Skip to content

How Local Should Your Energy Retailer Be?

Even my favorite colleagues can’t agree.

When you listen to conversations between energy economists about pretty much anything, it often feels like an episode of Debbie Downer. We find something wrong with everything – from energy efficiency policy to most carbon tax proposals. I find this highly annoying sometimes. Inspired by a discussion about community choice aggregators at the coveted Energy Institute lunch table the other day, I complained about this and challenged my colleagues to actually put down some intellectual stakes and tell us what an economist’s dream distribution utility of the future would look like. The energy sector is undergoing the possibly biggest transformation in the past 100 years and there is a lot of discussion about what institutions this brave new world would require.

Some background. Pour yourself a fresh cup. The electricity sector is not only a marvel of engineering (I think it should be designated the 8th wonder of the world), but also of economics. Here is why. There are essentially three pieces that guarantee that electrons end up in your coffee maker when you need it. Generators make electrons from fossil fuels and renewable sources of energy at power plants (some of which are now located on your roof). “Transmission” gets the electrons from the plant into your broader neighborhood through a large network of wires (above and below ground). Distribution utilities connect short wires to the long ones that lead to your house, meter your electricity (and gas, which comes through a pipe) and bill you for it. Sounds simple right? It is not.

First off, if you let one big utility operate all three branches in a reasonably sized area, and fail to regulate it, it will charge a really high price, and provide an inefficiently low amount of electricity/gas. This is the classical monopoly problem and the reason we have antitrust laws. The usual prescription– to break up the monopoly into more smaller firms– does not work here.

The nature of the infrastructure (think transmission wires and the distribution lines running down your street) requires massive up front (fixed cost) investments that two firms competing would just have to duplicate. Hence, it is cheaper for society to have a single firm provide the service and force them to charge a lower price. Thus, we usually argue that you want a monopolist, but one that is not allowed to charge the very high price it wants to charge and has to produce the desired higher output level. This is essentially called rate of return regulation and agencies like the California Public Utilities Commission are charged with making sure that utilities do not charge inefficiently high prices.

The reality is much more complex than the textbook. There are lots of generators that operate power plants and sell their electricity in a big market (the wholesale market). The cheapest electrons get sold first, then the second cheapest and so on. The last electron that gets sold is generated at a cost that the buyer of that electron is willing to pay. I am going to leave out the “thrilling” economics of transmission. Buy me three beers and I’ll explain them to you (or even better, talk to Jim Bushnell!).

So, here is the pickle. In the old days, the carbon-free sources of electricity were a lot of hydro, some wind and nukes. These generators cost a lot to build and are very cheap to operate. The rest was provided by coal, gas and some oil. These plants were cheaper to build, but cost more money to operate, since you have to pay for coal, gas and oil. Wind and sun are free. In this brave new world we are walking into, we are going to get a lot more of the latter sources of energy – high up front fixed costs and extremely low operating costs. In the long run, if we figure out reasonable amounts of low cost storage, it is possible that we will have a lot of extremely cheap clean electricity. Yet this electricity supply is possibly going to be much more variable during the day and across seasons.

The distribution utility of the future is going to buy electrons in this reordered market (mostly renewables and some fossils) and sell them to its customers. It is also going to engage in massive efforts to improve energy services. It will do this by hopefully:

  • Improve the energy efficiency of its customers to deal with “peak-i-ness” of demand.
  • Provide innovative (by that I mean stuff suggested by economists in the 1970s) pricing to deal with demand peakiness.
  • Advocate for low social cost (counting both the production costs and the pollution they produce) generation
  • Provide incentives for load shifting through storage or further behavioral interventions

The question is whether this is better done via a large behemoth distribution utility or a large number of small local providers, something like the community choice aggregators we have seen popping up in recent years. The lunch table did not agree on this one!

Senior famous energy economist #1 argued very much in favor of a small utility type model. (S)he argued that a small local utility is much better at “getting to know” its customers and at providing locally tailored pricing and energy efficiency programs. (S)he recognized that you don’t want duplicate wires running down the street, but once you eliminate the obvious overlap inefficiency, there’s not much evidence that having one firm serve huge areas is helpful.

Senior famous energy economist #2 argued very much in favor of one very large utility. The argument was a large utility through its size would be able to attract better talent, would be more effective at advocating for more efficient generation (less rooftop, more centralized solar for example), would be better at implementing large scale energy efficiency programs and would be able to offer innovative pricing structures in much the same way a smaller local CCA would. (S)he noted that many industries in today’s economy are dominated by very large companies, and we all benefit from their low costs and rapid innovation. Why is almost every Californian happy to have Amazon deliver them everything from videos to cleaning products, but we all want a local, community-based electricity provider?

This is a fascinating discussion to me and much is at stake. I have a number of questions without good answers at this point. At a larger scale there is a tension between possibly allowing retail choice (where you get to choose your distribution utility, which could be a local CCA, a CCA from another region or some other firm [mine would be called HammerTrons!]) and coordination of investment. There is a lively debate about how costly lack of perfect coordination is, with some arguing that the world will come to an end and others just shrugging their shoulders. Further, it is not clear how the regulatory planning process will affect our ability to coordinate – for better or worse.

Overall, getting the institutions right for this brave new world is key. I have had similar discussions with utilities in Germany, France and North America. We have to get to work on figuring this out. There are a number of really smart young (and old) energy economists out there, who have a much better nitty gritty understanding of the issues involved, and should insert themselves into this important debate. I look forward to powering my iPhone XV using 100% properly priced green electrons. I am intrigued by what the utility selling me these will look like.

Maximilian Auffhammer View All

Maximilian Auffhammer is the George Pardee Professor of International Sustainable Development at the University of California Berkeley. His fields of expertise are environmental and energy economics, with a specific focus on the impacts and regulation of climate change and air pollution.

27 thoughts on “How Local Should Your Energy Retailer Be? Leave a comment

  1. What a shame I missed this party! I think the consumer is (or should be) in the driving seat so they are the judge of the retailer beauty contest. They get to decide which retailer (the party that interfaces with the wholesale market and provides risk management and billing services) looks the best – big, small, green, not-so-green – according to their own criteria.

    Consumers already make significant investments and behavourial changes with respect to energy use in response to prices (eg install solar PV, batteries, buy an electric vehicle, etc) so the most important change we can make is to make the prices they face efficient. Those smart economists in the late 1970s (Schweppe et al) wanted to give consumers the power to make their own choices according to the costs. We got half the job done in the 1990s (one sided generation wholesale market) and dragged the chain on smart meters. It is unfortunate that we’ve been spoon feeding consumers for so long that (nearly) everyone has forgotten how this electricity market story was supposed to end.

    Consumers should know the wholesale cost of electricity they would otherwise pay and how it has been adjusted by the financial contract they hold with their retailer. Network costs should not be volumetric and not TOU or critical peak pricing because spot prices should be adjusted for local congestion instead (price drop steeply if local generation must be rationed and rise steeply if demand must be managed). This is more efficient and diurnal patterns in prices are especially dumb if wind is a significant portion of generation (it does not ebb and flow diurnally).

    And if that was not radical enough, I’m finishing with a real doozy. Having a smart meter with remote disconnection enables consumers to negotiate their own level of reliability (ie if there is not enough generation to meet demand it should be retailers that choose which of their customers should be shed first). This would make consumers in control of their own value of lost load and provide them the ability to sue their retailer for breach of contract if those terms were exceeded!

    • This level of market engagement makes sense for electricity consumers for whom energy costs are significant, but not for others. Understand that electricity costs are much less than 5% of the median income of most households, and managing electricity in this manner is probably too burdensome for at least 80% of the households to bother. Remember that any cost savings will be a percentage of the overall cost, so it’s a percentage of less than 5%. And this doesn’t even consider that those households for whom energy costs can be significant are also much more likely to be tenants with little or no ability to install energy-saving measures and appliances. The target audience for residential retail pricing is the one that cares the least about energy costs.

      Even among agricultural customers, I’ve been told that the benefits of managing to electricity prices except on a broad level (i.e., known, fixed TOU periods) are not sufficient to outweigh the need to manage to water supply availability. And most small businesses are tenants with limited access and control of energy use through capital investments (the only truly durable means of managing energy use, not behavioral).

      So the dream of “retail” pricing as a strong market driver seems remote unless 1) it is highly automated at very low costs and 2) the benefits can be shown to be truly significant within the overall budget scheme.

  2. Building on the comment by Russ, the use of incorrect mental model that utilities are selling electrons is a pet peeve of mine. It would be nice if economists (and environmentalists) could get the science correct here. It would help them think about the economics and environmental impacts in a less distorted way.

    Here is a layman’s explanation of the science of electricity in wires on the grid in the context of estimating greenhouse gas emissions:

    • The response by “Tom”, which is the first one on the list, aptly refutes the point of this article, and why we have GHG accounting in the way we do.

  3. Robert Borlick
    Since I’m a witness for the CCAs at the CPUC, I’m very aware of the difference between LSEs and distribution utilities. I’m not sure where you see my apparent confusion. There’s likely little in the way of scale economies in procuring power generation–just sufficient size to provide financial feasibility.

    As for the nukes, the problem began in the 1970s when the utilities with the blessing of their PUCs and boards decided to go even bigger with centralization. SMUD paid dearly for this mistake (I worked on the analysis that led to the closure of the Ranch.)

    As to your response to David’s comment “…IOUs were locked in to high priced RPS contracts early on”, the IOUs overbought RPS PPAs early on, and then failed to dispose of those contracts (perhaps at a loss) to the CCAs as they formed. PG&E in its 2016 RPS procurement plan justified holding these high priced contracts with a fantasy about future “price spikes” (their words). I calculated the risk premium that PG&E placed on these PPAs was $33/MWH.

    • Perhaps I misinterpreted what David was saying. My comment was only meant to point out that every retail electricity supplier in the state must own sufficient RECs to cover its RPS obligation. CCAs are not exempt.

      Now you point out that the IOUs procured RECs in excess of their obligations. Obviously PPAs for renewable energy are more expensive than energy purchased from conventional resources (i.e.,”null energy”). This is one reason why most RECs are priced close to zero in California and throughout WECC. It’s a bit more complicated because in California (surprise, surprise) there are different flavors of RECs with different market values.

  4. At the heart of this issue is the question of whether the gains of “perfect” coordination outweigh the losses from rent-seeking and increased risks from centralized decision making. I don’t consider myself an Austrian economist, but I’m becoming a fan of the principle that the overall outcomes of many decentralized decisions is likely to be better than a single “all eggs in one basket” decision. We pretend that the “central” planner is somehow omniscient and prudently minimizes risks. But after three decades of regulatory practice, I see that the regulators are not particularly competent at choosing the best course of action and have difficulty understanding key concepts in risk mitigation. By distributing decision making, we better capture a range of risk tolerances and bring more information to the market place.
    Of course, there’s a limit on how far decentralization should go–each household can’t effectively negotiate separate power contracts. But we gain much more information by adding a number of generation service providers or “load serving entities” (LSE) to the market.

    Further, in relation to California specifically, at least two of our IOUs are too large. A study submitted in PG&E’s 1996 General Rate Case by Christensen Associates, and then confirmed by PG&E’s consulting witness, showed that the greatest efficiencies were gained at about 500,000 customers. PG&E and SCE each have in excess of 4 million now.

    And as mentioned previously, transmission costs have been escalating. In a commentary on a previous blog, it was revealed that the Sunrise line may have cost as much as $80 per MWH for power from the desert. And we are seeing that renewable technology scale economies are topping out at 10 MW due to their modularity. This all adds up to economic gains from dispersed generation resources.

    There are further social gains from dispersed political decision making that brings accountability much closer to home and increases transparency.

    Which brings us to the important difference between Amazon and PG&E. Amazon improves its efficiency because it is directly at risk for lost revenues and profits if it fails to make the right management decisions. Consumers reap the benefits of those good decisions, and suffer minimal consequences when Amazon bets wrong–another merchant will step in if Amazon falters. On the other hand, PG&E has suffered almost no consequences–and even profited–from a series of bad decisions dating back to the mid 1970s. Even now, the utility is fighting against being held liable for damages created by failing to properly manage its distribution system which led to the Wine Country fires. So the debate about the gains from scale are not about relative size, but rather about the institutional incentives for different types of service providers.

    By the way, I am too confused by the use of the term “distribution utility” here. In the industry discussions, that term is limited to the sub-transmission voltage wires providers. Load serving entity (LSE) is the more appropriate term for what you are describing.

    • MCubed,

      I have to agree with much of what you say regarding the fallacy of thinking that central planning leads to better investment decisions. The massive nuclear plant cancellations that took place in the 1980s is proof of that.

      I do think you are confusing a load serving entity (LSE) with a distribution utility. The former is a seller of energy to retail customers while the latter provides the physical plant to deliver that energy. Also note that where retail choice exists the retail suppliers (LSEs) typically own no physical assets but rather simply engage in financial transactions with generators and retail customers. The traditional vertically integrated utility is an exception in that it is an LSE that owns generation (usually) and also the wires that deliver the energy to its retail customers.

  5. Just as an observation, it is worth noting that the CCAs are banding together to join or form purchasing pools or making wholesale arrangements through ESCOs. So I think there are clear signs that at least on the wholesale interacting side of the retail operation, there are economies of scale. I suspect also on the rate design and customer analytics perspective, most CCAs are going to underinvest because doing that work well requires expensive professionals. Perhaps that will come to CCAs by way of contracted services from a small number of firms.

    On a more frivolous note: boy does it make me cray to see all this talk about electrons this and electrons that. Electrons and energy are not even close to being the same thing. This shorthand drives me bonkers. Electricity in a wire moves a significant fraction of the speed of light. Drift velocity of electrons in a wire is snail-slow, and in fact, in an AC system, the electrons never go anywhere at all. The electrons in your toaster right now are the very same electrons it had when you took it out of the box. 🙂

  6. Here is some emperical evidence for your colleagues that I’m surprised was not mentioned: smaller, local municipal utilities have consistently, significantly lower rates and bills than PG&E.
    Reasons: fewer state mandates (for now), no need to profit shareholders, no inefficiencies from large bureaucracies, cheaper federal hydro power, option to be in a cheaper BA than CAISO, and so on. CCAs are only viable because IOUs were locked in to high priced RPS contracts early on. Happy to provide more perspective if you’re curious. I’ve worked at every type of entity except CCAs and CAISO.

    • Since when is a CCA exempt from the RPS? Every retail supplier of electricity within the state, not just an IOU, has to hold sufficient RECs to satisfy the state RPS.

%d bloggers like this: