Pricing Mechanisms

Existing literature on pricing of district heating is mainly focused on two representative pricing policies – marginal cost pricing and cost-plus pricing. The main point of reference in selecting the appropriate pricing mechanisms is market characteristics. District heating is often characterized into two types of markets; regulated and deregulated markets (Li, Sun, Zhang, & Wallin, 2015). A regulated market is characterized by government intervention to change market outcomes. This typically involves regulation on prices, terms of service and market entry, not facilitating to a freely competitive market situation. A deregulated market on the other hand, involves less government intervention to allow for a larger degree of competitiveness in the market with prices derived in the market (Church & Ware, 2000). It is

difficult to determine which situation is best for the district heating market. However, it is evident that the heating market cannot be fully regulated, nor fully deregulated. Rather, the consensus has become that there should be competition with some degree of control by government (Zhang, Ge, & Xu, 2013). The classification into regulated and deregulated markets reveals different methods of pricing. In a regulated district heating market, the cost-plus pricing method is most often utilized, while for a deregulated district heating market, marginal-cost pricing is the dominant method (Li et al., 2015).

3.3.1 Pricing in Regulated District Heating Markets

In regulated district heating markets, price is government regulated. The regulated price therefore orders the profit made by district heating suppliers. In such markets, the cost-plus pricing method is often used, where the price for district heating equals the sum of costs to be recovered and a reasonable profit for district heating supplier (Li et al., 2015). The key issue here is to determine the permitted profit a district heating supplier can earn. The benefits of using this method include simplicity, flexibility and ease of administration. However, in a regulated market situation, there are several restrictions imposed on the supplier. For instance, the district heating supplier is not permitted to compete with other heating solutions by adjusting their prices. Subsidies for district heating is therefore often needed in order to make district heating a competitive option compared to other heating alternatives (electric heating, boilers etc.). Subsidies on district heating systems are important to ensure stable energy prices, development of local energy systems, reduction of energy imports, reduced pollution and job creation. However, the cost-plus method normally uses historical data on real plants, containing uncertainties when used for predicting future situations (Li et al., 2015).

Li et al. (2015) also point on the unfavorable incentives created for district heating companies under regulated market control. “Under a cost-pricing mechanism, DH companies have incentives to increase profits by inflating costs, since permitted profits are usually related to costs. […] Consequently, the cost-plus pricing method undermines suppliers’

incentives to reduce cost and to upgrade their technology” (Li et al., 2015, p. 59). This can hinder future growth in the market and slow down development of district heating markets.

Because of these incentives, companies that are efficient and manage to reduce their production costs, are punished with lower profits (Zhang et al., 2013).

3.3.2 Pricing in Deregulated District Heating Markets

To determine the price in a deregulated district heating market, pricing is most often done in accordance with marginal cost (Li et al., 2015, p. 59). A marginal cost is the cost of one additional unit of the product, in this case being the cost of generating one more unit of heat.

The market price is obtained at the equilibrium point where total heat supply equals total heat demand. Facing an exogenous market price in a deregulated market, suppliers are motivated to set the price below market price in order to obtain a larger share of consumers and to achieve larger profits. In this way, all suppliers in the market will be motivated to increase efficiency, reduce costs and make profitable investments in equipment and infrastructure. Due to these incentives, marginal cost pricing will benefit not only district heating producers, but also the environment in terms of reduced emissions.

Sjödin and Henning (2004) suggest the marginal cost method as being the optimal choice for pricing district heating. The use of marginal cost for pricing allows for variation in peak and off peak seasons. During summer, when the demand for heating is lower, they find a lower marginal cost for district heating. It is therefore proposed that the marginal cost should be reflected in the price. In addition, they support the use of a fixed portion to be included in the total price, to eliminate some of the risk of the utility running at a loss. Combining the use of short-range marginal cost and a fixed cost “should be able to bring about a close to optimal resource-allocation” (Sjödin & Henning, 2004, p. 17).

Compared to the cost-plus pricing mechanism, the marginal cost approach is more complicated as it makes more factors into consideration. As a consequence, marginal-cost pricing is more difficult to apply in reality, as it is more challenging to precisely obtain all the relevant figures. Nevertheless, if figures are obtained, marginal-cost pricing provides a presentation of variations in production costs.

Recognizing that existing pricing methods for district heating, such as cost-plus pricing and marginal-cost pricing cannot simultaneously provide both high efficiency and sufficient investment cost return, Zhang et al. (2013) propose a new pricing model – Equivalent Marginal Cost Pricing (EMCP). This method incorporates both short- and long-run marginal costs. The method promotes efficiency in the district heating market, ensures investments and promotes efficient resource allocation. However, this method is based on a number of assumptions, making it less valid for practical use (Li et al., 2015).