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The Decline of Sloppy Electricity Rate Making

Back in the “good old days” most customers had no choice about how to buy electricity and a regulator’s life was pretty easy.  The utility needed sufficient revenue to cover its costs, but the regulator approving rates was mostly just deciding whose ox to gore.    How much should industrial customers cover versus commercial or residential customers?  Is a fixed charge fair to those who don’t consume much?  That sort of thing.

Of course, even back in the old days some customers had choices, particularly large industrial firms.  They could self-generate if the utility tried to charge them a price that was too high.  And if they hadn’t already set up shop in the utility’s territory or weren’t too invested in the area, they could take their demand elsewhere.  Regulators were pressured not to foist too much cost on the large customers who had an option to bypass the utility in whole or in part.  That showed up in rate design and, sometimes, in customer-specific arrangements.

CustSpecFixedCosts

For those customers, rates were set to reduce so-called “inefficient bypass,” which described when a customer would find an alternative supplier (or self-generation) that wasn’t actually lower cost than the utility, but offered a lower price.  Avoiding inefficient bypass meant the utility tried to keep customers for which it was the lowest-cost supplier by setting price close to that cost.

Luckily for utilities — and for the stress level of regulators — few customers had real bypass opportunities in those days, certainly not residential or small commercial customers.  But that luck has run out; technology is now making every customer a potential bypasser.

Rooftop solar panels are the leading bypass mechanism for small customers.  They make economic sense for the customer so long as the retail price of the kilowatt-hours crowded out by the solar generation is greater than the cost of solar electricity.  But, as I’ve discussed previously, they are only efficient for society if they lower the overall cost of supplying the electricity needed on the grid.  The gap between retail price and avoided cost opens the door for inefficient bypass.

And solar panels aren’t the only bypass news.   With low natural gas prices, combined heat and power (CHP) installations onsite can lower bills for some customers.   Fuel cell technology continues to advance, pushing closer to the retail cost of electricity.  Batteries can store power from the grid or from onsite generation at lower and lower costs, making it easier for customers to rely less on the grid or to choose when they want to rely on the grid.

spiral

Except for some very particular narrow applications, none of these technologies lowers total grid costs by as much as it lowers customer bills, which means bypass leaves the utility with a revenue shortfall.  The potential shortfall, and the need to then raise prices, and the resulting incentive for more bypass, has been dubbed “the utility death spiral.”

The drama, and implied visuals, of a utility spiraling into the abyss (exactly what? a power plant?) creates lots of excitement, but the phrase leads us away from the real issue.  No technology available today — or likely to be available for years to come — will lead more than a fraction of the customer base to fully cut the cord, and operate without the utility.   Decades from now, most customers will still want access to the grid, and will still need the utility.

Something is dying alright, just not the utility.  It’s the ability of regulators, utilities, and interest groups to push around revenue collection among customers without the customers pushing back.

  • Try to punish high-consuming households by raising their price many times above cost – as has been done in California for the last 15 years – and they will now install solar to reduce their grid purchases, undermining revenue collection.
  • Try to use “demand charges” that are based on a customer’s peak usage — regardless of whether its peak coincides with system peak — and soon they will be installing batteries to smooth their peak, but in many cases without helping to lower grid costs.
  • Try to raise retail rates for most customers in order to offer discount electricity to low-income households and the high-price customers will turn to all forms of distributed generation instead of subsidizing the poor.
  • Try to stick commercial and industrial customers with more of the utility costs and they will invest in CHP and other onsite technologies.
  • Try to encourage demand shifting to off peak with exaggerated peak-period prices during all summer weekdays and the customer will use batteries to shift not just on the hottest high-demand days, but also on days when there is no benefit to society, though still an arbitrage play for the customer.

Smart Meter

You may agree with the equity goals behind some rate design choices and may disagree with others.  That’s not the point.  The point is that technology is making it ever easier for customers to respond to prices, and to arbitrage between price differences.  That’s great news when those prices and price differences reflect real cost impacts, because customers can respond to efficient cost-based prices with efficient actions.  But when the prices don’t reflect costs, customers are still going to respond, and that will undermine system efficiency.

That means that the flexibility regulators have had in designing retail rates to pursue other goals – whether helping the poor, subsidizing grid-scale renewables, paying for energy efficiency programs, or just keeping rate design “simple” – is going to come under increasing pressure by market participants ready to exploit any price wedge, whether it is based on a real cost differential or not.

Economists have for years argued that utility rate design should follow cost causation principles, because departures from cost will lead to inefficient customer response.  Regulators have often paid little heed largely because the inefficiency was small when customer ability to respond was limited.  That left regulators a free hand to harness rates for pursuit of other policy agendas.

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Distributed generation, storage, electric vehicle charging, and smart customer-side usage technologies (think controllable communicating thermostats) mean that the inefficiencies from sloppy rate design – prices that depart substantially from cost – will be magnified.

But the flip side is that the opportunity to incent efficient customer-side participation in the market with smart rate design is greater than ever.  And that opportunity will grow exponentially in the next few years as we see continued improvement in generation technologies, batteries, and sensors that can control a panoply of household activities.  Accurate cost-based pricing can not only lower costs, but can also use customer-side participation to gain the flexibility that will be required to integrate more wind and solar power.

The pressures to align utility rates with costs are only going to increase.  Here’s hoping regulators will harness these changes to reduce total system costs and smooth the integration of intermittent generation.

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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.

33 thoughts on “The Decline of Sloppy Electricity Rate Making Leave a comment

  1. Severin, I think you’ve once again hit the nail squarely on the head. As for “cohesive environmental policy”, the multiple, belt-and-suspenders command-and-control policies we have in California are anything but. A cohesive policy would impose either a carbon tax or cap-and-trade and then let consumers and producers figure out the rest. When the legislature mandates a renewable portfolio standard that abates carbon at a cost of over $100/ton and then limits prices in the current cap-and-trade regime, that’s hardly cohesive or sensible.

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