Imagine walking into your supermarket with a bag of zucchini from your garden and saying that you’d like to trade them straight up for an equal quantity of zucchini next month.
The store manager would explain that they aren’t in the business of making wholesale purchases at such small scale, and that when they do make wholesale purchases it is at a much lower price than the retail price at which they sell.
Swapping zucchini today for zucchini tomorrow
You can, of course, eat the zucchini you grow, the manager might say, but once you start trading zucchinis with the store, you can’t expect to get the same price on sales to the store as you pay on purchases from the store. The margin the store makes between the wholesale and retail price is what pays for the building, heating and cooling, labor, and other costs that are mostly fixed with respect to the amount you buy.
The same economics applies in electricity, only more so. The retail price, especially in California, is covering a lot more than just the incremental cost of providing an extra kilowatt-hour to you. In economic terms price is above the marginal cost of the incremental unit of energy, much further above than for goods you buy at the supermarket. That price gap is paying for past losses from failed deregulation, costly nuclear power, expensive contracts with large scale renewables producers, and local distribution systems that carry power from the grid to your house, as well as metering consumption, billing and account collection. As a result, when you consume less electricity, the cost the utility saves is much less than the revenue they lose.
Pricing above marginal cost means any decline in energy bought from the utility makes it harder to recover fixed costs, whether the quantity decline is from installing residential solar PV, improving energy efficiency, or just slow economic growth. But buying less electricity for these reasons corresponds to growing your own zucchini (or just eating less zucchini).
Net metering of solar PV is equivalent to forcing the supermarket to take your zucchini on an even up trade for future zucchini. The customer gets a one-for-one credit for electricity it puts into the grid against future consumption from the grid. This expands the customer’s opportunity to save money, though in a way that reduces the utility’s net revenue.
This risk was largely ignored in the mid-1990s when net metering of residential solar PV was established. It wasn’t that utilities or industry analysts failed to understand the simple math. It’s that they didn’t think the exposure was very large, because solar PV was so expensive and the subsidies were smaller. As recently as a decade ago, the cost of a residential system was still north of $10/watt, translating to at least $0.50/kWh. Even with aggressive state subsidies and small federal subsidies, it was difficult to get the end-use consumer cost below $0.35/kWh. The average retail price for the kWh replaced by a solar system was generally well below that, so very few consumers could really save money putting in solar.
But technology marches forward and PV panel costs have come way down. Politics also marches (assign your own direction to it) and the effective subsidies for PV have increased substantially. The war that is now erupting over tariff design is coming largely from utilities now taking distributed PV seriously.
A decade ago, utilities saw net metering as a small indirect subsidy to a nascent technology that was unlikely to ever be able to compete with even the retail price of electricity. With plummeting prices of solar panels and some progress on installation costs, along with increased federal subsidies that now cover about half the cost, residential PV can now lower the retail energy bill of many California consumers, particularly customers of the large investor-owned utilities, which have the highest rates.
Two aspects of utility electricity tariffs are major contributors to the attractive economics of residential PV. First, increasing-block pricing (“IBP”, higher price tiers as you consume more during the month) mean that for some heavy users, solar PV makes sense because it is replacing power on the highest tiers, where those consumers now pay $0.30-$0.40/kWh. With lower costs and higher subsidies, PV has been able to beat those prices for at least a few years now. That’s a major factor in the utilities pushing to flatten or eliminate IBP.
But the real panic in the industry has set in this year as the net-of-subsidy cost of PV has dropped below even the average retail price. Even if increasing-block pricing were eliminated and the big IOUs sold all residential power for their average price of about $0.17/kWh, solar PV could beat that for many customers. According to a recent report from Lawrence Berkeley Lab (and confirmed by other industry studies and media reports), the full cost of a typical residential system has fallen below $6/watt and may be below $5/watt by now, which corresponds to $0.25-$0.30/kWh. The 30% federal tax credit and what’s left of the California Solar Initiative subsidies cuts that by about a third. A less well-known tax effect – accelerated depreciation for leased systems – transfers another 15%-20% of the cost from the end-user to the federal government. The net cost to the consumer can now be $0.15/kWh or less.
This is why we are hearing more often the phrase “death spiral” from the utilities. If many customers act on the attractive economics of PV at home, the utility sells less energy and earns less above marginal cost to cover those costs of past sunk mistakes and ongoing fixed costs. To make up the revenue, they would have to raise rates, which makes the economics of PV even better.
So, the utilities are now desperately pushing for tariff changes that a few years ago they saw as only a distant dream. Not only do they want to eliminate increasing-block pricing, they want to further reduce the incremental energy price by implementing a fixed monthly charge on each customer, aimed at covering some of the costs of retail distribution, metering and billing. Most economists support such changes as they move electricity pricing towards a more cost-based system. In fact, the large publicly-owned utilities – Sacramento (SMUD) and Los Angeles (LADWP) – already have the tariff design the IOUs are now fighting for. SMUD’s fixed monthly charge is $13, going up to $20 in a few years.
Not surprisingly, solar advocates love IBP and hate fixed monthly charges. They argue that the proposed changes would hurt the poor – which is true if the changes aren’t accompanied by expanded discounts for low-income customers — though solar PV advocates don’t have a credible track record of protecting poor rate payers. They also assert, with much less support, that solar PV adds so much extra value to the grid – by reducing line losses and the need for infrastructure upgrades – that solar should be favored through the advantages that current tariff design gives them.
What makes the policy debate so difficult to resolve is that tariff design is a very indirect way to support residential PV. In Germany, they’ve gone with feed-in tariffs for solar PV instead – a direct subsidy for every kWh of energy coming from your PV system. Much simpler, and allows a reasoned debate on tariff design apart from solar PV policy. But also makes it easier to see how much they are paying people to eat zucchini, and how that is driving up the bills of the people who prefer carrots (as made clear in a recent article in the center/left magazine Spiegel).
In the coming months, we are going to hear a lot of talk about tariff redesigns, solar PV penetration, and the utility business model. Unless policy makers can separate rate design from residential PV policy, it’s not going to be easy to follow, or pretty to watch.
Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.