As temperatures climb, utilities sell more electricity.
We had a heat wave in Berkeley last month. I know, a high temperature of 88° Fahrenheit doesn’t sound very hot to most people, but we’re not used to it and our house is neither air-conditioned nor super well insulated.
After a couple nights of tossing and turning, my daughter and I headed straight to Target to get fans for our bedrooms. Unfortunately for us, many other shoppers had the same idea, so the shelves were literally bare.
This reminded me of a maxim I learned early in my career. I was a rate analyst at the Department of Public Utilities in Massachusetts and during a Boston heat wave (much less comfortable than the Berkeley version, as both temperature AND humidity exceeded 90), one of my colleagues pointed out that, “utilities love heat waves.” He went on to explain that during heat waves, people ran out to buy fans and window-unit air conditioners, just as we had (Amazon Prime succeeded for us where Target failed). The next time it was hot, they cranked up their new appliances and electricity consumption was even higher.
After our Berkeley heat wave, I decided to see if any evidence supported his claim. I found that (a) indeed, temperature drives peak demand, (b) there’s some evidence that adjustments people make to their electricity consumption in response to temporary shocks can have long-run impacts, but (c) the relationship between increased sales and increased profits is complicated for regulated utilities.
Temperature and Peak Demand
A neat paper by co-blogger, Max Auffhammer, with Patrick Baylis and Catherine Hausman (both former Energy Institute grad students) uses data from over 150 areas around the country to estimate the relationship between temperature and both daily average consumption and daily peak consumption. (Max blogged about it earlier here.)
I’ve reproduced one of the figures from their paper below. It shows that in the Texas wholesale market, peak demand (in red) is almost 25,000 MWs higher on days when the average daily temperature is 90° F compared to days when the average daily temperature is more like 60° F.
The average daily temperature is the sum of the minimum and the maximum temperatures on a day divided by two. On a 90° F day, for example, the overnight low could have been 80° F and the high 100° F – not good sleeping weather!
My quick analysis of California data supports the temperature-peak demand relationship across years. The figure below plots annual peak demand in the California ISO against the sum of the Sacramento and Los Angeles high temperature on the corresponding day. I’ve normalized each data point to 1 in 1998, so the figure shows temperatures and peak demands relative to what they were in that year. The highest peak demand we’ve seen over the period was in 2006, when temperatures were as hot as they’ve been over the 19-year period. (The California Electricity Commission is looking at peak demands in much more depth. See the last agenda item here.)
Is there any evidence that a heat wave one year leads to more electricity demand the following year? If you look closely at the California graph above, 2007 has about the same high temperature as 2005, but peak demand is a lot higher in 2007. This could reflect a number of different factors. For example, maybe the temperature on the day preceding the peak was a lot higher in 2007 than in 2005. But, it’s also consistent with the fan-buying phenomenon. July 2006 was really hot, so I’m guessing a lot of Californians bought new fans, which they still owned on the hot day in 2007.
A paper by Francisco Costa and Francois Gerard substantiates this idea, although they come at it by looking at a period when people reduced consumption. They study a 9-month period in 2001 when several regions in Brazil, which depends heavily on hydroelectricity, were in a severe drought. Consumers in the affected regions were assigned consumption quotas and faced fines and possible disconnection if they exceeded their quotas. During the crisis, these measures led consumers to reduce their consumption by nearly 25% on average. More interestingly, customers who faced the quotas still consumed 10% less electricity ten years later.
They go on to show that households reduced their consumption both by getting rid of appliances, including air conditioners, and also by changing habits. For example, customers in the drought-affected areas were less likely to have their electric water heaters set to the highest temperature five years later.
The Relationship Between Sales and Profits is Complicated
The question I’ve posed in the title assigns an emotion to utilities, so let me be more precise. The idea is that utilities “like” to see higher electricity consumption during heat waves since they will earn more money by selling more kWhs.
In fact, for regulated utilities, the relationship between increased sales and increased profits is complicated. Over the past 10-15 years, 19 state public utility commissions (plus DC) have instituted “decoupling” programs for their electric utilities – see the purple and blue states below. The specifics vary, but in principle decoupling guarantees that utilities will earn a specific amount of money (called the “revenue requirement”) to cover their costs. If sales spike during a heat wave, rates will be set slightly lower in the future to offset that increased revenue.
In states that do not have decoupling, utilities will likely be able to keep the extra revenue from increased heat-driven sales. Their costs will also be higher as they run plants with higher fuel costs or purchase expensive power from wholesale markets. But, for most utilities, fuel and purchased power costs are passed directly to ratepayers through fuel adjustment clauses.
Utilities might also experience higher costs operating their transmission and distribution systems as both the heat and increased demand strain the networks. These sorts of costs are harder to pass on to customers. And, to the extent the strain on the system leads to outages (like it did in Los Angeles two weeks ago), utilities will face irate customers.
In the long run, though, higher peaks require more investment in new capacity, which generally increases utility profits. This is true across generation, transmission and distribution, and even true for companies in decoupled states.
So, while the decoupled Massachusetts utilities may now be less effusive about heat waves than my former colleague suggested, I’m guessing that utilities in places like Florida are still cheering – or at least doing silent fist pumps – as temperatures climb. And, as Max and his co-authors have pointed out, we all need to pay attention to these heat-driven peaks since they’re becoming more and more common with climate change.
Catherine Wolfram is the Cora Jane Flood Professor of Business Administration at the Haas School of Business, University of California, Berkeley. During Academic year 2018-19, she will serve as the Acting Associate Dean for Academic Affairs at Berkeley Haas. She is the Program Director of the National Bureau of Economic Research's Environment and Energy Economics Program, Faculty Director of The E2e Project, a research organization focused on energy efficiency and a research affiliate at the Energy Institute at Haas. She is also an affiliated faculty member of in the Agriculture and Resource Economics department and the Energy and Resources Group at Berkeley.
Wolfram has published extensively on the economics of energy markets. Her work has analyzed rural electrification programs in the developing world, energy efficiency programs in the US, the effects of environmental regulation on energy markets and the impact of privatization and restructuring in the US and UK. She is currently implementing several randomized controlled trials to evaluate energy programs in the U.S., Ghana, and Kenya.
She received a PhD in Economics from MIT in 1996 and an AB from Harvard in 1989. Before joining the faculty at UC Berkeley, she was an Assistant Professor of Economics at Harvard.