Skip to content

What’s so Great about Fixed Charges?

There’s a lot of talk in California these days about imposing fixed monthly charges on residential electricity bills.  The large investor-owned utilities in California have small or no fixed charges,[1] instead collecting all of their revenue from households through usage-based charges, called volumetric pricing.  (And those volumetric prices increase steeply with your monthly usage, the “increasing-block pricing” approach that I discussed in September.)

Interestingly, one of the three natural gas distribution companies in California has a fixed charge, but the other two don’t  (SoCal Gas has a charge that is about $5/month.  Feel free to chime in if you know how this difference came to be.)  Most other electric utilities in the U.S. do charge some fixed monthly fee for being hooked up to the electric grid.

FixedChargesBarChartFixed monthly charges at regulated and muni utilities (randomly selected outside CA)

Fixed charges are often justified based on the utility having fixed costs.  The connection seems logical at first glance, but when you look closer it’s more complicated.

Fixed costs fall roughly into two types: customer-specific and systemwide.  When having one more customer on the system raises the utility’s costs regardless of how much the customer uses – for instance, for metering, billing, and maintaining the line from the distribution system to the house – then a fixed charge to reflect that additional fixed cost the customer imposes on the system makes perfect economic sense.  The idea that each household has to cover its customer-specific fixed cost also has obvious appeal on ground of fairness or equity.

CustSpecFixedCostsCustomer-specific fixed costs from things like metering, billing, electric drop to house

But much of the utility fixed costs that are being discussed are systemwide – such as maintaining the distribution networks in residential neighborhoods.  These costs wouldn’t change if one customer were to drop off the system.  In other words, running the system as a whole has certain unavoidable costs and someone has to pay them.  There isn’t much guidance, based on economics or equity, about who should pay, because there is no “cost causation” as it is termed in the utility world.   In particular, the statement I have heard a number of times recently that “the utility should cover fixed costs with fixed charges” has no basis in economics when it comes to system fixed costs.

Before we discuss how to pay for system fixed costs, let’s step back and remember where economics does provide a valuable guide, that is, in setting the price of an incremental or marginal kilowatt-hour.  The price for a marginal kilowatt-hour should reflect the full “societal” marginal cost of providing that electricity, meaning that it should include the industry’s marginal production costs plus the marginal externality costs imposed on others outside the production process, like the cost of greenhouse gases that are released.  The idea is that if you don’t place a value on the good that is at least as great as the full cost of producing it (including the pollution it creates), then society shouldn’t allocate resources to produce it for you.

If you don’t think about it too hard, you might conclude that if the marginal (or volumetric) price just covers marginal cost, then what is left over is fixed costs, so fixed charges “should” cover fixed costs.

But there are at least three good reasons to think harder about it.

First, the marginal cost that the utility faces is less than the full marginal cost it imposes on society when it produces electricity because the utility does not have to pay the full social cost of the pollution it produces — including NOx, particulates, and greenhouse gases.[2]

If the utility charges a price that covers the full marginal cost including all the externalities, but doesn’t itself actually have to pay for those externalities, then it generates extra revenue.  That revenue can go towards covering fixed costs.   That lowers the fixed charge necessary to cover costs while at the same time setting appropriate marginal prices.[3]

Second, as everyone who studies electricity markets knows (and even much of the energy media have grown to understand), the marginal cost of electricity generation goes up at higher-demand times, and all generation gets paid those high peak prices.  That means extra revenue for the baseload plants above their lower marginal cost, and that revenue that can go to pay the fixed costs of those plants, as I discussed in a paper back in 1999.

The same argument goes for transmission lines, where price differentials between locations mean that the transmission line generates revenue above its marginal cost (which is effectively zero), and can go to pay the fixed costs of transmission lines.  In fact, the fixed costs of generation and transmission should generally be covered without resorting to fixed monthly charges.

The same is not true, however, for distribution costs.  Retail prices don’t rise at peak times and create extra revenue that covers fixed costs of distribution.  That creates a revenue shortfall that has to be made up somewhere. Likewise, the cost of customer-specific fixed costs don’t get compensated in a system where the volumetric charge for electricity reflects its true marginal cost.

But unlike customer-specific fixed costs, there isn’t a strong fairness or economic efficiency argument for recovering fixed distribution costs – which are not customer-specific — through a fixed monthly charge.

Lots of potential?

Programs subsidizing high-efficiency light bulbs, refrigerators and washing machines may be a great idea, but they still create fixed costs that ratepayers have to cover

And then there are sunk losses from the mistakes of the past, such as expensive nuclear power plants and high-priced contracts signed during the California electricity crisis.   And don’t forget ongoing expenses that are not directly part of the electric utility function, like energy efficiency.  Someone has to pay for those subsidies on new refrigerators and clothes washers.[4]

That brings us to the third reason to think hard about fixed charges: fairness and distributional considerations.  If customer A uses 10 times more electricity than customer B, should they pay the same share of the system fixed costs?  And, by the way, customer A is on average wealthier than customer B.  My informal poll suggests most people think customer A should pay more.

But any approach that is based on usage amounts to raising the volumetric price further, after we have already raised it to reflect the real externalities.  Doing that encourages inefficient substitution away from electricity.  Yes, there can be such a thing as too much energy efficiency investment (take a look at the cost of retrofitting windows).  Nor does it really help society when high marginal prices incent households to install solar just to shift fixed costs to others.  And, of course, Max recently blogged about how high marginal electricity prices discourage EVs.

And that’s where it can make sense to resort to fixed monthly charges to cover at least part of the shortfall.   Fixed charges may be the least bad way for utilities to balance their books without setting volumetric electricity prices so high that they unreasonably distort behavior.

But the mere existence of systemwide fixed costs doesn’t justify fixed charges.  We should get marginal prices right, including the externalities associated with electricity production.  We should use fixed charges to cover customer-specific fixed costs.  Beyond that, we should think hard about balancing economic efficiency versus fairness when we use additional fixed charges to help address revenue shortfalls.

 

I tweet energy news articles, and the occasional research article, nearly daily @BorensteinS

—————

[1] PG&E and SDG&E have no fixed charge, SCE’s is $0.99/month.  All three have a small minimum bill, less than $10,  which is binding on extremely few customers.

[2] What’s that you say? that California utilities already have to cover their GHG emissions in the state’s cap-and-trade market? Oh please.  First, the utilities are given free permits to cover most of their emissions.  Second, the regulatory agency (CPUC) has said publicly that it will not allow GHG costs to raise residential rates.  And, finally, do you really think the current price in the cap-and-trade market of $12/ton – an amount that will lead to virtually zero change in production or consumption behavior — covers anything like the full cost of the GHG emissions?  It’s less than one-third of the U.S. government’s estimate of the true externality cost  (which I think is likely still too low).

[3] Of course, if we ever get to actually charging polluters for their emissions, then this source of extra revenue to the utility will go away.  That will still be a happy day for me.

[4] Please, save the comments arguing that energy efficiency programs pay for themselves.  They may save society as much or more in energy resource costs as they cost the utility, but when it comes to rate making, the money for those programs comes from ratepayers, and energy efficiency programs don’t justify a volumetric rate increase on economic grounds.

Severin Borenstein View All

Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business and Faculty Director of the Energy Institute at Haas. 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. He chaired the California Energy Commission's Petroleum Market Advisory Committee from 2015 until its completion in 2017. Currently, he is a member of the Bay Area Air Quality Management District's Advisory Council and a member of the Board of Governors of the California Independent System Operator.

32 thoughts on “What’s so Great about Fixed Charges? Leave a comment

  1. SDG&E is just now seeking a $10/month minimum charge for natural gas service and also another minimum charge for electricity. Presently I don’t use much natural gas. I installed a tankless water heater 10 years ago and we keep the thermostat down in the winter to save money and to pollute less. I’ve never exceeded $120 for the whole year with all of our natural gas usage. I have two major issues with a fixed minimum monthly charge.

    First, it encourages waste because the incremental usage of natural gas doesn’t cost much more because a portion of the billing has been moved to the fixed delivery fee. Had there been a minimum monthly charge previously I would not have purchased the tankless water heater, for example. The small incremental extra cost for just the gas would have made the tankless water heater a poor investment. My tankless water heater reduced my typical summer monthly natural gas charges from $11 to $2.

    Second, there’s no competition for natural gas service. If my cable company or mobile phone company tried to set some sort of fixed monthly minimum price for service I could go with another provider. Can you imagine receiving a Cox Communication bill that shows a $10/month minimum fixed charge for video-on-demand regardless if you use it or not. All of the arguments are the same, Cox Communications has fixed costs for video-on-demand and they need to recoup. You would drop Cox Communications service in a heartbeat and they know it. We do not have a choice with SDG&E natural gas service, they’re a monopoly.

  2. The question of recover of “fixed” costs through a fixed monthly charge raises a more fundamental question: Should we revisit the question of whether utilities should be at risk for recovery of their investments? As is stands now if a utility overinvests in local distribution it faces almost no risk in recovering those costs. As we’ve seen recently demand has trended well below forecasts since 2006 and there’s no indication that the trend will reverse soon. I’ve testified in both the PG&E and SCE rate cases about how this has led to substantial stranded capacity. Up to now the utilities have done little to correct their investment forecasting methods and continue to ask for authority to make substantial “traditional” investment. Shareholders suffer no consequences from having too much distribution investment–this is a one-sided incentive and it’s no surprise that they add yet more. Providing a fixed charge instead of including it as a variable charge only reinforces that incentive. At least a variable charge gives them some incentive to avoid a mismatch of revenues and costs.

    When demand was always growing, the issue of risk-sharing seemed secondary, but now it should be moving front and center. What mechanism can we give the utilities so that they more properly balance their investment decisions?

      • Unfortunately, simply “regulating” has failed. One primary reason is that regulators don’t have the resources to appropriately monitor utility investment decisions and spending. (I’ve witnessed this in participating in proceedings at the CPUC.) In addtion, it’s apparent moving to more centralized decision making is unlikely to lead to better outcomes because our system is too complex for a single entity to be able to all encompassing decisions. No, “regulation” is not the answer–been there, done that.

        • I appreciate your view, but economic regulation is not meant to provide centralized decision making or micro-manage utilities. When done well, regulation sets up a well-informed and reasonable framework of standards, accountability, and incentives within which utilities are expected to perform prudently. This is the ideal, of course.

          • And it’s evident that regulation has been far from ideal, and there’s no real proposal on how to fix it directly. More resources are unlikely to be forthcoming, and experience shows that trying increase regulation of this type is rarely successful. Rate of return regulation is exactly what has gotten us into this overinvestment conundrum. I’m looking for a more detailed response than “more of the same” because that’s what we already have.

            The lesson of the last three decades has been that moving away from direct regulation and providing other outside incentives has been more effective. Probably the biggest single innovation that has been most effective has been imposing more risk on the providers in the market.

            Maybe I should ask you a different question: Are you saying that we are not regulating utilities now on distribution investment?

          • We need effective regulation and I believe we agree that regulation is not always as effective as it could or should be. So at issue is whether the problem is with the paradigm or those entrusted with it. (Now, let’s get back to fixed/variable issue.)

          • As I stated, I see the fixed/variable issue as embedded in this larger question of the regulatory paradigm. California has devoted as many resources as any state to trying to get the regulatory structure right–and to most of its participants, it’s not working at the moment. Thus the discussion of whether fixed charges are appropriate need to be in the context of what is the appropriate risk sharing that utility shareholders should bear.

            This is not a one-side discussion about how groups of ratepayers should share the relative risk among themselves for the total utility revenue requirement. That’s exactly the argument that the utilities want us to have. We need to move the argument to the larger question of how should the revenue requirement risk be shared between ratepayers and shareholders. The answer to that question then informs us about what portion of the costs might be considered unavoidable revenue responsibility for the ratepayers (or billpayers as I recently heard at the CAISO Symposium) and what portion shareholders will need to work at recovering in the future. Thus the discussion has two sides to it now and revenue requirements aren’t a simple given handed down from on high.

  3. These are interesting points that make me think about how utilities should attempt to adequately recover fixed costs under increasing amounts of self-generation. As has been discussed fairly thoroughly elsewhere, the high-usage customer (cust. A) in Severin’s example is not only more likely to be wealthier, but also more likely therefore to own rooftop solar or another means of self-generation. As a higher-tier consumer, the avoided kWh are quite expensive and where the bulk of fixed costs normally get recovered. As a result, self-generation, for all its many potential virtues, erodes fixed cost recovery (and I think it’s fair to say that these costs are both customer-specific and systemwide fixed costs).

    This introduces another wrinkle in the question of how utilities allocate these fixed costs equitably. It seems unpalatable as a matter of policy for this shift toward self-generation by wealthier customers to prompt higher volumetric rates for customers that are more grid-reliant (evidence of this cost-shifting has been mixed so far, but seems like a fair possibility as renewables expand in the coming years). So the logical conclusion is to assess fixed charges so that self-generators still pay (roughly) their share of systemwide fixed costs and don’t impose their customer-specific fixed costs on others. But this approach, which seems like a reasonable way to balance efficiency with equity, gets cast as an attack on solar, so PUCs are left deciding which outcome is the lesser of two evils.

    I’d be curious to hear views on fixed charges as a way to ameliorate this potentially gnarly equity question under a high-DG future.

  4. Severin: There is a third type of charge, other than fixed charges and volumetric prices, which can be used to recover your “system-wide” fixed distribution costs in an equitable way. These are demand charges, which are based on the maximum amount used over a short time period (e.g., 15-minutes or an hour). These can address your fairness issue in the example of one type of customer who uses 10 times more electricity than another type. No, they should not pay the same fixed charge to cover distribution costs. However, under a demand charge, the larger customer type, whose maximum demand is presumably as much larger as his energy usage, would pay considerably more than the smaller customer type to cover the larger distribution system costs that they impose on the system (i.e., cost causation). While demand charges have rarely been employed for residential customers, largely due to metering costs needed to measure maximum demand, the rapid expansion of smart metering makes that information readily available. My understanding is that a number of utilities are considering adopting demand charges to help cover fixed distribution system costs.

    • Steven,
      Thanks for the comments that you gave me last week in regard to the article I wrote on this three part tariff concept which I referenced above in “Demand a Better Utility Charge During Era of Renewables: Getting Renewable Incentives Correct With Residential Demand Charges,” Dialogue, United States Association for Energy Economics, 2015 January, http://dialog.usaee.org/index.php/volume-23-number-1-2015/271-lively
      A demand charge would have resulted in a revenue shift of 19-23%, generally protecting the low use customer who can’t afford to put in roof top solar, and that is without a charge for using the distribution grid to deliver electricity from the customer.

    • A daily demand charge is now technically feasible, and a daily charge avoids many of the conservation disincentives that occur with a “ratcheted” monthly charge. A month is an arbitrary billing paradigm that has no relationship to physical attributes like diurnal or seasonal cycles. If a customer hits a maximum peak early in the month, they lose any incentive to reduce their peak later in the month under the old style. A daily demand charge resets the meter each morning. I’d be interested to see if residential customers can more clearly understand that they should avoid turning on all of their appliances at the same time to reduce their bill. I’m agnostic on that vs TOU/RTP energy pricing, but I don’t believe anyone’s unsupported assertions one way or the other.

  5. Severin, I’d like to correct your characterization of the CPUC’s position on the inclusion of the GHG price in residential rates. Decision 12-12-033, which set the basic framework for the return of GHG allowance revenues to electric utility customers, adopted “preserving the carbon price signal” as a key policy objective. However, the decision explains that the Commission decided not to pass through GHG costs to customers of the large IOUs due to the large disparities between upper-tier and lower-tier rates and the statutory restrictions that prevented the Commission from passing the GHG price through to lower-tiers. The Commission reasoned that it would not be fair to charge upper-tier customers a GHG price when upper-tier rates already greatly exceed cost while lower-tier customers would be completely shielded from the GHG price. In fact, where the Commission was able to fairly pass through GHG costs, (i.e, in the case of Pacific Power and Liberty Utilities (formerly Sierra Pacific), which were not subject to AB 1X and SB 695 rate restrictions) it did so. (While each of the semi-annual Climate Credits received by the customers of the big IOUs this year ranges from $30 to $40, Pacific Power customers received $194!)

    The body of D.12-12-033 stated the clear intent of the CPUC to pass the GHG price signal through to residential customers once it had the authority to do so in an equitable manner. “Should the differences between lower and upper-tier residential rates be substantially reduced or eliminated, it would no longer be appropriate to use allowance revenue for this purpose [of reducing residential rates]. In that event, the carbon price signal should be fully reflected in residential rates and all remaining revenue should be returned on a non-volumetric basis as described below.” This question has been teed up in the residential rate reform proceeding. An April 15, 2014 scoping ruling includes in the scope of the proceeding “what, if any, implementation steps are
    necessary to begin including greenhouse gas (GHG) costs in residential rates pursuant to the direction in Decision 12-12-033 that GHG costs should be included in residential rates once restrictions on lower tier rates are removed?”

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: