This is part of a series of monthly posts reflecting different thought leader perspectives on utility rate design. All five opinion pieces appear in full in Leadership in Rate Design: A Compendium of Essays, which was designed to help public power utilities to rethink rate design strategies in the face of evolving technologies and customer preferences. The essays were developed as part of the Association's Moving Public Power Forward initiative.
One of the most ironic aspects of electricity pricing in the United States is that we have invested a great deal of money, thought, and effort into designing wholesale market pricing — at least in the organized markets — that provides meaningful price signals on a real-time and location-relevant basis. However, at the same time, we have spent time and money to perpetuate policies and practices to make sure that few end-use consumers ever see those prices.
Our policies and practices fall short despite the availability of meters and other technologies that allow for both meaningful communication and easy utilization of the information, and despite the existence of demand response markets.
Retail rate design fails to incentivize energy efficiency, meaningfully capture the economic value of distributed generation, and incentivize subsidies and other price distortions in lieu of pricing that internalizes the value sought by policymakers. These failures of retail pricing are not economically sustainable in the face of the growth of distributed resources, the increased electrification of the economy (e.g., electric vehicles), and the growing need for sensitivity to environmental considerations.
The predominant regime for retail pricing for residential and small commercial customers may best be described as “dumb” or “primitive” for a number of reasons, including:
- Pricing information is conveyed to customers in a manner that makes it useless for any purpose other than payment of the bill. The typical monthly bill provides no actionable or timely information and no hint of how one might more efficiently use energy. The bill offers no meaningful signal of how costs are incurred and how they might be reduced. Most significantly, given how sophisticated wholesale pricing has become, the customer bill offers none of the market information that is readily available.
- The bulk of the revenues are collected through the variable component of the bill, despite the fact that a substantial part of the variable component of the bill represents fixed and demand — not variable — costs. Thus, the price is divorced from the underlying costs.
- Even in regard to the variable costs themselves, most retail pricing regimes fail to reflect the market realities of supply and demand at specific times and locations.
The traditional pricing regime has been in place for many years and has developed constituencies that resist change and perpetuate the status quo, either because of a “the devil we know” frame of mind or because they’ve found financially attractive niches by taking advantage of the system’s flaws.
Without major changes in retail rate design, we will:
- Lose efficiencies in electricity markets and forego opportunities for serious innovation.
- Leave pricing at odds with many desirable social objectives.
- Deter movement toward electrification of heating and transportation.
- Leave ourselves vulnerable to market and price manipulation that may support some interests at the expense of others, such as the public.
In concrete terms, we can easily envision people charging their electric vehicles when they get home for dinner (in most places, dinnertime is coincident with peak demand) and paying no more for that than for off-peak charging. Similarly, we could continue paying a high price for excess rooftop solar energy at the off-peak times it usually is producing energy. Those are examples of the kind of inefficient behavior that is inevitable without tariff reform.
As technology continues to develop in ways we might not be able to foresee today (electrification of heating, for example, or advances in electricity storage), the penalties for pricing that does not reflect costs threaten to multiply.
The time is ripe for more accurate retail pricing. The following conditions, while certainly not exhaustive, make more modern, accurate rate design possible and necessary:
- The existence of highly precise real-time and location-specific prices in the wholesale market that can now be conveyed to end users.
- The ready availability of smart meters, smart appliances, and other intelligent technologies capable of conveying price signals and making them meaningful and actionable for consumers.
- The existence of demand response markets, which makes it possible to effectively monetize intelligent energy use.
- The dramatic decline in the costs of many distributed energy resources, notably rooftop solar, that has enabled their rapid expansion.
- Increased electrification of the economy — perhaps best illustrated by the growing sales of electric vehicles — that requires reasonably precise price signals to avoid significant uneconomic and inefficient consequences.
- The political pressure to devise and/or perpetuate rate designs that take advantage of deficiencies in the existing rate structure. One example is net metering, which takes advantage of the disconnect between how fixed and variable costs are incurred and how they are passed through to customers, causing potentially severe cost shifting among customer classes, often in a socially regressive way.
- The rapid changes in technology that might be efficiently harnessed for optimizing individual use of energy, as well as the entire grid, if correct price signals were provided.
A reformed rate design should keep in mind a few key principles:
- It is critical that the bill sent to customers comprises three components: fixed, variable, and demand charges. The prices set out in each component should be derived from how those costs are incurred and how the underlying assets are deployed. Prudently incurred fixed, variable, and demand costs should be passed on to customers in ways that meaningfully signal how customers might be able to avoid incurring each element of those costs.
- Energy and other variable costs should be passed on to customers in dynamic prices that accurately reflect the real-time (or as close thereto as possible) locational prices in the wholesale market.
- Cross-subsidies in rates should be generally avoided, but where they are deemed necessary (e.g., for low-income households), they should be transparent, narrowly targeted, and implemented in ways that are minimally disruptive of overall prices.
- Price signals to customers should be actionable. Customers should be able to translate the prices being communicated into actions that allow them to shape their load characteristics and control their costs and environmental footprint.
- The traditional classes might no longer be sufficiently granular. Residential customers, for example, might be distinguished based on whether they have distributed generation or electric vehicles, or if they use electricity in ways that make them different from other customers that are otherwise similarly situated.
- Customers who deploy distributed generation should be afforded full market access but should be recognized as a separate class of partial requirements customers whose rates fully reflect their use of and dependence upon the system, and whose compensation for the energy they sell into the grid should be reflective of market prices (the locational market price at the time they are outputting energy). Any compensation for ancillary or other services they may provide should be based on actual services rendered, not simply on the possibility that they might provide such services.
The electricity industry is undergoing rapid change — technologically, economically, and in regard to social expectations. To prepare for such change, utilities must have a tariff structure that is fully reflective of costs and cost causation. Having such a rate design positions the utility to adapt to change. It also enables customers to take full advantage of new opportunities without imposing added burden on the system and on those customers who are not able to avail themselves of these opportunities.
About the Author
Ashley Brown is the executive director of the Harvard Electricity Policy Group at Harvard University’s Kennedy School of Government. He is a former commissioner of the Public Utilities Commission of Ohio and former chair of the NARUC Electricity Committee.