Appeals to equity don’t salvage the argument for demand charges.
In the past, I have said some pretty unkind things about demand charges in electricity tariffs.
Demands charges are fees paid (mostly) by commercial and industrial customers based on their highest usage in any 15-minute (or sometimes, hour) interval of the billing period. They often constitute 30% or more of a customer’s bill, with most of the remainder based on total electricity consumption. Demand charges are going through something of a revival — even spreading to some residential rates. They have become particularly popular among utilities trying to get more revenues out of customers who install solar.
In a nutshell, my argument against the economic efficiency of demand charges has been that they accomplish nothing that couldn’t be better done with dynamic pricing. Demand charges are based on the customer’s highest 15 minutes of usage regardless of whether the cost of actually providing electricity in that period was particularly high. Changing prices that reflect the actual cost of supplying electricity all the time makes a whole lot more sense than a demand charge that whacks a customer for high usage in a single 15-minute period whether or not it is costly to provide electricity during that period. There are many branches to the argument about the efficiency of demand charges – such as whether they are a good way to reflect high energy prices or distribution-level capacity constraints, or to cover customer-specific fixed costs of service – but I addressed those in my previous blog.
I want to return to demand charges, because a number of people I respect in industry, government, and consumer groups still assert they should be part of modern rate design, and I recently realized that my arguments about economic efficiency may be missing their main point. Their case is often made on equity grounds, not efficiency. So, today I want to focus (mainly) on the equity aspects of demand charges.
The Revenue Shortfall Problem
Equity arguments arises in part because regardless of where you come out on efficient electricity pricing, those prices are not generally going to raise enough revenue to cover a utility’s total costs. To make up some of the difference from residential customers, most utilities levy a monthly fixed charge that is unrelated to consumption level. This doesn’t seem very fair, however, because heavy-use households pay the same fixed charge as light users. (For some very geeky economic thoughts about the ideal fixed charge, see the “bonus” section below.)
In fact, when I have surveyed people about this concern, they generally suggest that the fairest approach is to divide up any revenue shortfall proportionally to usage, that is, make it a volume-based charge. But that is when economists (including me) pipe up about the inefficiencies of charging a volumetric price that is far above marginal cost, because it discourages valuable electricity use. This is especially true when that discouraged usage would have substituted for more-polluting energy sources, like gasoline for transportation or natural gas for space or water heating.
This conundrum is worse when it comes to commercial and industrial customers. It seems even less fair to apply the same monthly fixed charge to a large factory that uses 3000 MWh per month as to a corner store that uses 3 MWh per month. Monthly fixed charges just don’t make a whole lot of sense when the scale of consumption varies drastically across customers.
That’s where demand charges come in. Demand charges are often seen as a way to charge something like a fixed fee that is higher for larger customers, without just making it part of the volumetric price. So, in practice do demand charges improve on the equity of tariff design compared to the other available pricing options? I don’t think so.
Once we agree on efficient dynamic pricing for electricity, demand charges seem to be a less equitable way to recover any remaining revenue shortfall than putting an adder on each kilowatt-hour. On efficiency grounds, I’m not a fan of such an adder, but it is pretty appealing on equity. To begin with, the equity concern most people have with fixed charges is that large-volume customers should pay more towards any revenue shortfall, not that customers with peakier demand should pay more.
Also, demand charges arbitrarily, almost randomly, impose more costs on some customers than others. Consider customers A and B that have the same total consumption and use the same quantity during times when the system is constrained. But customer A consumes its other energy in a more concentrated set of hours than customer B does. Customer A is likely to face a higher demand charge, and pay more towards the revenue shortfall, even though it is not doing anything more than customer B to constrain the system. With an adder to the volumetric price, that doesn’t happen.
Behind-the-meter (BTM) technologies have further undermined the fairness of demand charges. BTM storage can allow customers to substantially, and largely inefficiently, evade demand charges, which has become a beyond-cottage industry for consultants and battery producers catering to commercial and industrial customers. Installing batteries can be a bill-reducing strategy for the customer, but its often inefficient for society as a whole, because in the high-price states where it’s mostly taking place the individual savings are largely just cost shifts to other customers. And among residential customers, you can be sure that wealthy households are the first to install BTM storage to lower their demand charges. A per-kilowatt-hour adder does not create artificial savings for customers who install storage.
To be fair, a kilowatt-hour adder can be substantially evaded through installing BTM generation, a strategy that is also disproportionately pursued by wealthier households. In fact, this problem using BTM generation to evade cranked-up volumetric charges is what has led some utilities to advocate for demand charges instead. But that seems like a 2010 solution to a 2020 problem. As BTM generation is increasingly paired with storage, demand charges become a less effective mechanism for capturing additional revenue from such “prosumers.”
The bottom line is that neither demand charges nor kilowatt-hour price adders are a good solution to the revenue shortfall problem. The inefficiencies and inequities they create, particularly as BTM storage and generation expands, make the case even stronger for moving quickly to adopt efficient dynamic pricing. But efficient price variation alone generally isn’t going to raise all the revenue a utility needs. So the search continues for other revenue sources that fill the gap equitably without triggering evasive behavior and investments that primarily shift costs.
Bonus Section: Thinking about the ideal fixed fee (For those who really want to dive into economics.)
When considering pricing issues, I often find it useful to think about the ideal tariff design as a reference point, even if it is not feasible. When it comes to recovering a revenue shortfall after setting efficient prices, for efficiency sake we would like something that is not based on the level of consumption the customer chooses. But equity might suggest that customers who get more value out of the system should make a larger contribution.
A theoretical solution is straightforward, though impractical. If we knew each customer’s demand function, we could calculate the consumer surplus each customer obtains when the volumetric price is set equal to full social marginal cost (SMC, which includes the cost of pollution externalities, as I discussed in a blog last fall) in each hour. Then we could impose an individualized fixed charge equal to X% of their consumer surplus, where X (between 0 and 100) is set just high enough to cover the utility’s revenue shortfall. No customer would have an incentive to inefficiently reduce or increase their usage, because the consumer surplus from each unit they value more than SMC is still positive after the utility has taken X%, and the consumer surplus from any unit they value less than SMC it is still negative after the utility has taken X%.
The idea of a flat “tax” on consumer surplus is appealing on equity grounds, because customers who get a lot of value from their total electricity consumption – who would generally be high-usage customers – would pay more towards the revenue shortfall. (As we do now, we would probably want to carve out a different rate structure for customers who have high value and usage due to medical necessity.) But if one were considering equity from behind a Rawlsian “veil of ignorance”, one might opt for a progressive fixed fee where X is larger for consumers who get a lot of surplus, though probably only if such consumers were richer overall, not if their high usage were due to, for instance, having many people living in the same house.
This thought exercise illustrates the trade-off we face in the real world where we cannot observe a customer’s consumer surplus (though I suppose Facebook will have that information soon enough). If we try to use consumption quantity as a proxy for consumer surplus, and scale the “fixed fee” to quantity, it becomes a volumetric charge and creates an inefficient gap between price and SMC. If we ignore consumption quantity and ask everyone to contribute the same fixed fee, we are taking a much larger share of the consumer surplus of some customers than others, and likely a larger share from poorer customers, which most people would consider inequitable.
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Suggested citation: Borenstein, Severin. “Are Demand Charges Fair?”, Energy Institute Blog, UC Berkeley, July 8, 2019, https://energyathaas.wordpress.com/2019/07/08/rethinking-demand-charges/
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.