for countries and their economies. When wealth is concentrated, it narrows the number of parties actively involved in decision-making and investment, so reducing overall economic activity. Inequality skews political process and societal decision-making, and increases the likelihood that more people will be dependent on government services.

Secondly, and more simply, it reduces the opportunity for people to play a part in the world around them. When people feel that their voice and their right to play a part in improving their situation is taken away, they will tend to look for opportunities to find it another way, either through active involvement in the political process, or, in extreme cases, via direct action - as Louis XVI discovered. 

The myth of egalitarianism

Many of us fortunate enough to live in developed countries like to think that our societies are egalitarian. But the figures tell a different story:

• In the US, inequality is growing. The top 10% average nearly nine times as much income as the bottom 90%. (Source: Inequality.org)
• In the UK, the top 10% earners have a net income nine times that of the bottom 10% while the richest 10% of households hold nearly half (45%) the nation’s wealth. (Source: The Equality Trust)
• In Australia, a person in the top 20% income group receives around five times as much income as a person in the bottom 20% while someone in the top 20% wealth group has a staggering 70 times as much wealth as a person in the bottom 20%. (Source: Australian Council of Social Services)

At the same time that the gap between the richest and poorest has been widening, the provision of essential services, such as energy and water, has changed as microeconomic reform has developed all around the world. With the advent of “user pays” pricing and consolidated water and power companies, a “capital expenditure social contract” has been the main method by which companies designed and paid for transformation and big builds.  By this, I mean that when large projects are undertaken, the population is deemed to have agreed to repay this back over time under tariff structures for as long as they take supply.  The transformation programs underway in utilities as they embrace the age of digital and big data have been similar.

Equal prices for equal access

The nature of utility charging is that customers pay for services based on the capacity they draw from the system, not their economic circumstance. While some protection is provided through targeted pension and benefit programs, the sharpening of pricing signals and the era of full-cost recovery has seen the rise of tariff design which splits fixed and variable costs on purely economic grounds. That is, the fixed costs of a connection are borne by all on the basis of the type and size of connection provided, not the economic circumstances of the customer or the household.  As overall expenditure rises for a utility, these charges rise to repay them, thus levying a flat tax on the population.  Where adversity or hardship may occur, governments may deploy benefit systems to soften the impact of these sharpening charges on the poorest in our society.

At present, while wealth inequality is stark, rates of hardship are not outside the averages, and while there is certainly an argument that the costs of the utility of the future are falling upon parts of the population who neither need the optionality nor can afford it, the system is managing itself without uproar. For now …

Will the robotic revolution widen the inequality gap?

However, as the rate of change of society increases, keeping pace with the gap between the give and take can be a challenge. This is particularly an issue with the introduction of new technology that deepens inequality. For example, the rise of automation and robotics will see a vast reduction in the number of low paid jobs – machines are already replacing servers at US fast food chain Wendy’s.

As with the industrial revolution in Europe between 1800 and 1840, the returns from these inefficiencies will skew towards capital and away from labour, and represent an increasing source of inequality in our society. This will put pressure on the way in which our society taxes, spends and charges (https://piketty.pse.ens.fr/files/Allen05.pdf ).

How utilities choose to react to this will be interesting. On the one hand, the richer parts of society are demanding greater services which require scale investment in both systems and processes. These wealthier customers want to own water treatment, batteries, solar and virtual power plants. They demand options, choice and IT-enabled. The poorer sections of society, through the economic impacts of flat capacity and connection based tariffs, will get taken for the ride. 

But energy reforms of recent years have removed from utilities’ any social obligation regarding charges. They are empowered by government contracts to focus on efficiency and freedom of movement in relation to capacity based charging. Utilities are within their rights to ignore growing inequality and continue to design a system for the top 20%, enforcing a social contract with the remaining 80% to pay the access charges that accompany the design and execution of the smart network. 

The difficulty with electricity and water however is that no matter how they are traded, commoditised and sold, they are still considered to be basic rights of all. As society becomes increasing robotic, as the industrial step change begins again, utilities will see a growing trend of late payments and hardship among what could be termed an industrial proletariat, which they will lack the data to diagnose and which will form a small part of an overall system.

What to do?

There are two certainties. The first is that sometimes society can change faster than we can see. Rapid job losses, a lag in retraining and retooling those that have been affected by technology, and an absence of wealth reserves to allow time for a measured response, will leave some parts of society vulnerable. Designing benefit programs for this new brand of unemployed will inevitably lag behind the problem. The second inevitable fact is that flat tariff structures hit low income and low wealth households harder. 

Dealing with these certainties will be complex and may in fact require a measure of the cross subsidisation that utilities have tried so hard to remove from their systems. It may involve what we used to call sharing, a concept that economics deals harshly with in an absence of cost or utility based pricing.  Creation of low income tariffs with zero or small fixed charges, stronger hardship programs or interfaces with government social programs will be steps on the road to what will be a new world for utilities – one which may require senior managers to develop new and different skills. For it seems clear to me that how utilities decide how to balance the demands of the privileged few with the hardship of many more may be a landmark test of their role in a changing society.

Share your thoughts on this issue by leaving a comment below or contact me to discuss the issue further.

Follow me on Twitter @MattRennie_EY and visit the EY website for further sector insights at https://www.ey.com/Industries/Power---Utilities.

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