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Are Demand Charges Fair?

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.

RethinkingDemandChargesFig2In 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.

RethinkingDemandChargesFig3The 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. RethinkingDemandChargesFig1

Evading Fairness

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.

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

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

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 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.

70 thoughts on “Are Demand Charges Fair? Leave a comment

  1. Robert
    ” That suggests that the utilities should bear the risk because they can hedge through contracts and, in the longer run, by investing in plants that do not involve high fuel/operating price risk (e.g., renewables and nuclear)”

    Exactly my point. Right now in California (and it appears to be true more generally), ratepayers bear ALL of this price volatility risk yet they have few tools (solar rooftops being the most effective) to provide that rate certainty. Yet you and others argue against solar rooftops as inefficient, and even that ratepayers should see even more volatility through full on real time pricing. I’m saying that ratepayers should be able to gain at least some portion of price protection through contract terms with the utility. That is not available to most customers in California (and I haven’t heard of it elsewhere).

    “. Investors currently choose to bear risks even higher than that posed by fuel price uncertainty in return for the promise of high rates of return. ”

    In California, ratepayers bear the entire risk of fuel cost uncertainty under current state law and CPUC interpretation of that. There is almost no risk to shareholders in this state (and the Commission has made that even tighter with the recent PCIA OIR decision.) CEOs have a sweet deal right now. My point is that the Commission should adjust its perspective. Certain customers would be willing to pay higher rates in exchange for certainty–again look at solar rooftops.

    • Richard,

      “Exactly my point. Right now in California (and it appears to be true more generally), ratepayers bear ALL of this price volatility risk yet they have few tools (solar rooftops being the most effective) to provide that rate certainty.”

      My earlier comment referred to rate certainty over a period of years, not short-term price volatility, which is already hedged by utilities through their fixed tariff schedules. But I agree, small customers cannot easily hedge their rates over a long term, if at all. I’m in favor of utilities or retail electricity suppliers offering such hedged products.

      “Yet you and others argue against solar rooftops as inefficient, and even that ratepayers should see even more volatility through full on real time pricing.”

      I don’t oppose rooftop solar; I oppose the massive subsidies offered by some state and local governments (California being one of the worst examples) because it is generally more cost-effective to invest in large-scale solar. Large scale solar offers substantial economies of scale but receives no state or local subsidies, yet it provides largely the same benefits as rooftop solar does.

      If a customer is willing to invest in rooftop solar in return for receiving payments for the energy at prices that reflect the utility’s avoided costs (similar to PURPA payments) plus a payment reflecting the value of avoided emissions based on the Social Cost of Carbon and other health effects, I’m happy with that. What I am not happy with are the massive subsidies going to rootop solar through net metering, SREC set-asides and all the other state and local payments and credits.

      I advocate exposing customers to real time pricing because it provides an incentive for them to reduce their usage when the cost of delivering energy to them is higher than the value they place on consuming that energy. A Market will not function efficiently if the demand side does not participate in it.

      Consider what happened this week in ERCOT where wholesale prices hit $9000/MWh. Very few retail customers saw those prices so they didn’t adjust their consumption. Numerous studies indicate that residential customers value energy, on average, at around $3500/MWh. That’s really wasteful and represents an existential threat to ERCOT remaining an energy-only market.

      Now I understand customers’ reluctance to be exposed to the risk of receiving an enormous bill if the real time prices spike but there is a way to resolve this while still providing them with an incentive to efficiently reduce their usage. Provide them with a fully hedged fixed price schedule while allowing them the option to “sell back” their curtailed energy at the real time price less their hedged price. This is a win-win proposition for them. And it becomes even more attractive if they automate their responses through the use of enabling technology that controls the appliances in response to the real time price signals.

      This is similar to the peak-time rebate programs that exist today and have be well received. The important difference is that PTR programs are inherently inefficient because they use static, preset prices, rather than dynamic prices. I submit that the sell back option I just described is doable not just in Texas but throughout the country.

      “Certain customers would be willing to pay higher rates in exchange for certainty–again look at solar rooftops.”

      I think you are right about some customers being willing to pay more for long-term price certainty, though we don’t know how many; most people are short-term thinkers. But rooftop solar is not a good example of this behavior. In 2018, in California and at least other states, the federal, state and local subsidies (including the net metering subsidy) enabled solar customers to recoup more than 100 percent of the installed costs of their solar facilities.

      • We had an earlier debate on the relative costs of rooftop vs. large scale solar projects as I pointed out the avoided transmission costs are quite large. We don’t need to rehash this, but your point is not unchallenged.

        I wish I was getting back all of my investment in my solar panels! Instead I’m paying about $200 a month for 6 years after all of the subsidies. It doesn’t look like your information is current.

        • “We had an earlier debate on the relative costs of rooftop vs. large scale solar projects as I pointed out the avoided transmission costs are quite large.”

          In my previous comments I acknowledged that in some cases the high cost of transmission could make rooftop solar at least as attractive as large-scale solar. Generally that is not the case, where the large-scale solar facility can connect to the existing transmission line located nearby. But that has to be determined on a case-by-case basis. The example you previously described was the dedicated Sunrise Project connecting San Diego to the Salton Sea, a distance of about 100 miles.

          “I wish I was getting back all of my investment in my solar panels! Instead I’m paying about $200 a month for 6 years after all of the subsidies.”

          How much are your monthly bill savings from net metering? Also, will those bill savings end in 6 years or continue for another 19+ years? Solar panels are generally guaranteed to perform at about 85 percent nameplate capacity for at least 25 years but many continue to function for many more years.

          • SCE’s Tehachipi line is 173 miles long and includes a long underground segment through Chino. It’s true that incremental site expansions are low cost (and at least partly the reason for the recent sub $30/MWH deals), but the question is about comparing the LRMC with a local solar installation. Note that commercial rooftop and parking lot installation are much cheaper than residential rooftop.

            We installed solar when we bought this house. My office is here as well so I have a daily air conditioning and heating load although only for the office usually. I expect we’ll be here for at least another 20 years, so I’ll still have bills then (and I’ll be avoiding PG&E’s outrageous wildfire charges.)

  2. The answer is fairly obvious – electricity isn’t a commodity, it is a service. So yes they are perfectly fair.

    Let’s look at another service. When you pay for a taxi ride, what are you paying for exactly? Certainly you are paying for the gas burned by the taxi. But also the taxi driver’s time, the capital cost for the taxi, insurance for the car, maybe health care for the driver, the taxi company’s overhead, maintenance on the car, profit, etc. etc. There is an enormous amount of information stored in that taxi rate. Gas for the car is a small percentage of the total. For example, a taxi gets around 25 mpg, and gas costs $3.50 per gallon. Therefore your fuel costs to travel one mile in a taxi is around $0.14. However, a typical taxi costs $2 per mile. In other words, gas costs around 7% of the total cost for the ride. Or to put it another way, if gas were free, it would still cost $1.86 per mile to travel in a taxi.

    Another thing to think about, if the taxi is not getting enough customers, they are saving a small bit of money on gas, however, all their other expenses continue. There is a convenience charge. That is to say, the rate for a taxi cab contains a little bit of money to cover the time for the driver, the gas, the car, even when you are not using them. Having the taxi available in the city must be paid for by someone, even if no one is currently getting a ride. So you pay when you ride in the taxi, and toward all the times you are not riding in the taxi.

    Imagine a city where all forms of transportation other than taxis were banned. Taxis would have very high utilization rates, meaning very little wastage, and lowering of prices (fixed costs spread among more users).

    Now imagine a few people start riding bikes, and only using taxis occasionally. At first it doesn’t matter – the fixed costs for the taxis are still covered by the majority of the populace. But over time the fixed costs, which are a majority of the costs, are being borne by fewer and fewer people. Everyone still wants the cabs on a rainy day, but when it is sunny the cabs sit idle. Someone has to pay that cost. So the taxi companies agree – use the taxis a lot and you get a lower usage fee – use them only once in a while, and you must pay a higher fee. “Outrageous” the bike riders chant, “why do taxis cost more the less I use them?” Well because you are insisting on maintaining the convenience of using the taxi when you want to.

    Most of the cost for electricity is for making the electricity available to the consumer where and when they want it. Electricity generated and not used is wasted. That waste must be paid for by someone. Question is who should pay.

    Probably a refundable connection charge is most appropriate – the utility agrees that if you are hooked to the grid you will pay a certain amount each month, whether you use the grid or not. The amount decreases as you use more electricity. Above a certain amount of usage the connection to the grid is “free”.

    People who don’t like it are free to cut the wire to the utility. Just like people who don’t want to pay for water can dig a well or install a water tank, and those who don’t want to pay for sewer can install a septic system.

    • Is gasoline a commodity or a service?

      The price at the pump includes recovery of the capital investments in the service station, the refineries and the distribution infrastructure. But there are no demand charges, only volumetric charges.

      Why is electricity different?

    • BTW,

      The demand response advocates also argued in FERC Docket RM10-11 that DR is a “service,” not a buyback of energy (which was the initial argument for FERC jurisdiction). This recharacterization came about after Larry Ruff correctly observed that a retail customer cannot legitimately sell something that he never bought. That allowed them to argue for overcompensating the DR providers (most of which are large industrial& commercial customers).

    • Geo, when I pay for a taxi ride, I’m paying for a service – someone to drive me from Point A to Point B on time, safely, and in a reasonably courteous manner. That’s all. How much the drivers’

      • Taxi
      • Gasoline
      • Insurance
      • Health care
      • Company overhead
      • Maintenance
      • Profit etc., etc.

      cost, I care not a whit.

      If I and other taxi riders start riding a bike, some taxi drivers will go out of business. The ensuing scarcity of taxis will likely cause the price to rise as a result of simple supply/demand economics in a competitive environment.

      When I buy electricity from a utility monopoly I’m purchasing both a commodity (electricity) and a service (delivery of the commodity to my residence or business). But electricity customers are unable to choose their utility – thus, without choice on the part of the end user the idea there is any truly competitive “market” in electricity is a myth. So PUCs are tasked with deciding both a fair marginal cost utilities can bill to their customers for each kWh consumed, and a fair monthly cost for delivering electricity whenever it’s needed.

      You write “electricity generated and not used is wasted” – the only appreciable amount of electricity wasted is fractional line loss. All of the rest must be used. This is fundamental thermodynamics, and why grid operators work very hard to match generation to demand as closely as possible. If too much or not enough energy is generated at any given moment, breakers trip and the grid shuts down. Without breakers, utilities and municipalities would both face the possibility of $millions in damage to the grid.

      Charging a connection fee is a reasonable expense for the utiliity’s service of transmission, but decreasing the amount based on consumption, though often employed as for marketing purposes in a competitive business environment, provides nothing of value to consumers. In theory, PUCs are public servants, and their only priority should be making available reasonable profit to utilities while guaranteeing access to reliable, safe electricity for the public, offered at a price which is determined fairly and transparently.

      • I would add that the role of regulators should be to approve retail rate designs that are economically efficient and thus do not waste societal resources.

        The problem is that most regulators are lawyers not educated in economics (and generally not in any STEM discipline) so their thinking processes focus primarily on equity considerations which (of course) are subjective. Adding to this dysfunction is the fact that most regulators are political animals. How else would they get get elected or appointed to be commissioners?

        This is why retail rates are so screwed up in most of the country!

        • “The problem is that most regulators are lawyers…”

          There are two lawyers among CPUC’s commissioners, also an engineer and an economist. CPUC Chairman Michael Picker “holds an MBA from UC Davis, specializing in marketing, social marketing, and nonprofit management.”

          Hard to argue commissioners aren’t well-schooled with a variety of backgrounds. Also hard to argue their appointment by the Governor encourages diversity of opinion; historically, commissioners have been instruments of his policy objectives – and, some would say, his personal financial objectives – alone.

  3. Agree that demand charges based on the highest consumption in a given period, apparently with the goal of inducing customers to spread out their consumption evenly, is not economically efficient. But more importantly, it’s another example of a ratemaking strategy (like demand/response, etc) which prioritizes utilities’ needs over those of consumers.

    When do customers need electricity? How much does usage vary? That depends largely upon the zoning of the service address. If it’s zoned for industrial, why aren’t utilities adding a the cost of improvements as a flat surchage, to customers in that zone, so the cost will be borne evenly? Then charge the same straight volumetric, per-kWh price available to R1 units a few blocks away.

    Though the current shift of responsibility for resource adequacy to the demand side, i.e. DR and TOU, has been somehow deemed acceptable, it sucks in terms of social equity, forcing customers to bear what has traditionally been a utility’s responsibility as a burden in inconvenience. As utility holding companies expand their hold on government agencies and PUCs, however, we’re probably doomed to a future of wondering how we can help to make the job of energy execs more profitable and less challenging than it already is.

    A thought from outside the econ-bubble: though adding more fairness-time-of-use-apportioned-capacity-scarcity-paucity variables may sound attractive to econ wonks, complexity both 1) is a magnet for fraud, and 2) makes budgeting electricity consumption a nightmare for consumers. There’s something to be said for a simple per-kWh electricity bill, with a flat distribution charge based upon the zoning of the service address. It would allow individuals and businesses to budget current expenses and plan for the future, without having to worry whether the charge on their bill with seven asterisks is actually the one with six. And whether it’s legit.

    • The shift from centrally provided power to distributed generation is part of a larger society wide trend toward “prosumers”–rooftop solar, gig workers, YouTube distribution of entertainment, etc. This has two benefits. First consumers can tailor delivery of resources to their own needs and pricing arrangements. They don’t have to suffer through one size fits all. And second, consumers can gain control over their costs and effective pricing. One of the biggest attractions of solar rooftop is that the price of power is known for 20 years to the consumer. The utilities have refused to provide such price certainty to ratepayers.

      • MCUBED,

        It’s not that the utilities have “refused” to provide to provide price certainty to ratepayers, it’s that they can’t when their costs include fuel, the future price of which is unknown to them (or anyone else).

        The reason why the price of solar is fixed is that virtually all of the costs are in upfront investment. Once the investment is made there is no uncertainty. (Actually there is some because there are some O&M costs involved and the actual life of a solar facility is uncertain but there are small compared to recovery of the initial investment).

        • That premise is false. The point of futures and forward contracts is that they provide certainty for all sorts of costs–in the future. You are assuming that 1) such contracts must be provided to all ratepayers all at once rather than some ratepayers asking for such contracts for some or all of their power needs and 2) shareholders may be willing to shoulder the fuel price risk in exchange for a higher rate. As it is, ratepayers are currently shouldering all of the fuel price risk. Why can’t they pay shareholders to accept a portion of that risk? That already happens financial markets, as well as in other markets. Southwest Airlines famously rode out an oil price spike by prudently buying oil futures that transferred the price risk to the sellers. There’s is nothing in economic or financial theory that says that consumers must shoulder price risk.

          • MCUBED,

            “There’s is nothing in economic or financial theory that says that consumers must shoulder price risk.”

            I agree. Fuel price risk can be borne by either shareholders or ratepayers, or some combination thereof. However, a basic economic principle is that risk should be assigned to the party that is in the best position to manage it. That suggests that the utilities should bear the risk because they can hedge through contracts and, in the longer run, by investing in plants that do not involve high fuel/operating price risk (e.g., renewables and nuclear).

            Prior to the OPEC oil embargo in 1973, when the price of crude oil quadrupled and threatened to bankrupt many utilities whose generators burned oil, the utilities did bear the full risk of fuel prices. That was the genesis of the fuel adjustment clause.

            “shareholders may NOT be willing to shoulder the fuel price risk in exchange for a higher rate.”

            This statement flies in the face of finance theory. Investors currently choose to bear risks even higher than that posed by fuel price uncertainty in return for the promise of high rates of return. But to make this work for utilities the regulators need to authorize target rates of return that fully compensate the utilities for bearing the fuel price risk. My guess is that most utility CEOs are hesitant to assume that risk because they do not trust the regulators to authorize fully compensatory rates.

  4. Price signals only work when the end user can respond. Under a dynamic pricing model on a rural, largely residential system the price will be highest when it is three degrees outside and dark. You can only reduce your thermostat so far before your pipes freeze. Dynamic pricing in this scenario would be especially hard on low income consumers, who are often large consumers, because their homes tend to be inefficient.
    The fixed monthly charge should, in addition to recovering fixed costs, be scaled to be a proxy for demand charges. So large consumers fixed charge is higher than small consumers. i.e. a large home should pay a higher monthly access charge than an apartment. The proxy should be calculated for consumption during an on-peak window over the course of an entire year so that it isn’t impacted by one particular high use event.
    Another aspect of the author’s argument indicates that there isn’t an incremental cost to meeting a higher demand, there is, however if it occurs during an off peak period the incremental cost is lower because it only affects the transformer and service wire not the grid capacity.
    “Energy is cheap, reliability is expensive.” Demand charges represent one “fair” way to pay for reliability.

    • Michael,

      “Price signals only work when the end user can respond.” Great point! And one that economists must keep in mind.

      When price deviates from Short Run Marginal Cost the resulting welfare loss is small if price elasticity is small. This argues for recouping revenue shortfalls in ways that involve low or zero elasticities. This argues for recovering the revenues through the monthly grid access charges because it is unlikely that customers will disconnect their service as long as the monthly charges stay within a reasonable range.

      Exactly how to equitably apportion them among customers with different load profiles is a good question to which there is no definitive answer. Like beauty, equity is in the eyes of the beholder.

      • Equitable distribution can be better defined by economists; the profession has shied away from this endeavor trying to hide behind its claim that it has a clear, singular metric in efficiency. Unfortunately, that latter metric is irrelevant because the conditions never exist to achieve a first best outcome in the real world, particularly in a general equilibrium, and choosing the best among “second bests” isn’t possible. In the end, the profession is still left making a value judgement about which solution is preferable. In addition, the profession has slipped into a sloppy use of monetary metrics as the sole measure of utility.

        Recent research is showing that more equitable income and wealth distributions do lead to higher levels of society welfare and well being. It’s time that the profession applies these principles to constructing means of measuring equity as well as efficiency.

        • MCUBED,

          You have introduced the Theory of Second Best boogyman.

          Over a half-century ago two economists, Lipsey and Lancaster, mathematically demonstrated that moving prices closer to Short Run Marginal Costs (SRMC) in one market would not necessarily improve total societal welfare if prices in other interrelated markets were not already equal to their respective marginal costs. This is because the welfare gains in the primary market may well be more than offset by welfare losses in the interrelated markets. In its extreme interpretation the theory states that in the real world one cannot know how societal welfare will be affected overall by setting prices equal to SRMC in just one market even if social welfare increases for participants in that market. In effect it implies that we abandon economic efficiency as an achievable objective.

          In the 1970s this argument was used to oppose marginal cost pricing of electricity. And, as one might guess, Fred Kahn was in the middle of the fray. In his landmark work (The Economics of Regulation) Fred acknowledged the validity of the theory of second best but rejected the idea that it rendered economics valueless in informing pricing decisions. Instead he argued that the magnitude of the impacts of price changes in one market affects welfare in other market depends on the degree of interdependence, as measured by their respective cross-elasticities of demand. To the extent those cross-elasticities are low one can safely ignore the spillover effects. Fred concluded that, rather than do nothing, economists should do the best they can with the facts at hand.

          My interpretation of Fred’s conclusion is that we should set prices as close to SRMC as is possible while recognizing that doing so may cause negative spillover effects in other markets that trade products that are substitutes or complements to electricity, e.g., natural gas, plug-in electric vehicles, solar panels, energy-efficient appliances, etc. The question then is whether the net negative effects in these related markets outweigh the welfare gain in the primary market. Is a bird in hand worth two in the bush?

          Yes, setting economically efficient prices inevitably involves judgment calls – as does everything else in life – but inaction is not a useful option.

          I am all for achieving greater equality in the distributions of wealth and income, primarily through achieving greater equality of opportunity rather than through outright confiscation. That said, some degree of “confiscation” of wealth through higher taxes on the rich is necessary to create more opportunity for those on the lower rungs of the socioeconomic ladder. However, I don’t think that retail tariffs are an appropriate tool for promoting greater equality, particularly if it causes reductions in economic efficiency and associated welfare losses.

          Economics uses monetary metrics because they have been developed through rigorous analytic proofs. I am all for developing similar rigorous, objective measures of equity. Got any ideas how we start to do that, MCUBED?

          • “Yes, setting economically efficient prices inevitably involves judgment calls – as does everything else in life – but inaction is not a useful option.”
            The cross elasticities with the other markets you listed are pretty strong and the many of those markets have their own regulatory rigidities that create their own market failures. While using marginal costs is useful for evaluating relative cost effectiveness, the CPUC (and probably other jurisdictions that use forms of marginal cost pricing) have so undermined the principle of cost allocation that its not a valid approach any more. If you want to create the conditions for appropriate marginal-cost-based pricing, you must start with reforming our fundamental political system–you can’t do this from the bottom up and try to claim that is somehow fixes a distortion. It just creates a different distortion. Good luck on reforming the fundamental legislative horse-trading process.

            “I am all for achieving greater equality in the distributions of wealth and income, primarily through achieving greater equality of opportunity rather than through outright confiscation. That said, some degree of “confiscation” of wealth through higher taxes on the rich is necessary to create more opportunity for those on the lower rungs of the socioeconomic ladder. However, I don’t think that retail tariffs are an appropriate tool for promoting greater equality, particularly if it causes reductions in economic efficiency and associated welfare losses.
            Economics uses monetary metrics because they have been developed through rigorous analytic proofs. I am all for developing similar rigorous, objective measures of equity. Got any ideas how we start to do that, MCUBED?”

            Just getting to the point where we can agree that many segments of society can’t have equal opportunity because they start from such a deep deficit would be a huge step, but our nation appears to be headed the other direction at the moment, much to our detriment. I agree that rates and prices are not the correct mode of trying to achieve equity–it has to be a wealth transfer. (And it’s not “confiscation” because that presumes that wealthy got their wealth through their own efforts. The truth is that the wealthy get most of their wealth through a combination of luck (in many forms including who their parents are) and societal resources such as education and risk sharing. Such a transfer is an acknowledgement that the wealthy need to compensate the rest of us for that assistance and privilege.)

            The metrics for incorporating equity into economic measures would include how the well being of different segments of society. That also would include focusing on the change in well being of the median household rather than on the aggregate wealth. It’s even possible to link how aggregate wealth changes are impacted by the changes in wealth distribution. Since this is a blog, I’m not going spend extensive time to working through the mechanics of how this would work since it would involve much more time than I give to a free effort.

            I’m not aware of proofs that show that money is the best metric. One of the fundamental strands of environmental economics (which is my original educational focus) is that much of our resource use is unpriced and therefore has no monetary metric. There are various efforts to provide monetary measures of those attributes, but they are as yet incomplete.

  5. As Robert Borlick has already explained, there is no compelling theoretical reason why short-run marginal cost pricing of generation should lead to an expected deficit. The empirical reality of such deficits is due largely to avoidable costs, including bailouts to utility shareholders, mistaken pricing, excess capacity, and subsidies and mandates aimed at politically attractive objectives. So the first priority for solving the problem would seem to be avoiding these costs in the first place.
    Vernon Smith suggested 40 years ago that the economies of scale in transmission have already been exhausted (at least for medium and high-income countries). And economies in distribution may or may not exist, depending on the locational configuration of users.
    But let us stipulate that deficits are necessary for technical or political reasons. It is not clear that (Wicksellian) demand charges set as a proportion of consumer surplus are impractical. Suppose that estimated demand is not perfect but quite accurate. The question becomes whether demand charges based on estimated instead of actual demand could survive legal challenges (e.g. of discrimination).

    • Jim,

      “The empirical reality of such deficits is due largely to avoidable costs, including bailouts to utility shareholders, mistaken pricing, excess capacity, and subsidies and mandates aimed at politically attractive objectives.” Interesting observation.

      In 1998, when California was restructuring its wholesale market, LCG Consulting (in Los Altos, CA) produced a report that claimed the three IOUs were saddled with $40 billion in “regulatory assets,” all or most of which were above-market PURPA contracts. The report did not identify who funded the study. Does anyone know who the client was?

      • I was working with Rajit Deb at LCG for the CPUC on the utility divestiture applications. I believe he prepared them internally and used them as marketing reports for discussions with potential clients. We had access to utility book values and he was already doing many of the necessary modeling runs for the CPUC (with my input on a range of parameters.)

        • Thanks MCUBED.

          So do you think the LCG numbers are valid enough to be quoted as representative of the stranded costs associated with above-market PURPA contracts held by the IOUs? I would like to use these figures in a paper I am writing.

          • No, I don’t think that they encompass the full set of values, and the subsequent evidence supports that notion. In 1997, the CPUC and utilities assumed that their fossil generation fleet represented a large amount of stranded costs based on the same type of modeling that LGC conducted. Instead, the auctions produced a net gain of $1,067.9 million or about 50% above book value. Those evaluating the plants before the auction made the same mistake that the IOUs and CPUC made recently in the PCIA OIR–that short-run prices present the true market value of generation assets. That’s because the hourly and monthly markets fail to account for the other attributes that fall under asset control.

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