Arijit Sen, Sabin Center Summer Intern
Recently, two competing plans to reform California’s four-tier electricity rate structure of the three investor-owned utilities (IOUs)[1] have emerged from the California Public Utilities Commission (CPUC). On April 21, 2015, CPUC administrative law judges (ALJs) McKinney and Halligan filed a proposal that suggests implementing a two-tiered system, with a 20% maximum difference in rates for customers. At present, consumers at the highest tier of PG&E’s rates[2] pay 34 cents per kWh of electricity, while the lowest tier consumers pay 16 cents per kWh. The ALJs also proposed a fixed charge of $10 per month for every consumer, regardless of their electricity usage, and a shift to opt-out[3] time-of-use (ToU) pricing starting in 2019. On May 22, 2015, CPUC Commissioner Mike Florio issued an alternate proposal that is seen as a compromise between the existing regulations and the ALJs’ proposal. Commissioner Florio’s proposal includes three tiers instead of two, which is expected to lessen the burden of increased rates on lower-tier consumers, and a minimum bill of $10 instead of a fixed charge. It also noticeably skirts the issue of opt-out ToU pricing. While the ALJs’ proposal mandates that utilities transition to ToU pricing, Commissioner Florio’s proposal only asks utilities to “establish a goal” to do so.
Under the current tariff system, customers who use more electricity are charged significantly higher rates per kilowatt-hour (kWh).[4] This system promotes the principles of affordability and conservation by reducing the financial burden on low volume users of electricity and discouraging high volume users from wasting electricity. It is, however, inconsistent with the principles of marginal pricing, according to which the cost of retail electricity should reflect the cost of wholesale electricity. Relatedly, the price differential between the tiers does not reflect the cost of service differential amongst the tiers, and this essentially promotes cross-subsidization by one group of consumers to another group of consumers.
Research shows, moreover, that using a near-flat rate tariff, as California did before the infamous electricity crisis of 2000-2001, is not significantly less protective of lower income consumers. Consumers are more aware of the average price of electricity, which is provided on their bills, than they are of the marginal price of electricity, due to the lack of adequate real-time price signals. According to one recent study, “[t]his suboptimizing behavior makes nonlinear [tiered] pricing unsuccessful in achieving its policy goal of energy conservation and critically changes the welfare implications of nonlinear pricing”.[5]
The remainder of this blog post analyzes the impact of three aspects of the two proposals—tier flattening, ToU pricing, and fixed charges/minimum bills—and provides recommendations that may be relevant to upcoming CPUC hearings.
In particular, I look at the impacts on energy efficiency, equity amongst consumers and the burden on low-income consumers, the correlation between cost of procurement and cost of retail electricity, price signals to consumers, and solar energy generation.[6]
Tier flattening: Tier flattening means that higher tier consumers pay rates closer to lower tier consumers, despite consuming more energy. Understandably, there are concerns that tier flattening does not adequately incentivize efficient use of energy. According to The Utility Reform Network (TURN), “changing the rate structure to devalue conservation flies in the face of our state’s commitment to renewable energy, efficiency and reduced emissions”. A second implication of tier flattening is cost shifting from higher tier to lower-tier consumers, which means that lower-tier consumers would end up paying more for what they consume. Currently, the highest tier rate is double the lowest tier. The original CPUC proposal will decrease difference between the two tiers to 20%, and Commissioner Florio’s proposal will reduce the difference to 33%. This implication of tier flattening has been heavily criticized by the Sierra Club. SCE argues, on the other hand, that tier flattening promotes consumer equity, as the current system grossly penalizes higher tier consumers; they currently pay $600 million more in electricity bills than their actual cost of electricity. It is important, however, to note that tier flattening does not apply to users covered by the California Alternate Rates of Energy (CARE) system, which subsidizes electricity rates for certain consumers based on income level and household size.
There is considerable disagreement regarding who the major electricity users are. Some parties claim that wealthy households use more electricity, and others claim that middle class families with a large number of household members use more electricity and might benefit from lower rates. Without accurate data mapping household income, household size, and household electricity usage across the customer base, the impact of tier flattening will be hard to gauge.
ToU pricing: ToU pricing is based on the economic principle that the price of a commodity should reflect its marginal cost. While most experts agree that ToU pricing sends accurate price signals to consumers and incentivizes efficient behavior better than any tiered structure, TURN and the Sierra Club are concerned that ToU pricing will impact certain households during hot summer days, when prices may be higher than what they can afford. However, because opt-out ToU would be implemented gradually, the utilities will have time to experiment with the final rollout strategy.
ToU pricing is also complicated by the increasing reliance on distributed solar in California. In the classic “Duck Curve” scenario, overall grid electricity demand will be low on a relatively cool day due to reduced use of air-conditioning, and solar energy will make up a greater portion of total energy use. In the evening, energy demand suddenly increases when solar power does not function. This makes it necessary for the utility to obtain electricity at significantly higher prices[7], increasing the evening ToU tariff. ToU rates will need to address the operation of distributed resources so they contribute to reducing peak load.
Fixed charges/minimum bill: Fixed charges have been a major point of controversy in connection with rate reform. Consumers with distributed solar resources are paid retail rates for the energy they generate, which are considerably higher than wholesale rates for electricity. Thus, these customers are essentially cross-subsidized for the electricity generated by their systems. Yet the utility is not compensated for the customer’s utilization of the distribution network when the consumer sells electricity back to the grid. Utilities in California have long argued for a charge that covers the cost of serving a grid-connected distributed generator. Fixed charges and minimum bills have been proposed as easy ways to partially account for the cost to the utility for operating the grid.
Utilities argue that fixed charges should be used to recover the utilities’ fixed costs, just as variable rates are used to recover variable costs. However fixed charges applicable to all consumers, as the proposal suggests, will penalize consumers who use less electricity even without net metering. Moreover, since fixed charges do not improve price signals, they do not induce energy efficient behavior. The minimum bill, in contrast, is a floor on how much the consumer pays every month. With a $10 fixed charge, a household with a $9 bill (with or without net metering) will pay $19 for the month, but with a $10 minimum bill, the household will pay $10 for the month.
As some experts note, however, both fixed charges and minimum bills only roughly approximate the cost to the utilities for connecting consumers to the grid. In the long run, utilities will need to develop a system to more accurately reflect the marginal cost of electricity delivery and the value of solar relative to its expenses at different levels of use.
Recommendations: In preparing the final regulation, the CPUC should determine what its overarching objectives are and set its tariff structure accordingly. Implementing a mandatory ToU tariff regime would send the clearest price signals to the consumer and would not inherently place a greater burden on any particular consumer tier. That being said, ToU tariffs should be adjusted to help low-income consumers during warm weather and prevent the Duck Curve scenario. A cost-benefit analysis should be performed to determine whether a temporary adjustment of the existing tier system is warranted. However, considering transaction costs, it would probably be best if more time is spent on perfecting the ToU structure rather than the existing tier structure, especially if the tier system is phased out rather than being an opt-out option after 2018.
The two proposals do not discuss distributed generation and clean energy integration at any great length. These topics should be given more consideration since flattening tiers and fixed charges are likely to have a negative effect on both. Temporarily, a minimum bill instead of fixed costs should be implemented to reduce the impact on consumers with low electricity consumption. Eventually, however, the utility must determine the value each consumer brings to the grid and the cost of serving them beyond volumetric consumption and devise a separate charge accordingly. In the long run, the regulator needs to aid the utility in moving away from its dependency on electricity consumption as the source of revenue by creating an enabling environment, following examples such as New York’s Renewable Energy Vision.
Epilogue
On July 3rd, 2015, the CPUC passed a final decision on the residential electricity rate reform plan that uses elements of both proposals. The four-tier system will be reduced to two-tiers, with a difference of 25% between tariffs, as was proposed by ALJs McKinney and Halligan. A minimum bill of $10, as proposed by Commissioner Florio, instead of the fixed charge proposed by the two ALJs has been adopted. ToU will be the default option from 2019 onwards and the decision requires the three IOUs to come up with ToU rates by 2018. An important addition in the final decision, that wasn’t a part of either proposal, is the provision of a “super-user” charge for users consuming electricity more than 400% of the baseline. This will capture some of the high volume electricity users, but given that users in the four-tier system were penalized significantly for crossing 200% of the baseline usage, the number of users impacted by this charge will be significantly lower. The super-user charge is not a default option however, and the utility may choose not to impose it when designing their tariff structure.
The decision notes that “there is no evidence that a steep differential will lead to the type of behavioral changes necessary to sustain a consistent amount of conservation” while Florio stated that “none of the parties will be entirely happy with the decision.” The big winners of this decision are the higher-tier users whose rates will be cut drastically. Whether this impacts adoption of distributed generation, demand response, and energy efficiency measures depends on what decisions are taken with regards to related state regulations and proposals such as AB 327, Integrated Demand Side Management and Distributed Resource Plan.
[1] Investor-owned utilities are for-profit entities owned by private shareholders who are allowed a fair rate of return on their assets. The California IOUs comprise Pacific Gas & Electric (PG&E), Southern California Edison (SCE), and San Diego Gas & Electric (SDG&E). Together they serve around 75 per cent of the state’s total electricity demand.
[2] While PG&E is used as an illustration, the rate differential is largely consistent across all three IOUs.
[3] Time-of-use pricing charges consumers at rates based on the time of day they consume electricity instead of tiers based on monthly consumption. All IOUs offer ToU pricing as an optional rate plan. Opt-out ToU implementation will make ToU the default rate plan for consumers. Behavioral studies show that consumers are more likely to remain with a default choice than opt-in for a new option, even if the latter is more beneficial.
[4] In April 1, 2013, Southern California Edison switched to a four-tiered system from five-tiers, the last of the California IOU’s to do so.
[5] Ito, K, 2014. Do Consumers Respond to Marginal or Average Price? Evidence from Nonlinear Electricity Pricing, American Economic Review, Vol 104, No 2, pp. 537-563.
[6] In California, home rooftop solar generation is the main source of residential distributed generation. Consumers using rooftop solar are credited for each kWh generated at retail rates through the net metering system.
[7] Even if the utility owns the generation resources, the rapid increase in output requirements would be costly due to higher operational expenses.
