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The Electricity Price Isn’t Right

Setting prices too low is a climate problem, but so is setting prices too high.

We didn’t hear much about electricity pricing at last week’s Global Climate Action Summit in San Francisco. But when it comes to sub-national entities addressing climate change (as well as local pollution), electricity prices are one of the most powerful policy tools they have.

The Importance of Getting Price Right

A major part of the pollution problem is that we don’t make polluters pay for the emissions. As a result, final goods don’t reflect the full incremental costs that producing them imposes on all of society, what’s known as “social marginal cost” (SMC) in Econspeak (sadly, a language that Google Translate still can’t handle). Pricing electricity below SMC encourages wasteful use, such as computers left on all the time, cranking up the air conditioning rather than installing better insulation, and sticking with inefficient lighting and old refrigerators when more efficient versions would save money if the owner were paying the full SMC for electricity.

PvSMCfig1Where will a plug-in hybrid get “charged”?

But while ignoring pollution will drive the price of a kilowatt-hour (kWh) too low, an age-old issue for utilities pushes prices in the opposite direction – recovery of their fixed costs. For instance, if the cost of transmission and distribution lines does not vary with how much electricity you consume, then the SMC principle says that recovering that cost in the per-kWh price of electricity will tilt prices too high. That will cause consumers to cut out some usage that would have been worthwhile.

Paying the full SMC for each kWh of electricity, you might decide to leave some lights on for safety or comfort, watch an hour of silly cat videos, or heat your hot tub for a nice soak. More importantly, you might decide to switch from gas to electric hot water or space heating or look into an electric vehicle. But if the price of electricity is way above SMC, you will be discouraged from doing so, and society will be worse off.

If that sounds pretty abstract, it’s not to the three different California owners of plug-in hybrid cars who recently told me they never plug them in. Their electric rates are so high that it is cheaper to just run them on gasoline (while still getting access to the carpool lanes). But those electric rates are vastly higher than the SMC of the electricity. These drivers are “conserving” too much electricity.

New Research on the Gap Between Price and Social Cost

How do I know that their electric rates are too high? Research! In a new Energy Institute working paper that Jim Bushnell and I are releasing today — “Do Two Electricity Pricing Wrongs Make a Right? Cost Recovery, Externalities, and Efficiency” — we compare the residential rates of nearly all the utilities in the US with the social marginal cost of the electricity they provide.

You’ll have to read the paper to get into the gritty details, but our calculations incorporate both the generators’ direct costs of producing the power and the external costs imposed on society by the associated pollution from greenhouse gases (at $50 per ton…figured you’d want to know) and local pollution. In fact, for much of the country, we find that the societal costs from pollution are actually larger than the direct cost of generating electricity.  We also adjust for the fact that some of the electricity is dissipated as heat between the generators and the houses, known as line losses.

Failing to price pollution makes electricity too cheap, which is a big problem in the Midwest where a lot of coal generation is still putting out massive quantities of carbon dioxide and, just as important, sulfur dioxide, which causes acid rain and other local pollution problems. But it is a much smaller problem in California, where the majority of electricity comes from zero-GHG sources like solar, wind, geothermal, hydro and nuclear, and nearly all of the rest from relatively-low-GHG gas-fired generation.PvSMCfig3

On the other hand, all utilities have fixed costs that they recover at least partially through their price on each kilowatt-hour. This turns out to be a bigger problem in California and parts of New England, where electric rates are paying for energy efficiency programs, development of new alternative generation technologies, and rooftop solar panels, as well as the usual fixed costs like transmission and distribution lines. In addition, the large investor-owned California utilities have miniscule or no monthly fixed charge for residential customers, so they collect all of their revenue in the per-kilowatt-hour charge, which further pushes up the price.

The map above summarizes our findings on the average gap between price and SMC.   In some states – the lighter colors on the map – unpriced externalities are largely cancelled out by fixed cost recovery, so the gap between the standard residential electricity rate and the utility’s average social marginal cost is small. In other words, prices are – almost by coincidence – about right on average.

However, in the upper Midwest, where residential electricity prices are very low and pollution is high, prices are well below social marginal costs on average. By contrast, in California and the northeastern US, electricity rates are way above SMC, more than twice as high in much of California.

Yes, California, we can encourage too much electricity conservation. We are doing it. We have among the highest electricity prices in the country and among the cleanest electricity generation. It is a barrier to electrification of home heating and hot water, electric vehicle adoption, and other uses of electricity that create value in our lives greater than the full social cost of the power.

Meanwhile, the states in red on the map – many of which are politically “purple” or even “blue” – are pricing electricity well below the full social marginal cost, thereby encouraging excessive use: relying on more A/C rather than more insulation or shading, and discouraging upgrades to more energy-efficient A/C, refrigerators, lighting, and even hot tubs.PvSMCfig4We also find – frustratingly, but not surprising politically — that those states that are pricing electricity too high are also the ones spending the most through other programs to reduce electricity demand – particularly subsidies for energy efficiency and rooftop solar, as shown in the maps above and below. Most of those customers in the darker areas are already getting excessive rewards for cutting their usage, because they are avoiding high electricity prices that don’t reflect real costs to society. The lighter areas of these maps correlate closely with the redder areas of the previous map: both price and policy give those households little incentive to conserve.PvSMCfig5

Timing Matters Too

Our study also looks at the hourly variation in SMC, due to both generation marginal costs and the associated pollution, which residential rates almost never reflect at all. We find that for many utilities charging a constant price is probably an even bigger problem than its level. The price may be close to average SMC, but in some hours it is much too low and in other hours much too high. As information and control technologies improves – think smart charging that Nissan Leaf (bestselling EV globally) when the sun is shining or the wind is blowing – these differences suggest another set of opportunities to reduce greenhouse gases by aligning prices with the true social marginal cost of providing electricity.

Last week’s climate summit was a crisp reminder that even with the U.S. federal government AWOL on climate policy, there is strong commitment at state and local levels to reduce greenhouse gases. Direct support for new technologies should play a major role. But let’s not forget that a market economy runs on its prices. Getting the price right for electricity is something that every local jurisdiction can do.

I’m still tweeting energy news stories/research/blogs most days @BorensteinS

Keep up with Energy Institute blogs, research, and events on Twitter @energyathaas

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.

30 thoughts on “The Electricity Price Isn’t Right Leave a comment

  1. If I remember correctly, Boiteux, whom Joskow keeps telling people to read (it’s not all in French), prescribes long-run MC pricing, but that’s implicitly abstracting from uncertainty. Under perfect certainty, SRMC = LRMC. (You can do this w/ constraints, wherein SRMC goes vertical at max capacity, or just w/ increasing SRMC.) With uncertainty, the optimal price is set at SRMC, which (from the above) can be either greater or less than LRMC. So you could end up w/ a deficit, implicating fixed charges, or a surplus wherein the fixed charge is negative. (The surplus can also be returned by lowering prices on the inframarginal block.)

    • This is one of several cost foundations for the inclining block rates that exist with many of the Pacific Northwest utilities. Trying to price incremental usage at long-run incremental cost, and then reducing the fixed charge and first block rates to generate the correct revenue requirement. Lewis Perl and Sally Hunt Streiter from NERA testified before the Washington Utilities and Transportation Commission about the need to “get the tailblock rates up” even if that meant a zero customer charge and low first block rates.

      The other foundations of the inclining block rates are:

      a) providing a limited amount of low-cost hydropower at a hydropower-based cost (This same logic can be applied to Pacific Gas and Electric and SMUD, but not to SCE or SDG&E, which have almost no hydro).
      b) Recognizing the inferior load factor of high-use (space conditioning) customers. We found that lights and appliances (the first block) have about a 70% load factor, water heat about a 40% load factor, and space conditioning about a 20% load factor. So, just as a demand charge would price space heating at a higher overall rate, an inclining block rate does the same in a much more understandable way. and
      c) Ensuring all customers have access to power for essential needs at an affordable price (a social policy consideration, not an economic theory justification).

      The WUTC ruled on this in 1980, and rates have been rational ever since. Puget Sound Energy residential rates:

      Fixed Charge: $7.49/month
      First 600 kWh: $.09
      Over 600 kWh: $.11

      Looking at that rate, you in California can see why I plug in my PHEV every day, even though it has pushed me into the second block. My upper block is lower than your lower block. But you have better weather.

  2. Thanks for all the interest in this blog and the comments.

    Responding to many of the comments

    1. On the issue of short run social marginal cost pricing: It is a well-understood and accepted conclusion of basic microeconomics that departures from SRSMC cause deadweight loss by encouraging over and under consumption. In every hour, the efficient price is always SRSMC. But SRSMC will and should include significant scarcity rents when demand pushes up against capacity constraints. If it is an absolute hard capacity constraint, then the efficient P=SRSMC will be greater than the SRSMC of the last unit produced (but less than the SRSMC of producing one more unit, which would be infinite).

    2. On the relationship between SRSMC pricing and covering total costs: Although in theory there is a long-run equilibrium (in the absence of economies of scale) in which pricing at SRSMC over time leads to an adjustment in capital investment so that SRSMC pricing exactly covers total costs, that never happens in practice in any industry. Every industry experiences so-called boom and bust cycles, which in reality are a result of the fact that firms cannot perfectly predict the behavior of consumers or of other firms. As a result, nearly every industry goes through periods of very high profits and very low profits. There is no market in which firms reliably earn a competitive rate of return. (See: http://faculty.haas.berkeley.edu/borenste/download/ElecJo00MktPower.pdf)

    3. Scarcity pricing “working” to achieve a perfectly efficient market at every moment in time does indeed require perfect competition and perfect knowledge. But that is hardly an interesting comparison. Competition generally yields a more efficient allocation of resources than government central planning, as well as stronger incentives for innovation. It is not perfectly efficient hour by hour, but that is not a useful standard when comparing to inefficient regulation. For the vast majority of markets, developed economies have come to the conclusion that limiting economic regulation to antitrust/competition policy is likely to be much more efficient than interventions to guarantee rates of return or levels of investment. Electricity distribution providers, however, are not one of those markets. Because of economies of scale, they are universally regulated, or government owned. Our paper addresses how much deadweight loss the resulting residential prices create. The standard of perfect efficiency may not be achievable, but it is still useful to understand how much inefficiency current pricing practices are causing.

    4. The suggestion that many commodity markets are often dysfunctional is at odds with nearly all of the economic research that has been done on agriculture, metals, and everything else traded on futures markets. There are occasional attempts at market power and market manipulation, but the vast vast majority of economic researchers in these areas do not think that more government regulation would improve the outcomes in agriculture, metals and other commodity markets. We continue to have government intervention in agricultural commodity markets, and every ag economist I know thinks that they are almost uniformly a bad idea. (This is, of course, separate from the question of health and safety regulation, and other forms of intervention to improve consumer information.)

    5. That said, electricity is truly different, because it is a non-storable good and we insist that demand not be rationed with price. Note that this is no longer a technical requirement, but rather a policy choice. So long as we are going to insist that we don’t ration scarce supply with price, we are not going to have a standard commodity market in electricity, so we are going to produce alternative revenue streams. Still, there are markets that operate without capacity payments such as in Texas and Australia. They aren’t perfect, but neither are the markets that operate with capacity payments. I think it is an open question how we should best design competitive wholesale electricity markets. At this point, I have not been convinced by either side that they have a coherent and robust market model. But we do know that the historical model of regulated vertical integration (or state ownership) exhibits massive inefficiencies, so it is worth continuing the debate. (See http://deep.ucdavis.edu/uploads/5/6/8/7/56877229/deep_wp017.pdf and https://www.annualreviews.org/doi/pdf/10.1146/annurev-economics-080614-115630}

    6. Finally, yes, there are numerous municipal utilities in California that have substantial monthly fixed charges. As our excellent graduate student and research assistant, Stephen Jarvis, pointed out in the comments, however, the customers of the IOUs get fixed rebates from the California cap and trade program that far outweigh the minuscule fixed charge that SCE charges. So it is accurate to say that no customers of the California IOUs pay a positive monthly fixed charge. Minimum bills are binding on almost no customers, so they are for the most part no policy at all. As far as I can tell, they have been suggested only as an attempt to sidetrack discussions of increases in monthly fixed charges. (See http://ei.haas.berkeley.edu/research/papers/WP272.pdf)

    • Ah, the mythical “scarcity rents” – the moment when perfectly competitive markets degrade into oligopolistic or even monopolistic markets as suppliers charge whatever they want for an unknown duration. In a perfectly competitive market, scarcity rents don’t exist for the same reason “that $20 bill can’t be on the sidewalk”–new supply is always instantly available. This is why using a perfectly competitive market metric in a capital intensive industry is not useful for policy makers. Talking about to decision makers who don’t understand all of the assumptions underlying that premise doesn’t lead to useful policy outcomes.

      The temporal period of the definition of marginal costs then becomes relevant. Some how the housing market delivers an adequate price signal without relying on daily hotel rates as the price indicator. The full capital cost of a new house is considered the marginal cost indicator. In the airline industry, is the marginal fuel cost of a flight the marginal cost indicator for pricing? (I wish…)

    • Just as you might hope I think you can actually see this on the first map. The Sacramento area served by SMUD is noticeably lighter than the surrounding sea of dark blue served by PG&E. That difference is basically all due to SMUD having lower per kwh prices, with more of their revenue being raised through fixed charges instead.

  3. You might get your friends to sign up for an EV-A rate. If they charge during evening hours, the rate is ~13c pert kWh. For a EV using about 300 Wh/mile this cheaper than gas for a car with a 50 mpg rating. .13*.3*50 = $1.95/Gallon which is a pretty good deal! Not to mention that you can charge at home.

    I agree that the TOU signal is completely out of wack. The price profile with partial peak from 7am-1pm and 9-10pm and peak from 2-8pm makes no sense when wholesale prices are at their cheapest in the early afternoon…

  4. Paul raises an important issue. In the long-run, there are no fixed costs, so by what principle do we assert that optimal pricing should include fixed charges for transmission and distribution? Since economies of scale have typically been exhausted (e.g. Vernon Smith), full long-run MC pricing (including transmission and distribution charges) would more or less cover costs. Under, say, demand uncertainty, short-run MC pricing would imply higher than long-run prices during times of shortage so again it is not clear that MC pricing would imply a shortfall. This leaves only things like bailing out PG&E shareholders for uncovered costs, but these are politically-motivated transfers.

    • short-run marginal cost pricing, which includes scarcity pricing, is economically efficient. The scarcity pricing component is what recovers the fixed costs of the system.

      • I believe, but am not certain, that short-run optimal pricing is equivalent to the idea of a long-run MC pricing. The crux comes down to getting scarcity rents right, especially as storage plays a larger role. Without storage, we simply raise prices when a capacity constraint is reached, until quantity demanded equals the capacity. If these resource rents exceed to cost of capacity expansion, expansion happens. With storage, scarcity rent depends on current inventory plus expectations about future supply and demand and uncertainty. Markets ought to handle those expectations reasonably well. But not all locations have markets and it’s not entirely clear how competitive these markets actually are during relatively constrained times.

        Anyhow: my sense is that Robert Brolick is right. But is there an equivalency theorem somewhere? Does it require perfectly competitive pricing?

        • Yes, scarcity pricing requires perfect markets with perfect and full knowledge. Because we are far from “perfect” markets (which is why the economics profession exists), we have to look to other valuation mechanisms that capture long-term value rather than relying on chasing a myth.

          • Okay, but I think you’re overstating the case. Markets are not perfect, but commodity markets have functioned pretty well for a very long time. With emerging storage technologies, electricity should start to look more like standard commodity markets, which have scarcity rents embodied in them. It’s up to regulators to make these markets as competitive as possible.

          • Not sure which commodity markets you are referencing. Many are often dysfunctional. The dysfunction of agricultural commodity markets was the justification for U.S. intervention in the 1920s, and those markets continue to be propped up by government intervention to maintain investment viability in that sector.The metals markets are characterized by boom/bust that reeks havoc with developing world economies dependent on that income.

            For storage markets to function properly with short-run prices the ancillary services markets are going to have start including full commitment costs for generation plus the very localized short run scarcity value of reliability. The CAISO currently socializes the commitment cost through the bid cost recovery payment for residual unit commitment. (And they have been resistant to changing this paradigm when I pointed out this problem.) The localized scarcity value won’t come from operational resource costs and could be quite “knife edged” where one doesn’t need it until one needs a whole bunch of it–reliability largely is not a small incremental change. This assumes that customers will somehow become informed enough to bid in their very short run “value” of reliability, which of course is an unrealistic assumption because they would be overwhelmed.

      • “Scarcity” pricing doesn’t happen in most, if any, electricity systems. The CAISO’s Annual Market Performance Reviews show that it’s market revenues have only covered investment costs for new generation when the markets were being manipulated by merchant generators in 2000-01. Only a fool would invest in new generation based on the myth of perfect markets and “scarcity” pricing. Social and political concerns will ALWAYS mitigate those supposed price “signals”. It’s time to move away from the chase for the mythological and start defining appropriate market price signals that reflect true investment decision making in the industry.

  5. I don’t follow the reasoning that capacity charges (the amount and price of which are determined by load) are not load-related.
    And why aren’t the marginal costs of transmission and distribution included as marginal costs?
    The recent avoided-cost report for New England shows substantial marginal costs for generation and pool-level transmission. Note that the study did not estimate marginal distribution or local transmission.
    http://www.synapse-energy.com/sites/default/files/AESC-2018-17-080-June-Release.pdf

    • The short-run marginal costs of transmission and distribution systems (excluding losses, which are marginal energy costs) are zero. Long-run marginal costs are not zero if the system needs to be upgraded or expanded but economically efficient prices do not include long-run marginal costs.

      Many people (including some economists) get confused over this issue.

      • Unfortunately, it’s engineers that get confused over this pricing/marginal cost paradigm. In the putty/clay world of marginal cost, the long-run costs can diverge from the short run for many reasons, including the introduction of risk mitigation (in which the expected hazard never arises, or only in an erratic way), or with boom-bust investment cycles which are a trait of capital intensive industries. The political elements that enter every market because they are social constructs also distort the price signals in different ways. Maybe in the perfect world of incomplete mathematical models, short-run marginal costs eventually converge with long-run costs, but in reality they only do by coincidence.

      • Robert, I think you are allowing a slavish loyalty to economic dogma to blind you to reality.
        I a large customer’s usage contributes more than a small customer’s usage to the need to upgrade generation capacity, transmission and distribution, efficient pricing requires that the large customer pay more than the small customer. Short-run marginal cost is not a useful proxy for the full marginal cost of serving customers.

    • Not all California utilities are in the situation that Sev describes. Some are beginning to recover their capacity costs more appropriately, through the TOU energy charges.

      A good example is Burbank Water and Power. Their Schedule C commercial rate provides a strong incentive for workplace charging of electric vehicles, as opposed to “plug them in when you get home” behavior:

      Customer Charge: $9.78/month
      Off-Peak: $.1267 (overnight and weekends)
      Mid-Peak: $.1584 Daytime hours except on-peak window
      On-Peak: $.2535 (4-7 PM Monday-Friday, June-October ONLY)

      With this rate design, the cost of charging at work is much lower than the equivalent cost of gasoline. For people who lack a dedicated secure parking place to install an EVSE at home, this creates a good opportunity. The key is to eliminate the demand charges, except for site-specific installed capacity, and recover these costs appropriately in seasonally and time-differentiated usage costs (as other industries, like airlines, oil refineries, dairies, and supermarkets do).

      After all, the original (Munn v. Illinois) and still singular key function of regulation is to enforce on monopolies the pricing discipline that markets enforce under competition. We don’t see customer charges at Macy’s, or Demand Charges at Chevron stations.

      Imagine if you had to pay a fixed charge or demand charge for gas pump, pipeline, refinery, supertanker, and oil well expenses based on your highest 5-minute interval of usage (when you fill up the rented U-haul or motor home once a year). But, would it really make more sense to leave it at the gas pump, running at a trickle, for two days?

  6. Very interesting article. However, one question I had is about natural gas being classified as “relatively low GHG”, and how exactly life cycle emissions for gas production were factored into the calculations. There is no shortage of papers suggesting that life cycle methane emissions associated with gas production are likely much higher than assumed and disclosed by producers. Given that gas is the single biggest source of electricity generation in CA, it seems like accounting for life cycle GHG figures for natural gas production is crucial. Interested to hear your thoughts, and thanks again for the article!

  7. Really interesting analysis on the dangers of electricity pricing being too high. Another thought for the owners of those hybrids – is the SMC for gasoline accurately reflected in the price of gasoline? Is electricity priced too high, or are natural gas and gasoline too cheap?

  8. Severin,

    Great article. One knit-pick.

    You state that residential tariffs of California’s three IOUs do not have monthly fixed charges. But as I recall, the three IOUs did have monthly residential customer charges amounting to about 90 cents. I thought they were recently revised upward.

    Can you elaborate on this? (I’m too lazy to research this right now).

    • PG&E currently has a daily minimum charge of $0.32854 per day. SCE has long had a residential fixed charge that is currently $0.03 per day, with a daily minimum of $0.34 per day. SDG&E has a daily minimum of $0.329 per day.

    • This is true, but they are at most a couple of dollars per month and are completely swamped by the California climate credit, so the effective annual fixed charge in California for the three IOUs is basically negative. By comparison most utilities in the rest of the US have fixed charges in the $10-20 per month range. Hope this answers your question.

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