Electricity Utility Pricing in
the Present Environment
Ken Costello
National Regulatory Research Institute
[email protected]
Six Takeaways
 Ratemaking can address many of the challenges facing the electric utility





industry; as some observers have remarked, “Set the prices right and good
things will happen”
Ratemaking is tougher than choosing a car or a health care plan; changing
rate design, for example, would benefit some customers but hurt others,
and the information presented to commissions is fraught with problems
Ratemaking has become harder over time because of expanded public
policy objectives and more stakeholders in the regulatory process
Regulators do adapt to a changed environment, although cautiously, when
the public interest would otherwise suffer
Ratemaking comes down to the relative importance that regulators and
stakeholders place on different objectives
Reaching agreement on rate issues (i.e., a political equilibrium) requires a
balancing of interests, where each stakeholder has to give up its preferred
choice for the public good; stakeholders in many states have not yet
reached agreement on things like (1) compensation by the utility for
surplus rooftop solar PV power, (2) compensation to the utility for grid
services provided to DG customers, and (3) the optimal use of smart
meters for pricing
Costello NRRI
2
U.S. Electric Utilities Face Challenging
Times Ahead










Costly new environmental regulations
Aging infrastructure
Grid modernization
Increased emphasis on public-policy goals (e.g., clean energy)
Changing fuel and generation economics
Transitioning to a high penetration renewable-energy future
Integration of new technologies (e.g., smart grid, DG, EVs)
Cyber and physical security demands
Public demands for improved “superstorm” response (e.g., resiliency)
More active and demanding customers (e.g., desire for real-time information
and pricing, and value-added services)
 New technologies behind the meter
 Reduced or flat load growth
-------------------------------------------------------------------------- Is the threat of a “death spiral” real?
 What are the implications for regulators (e.g., ratemaking) and utility
operations (e.g., the utility business model)?
3
What Constitutes Good Pricing
 Cost-based (marginal cost preferably)
 Price discrimination under certain conditions (e.g.,







additional sales when price ≥ marginal cost )
Fairness (vague and subjective but important in the history
of utility pricing)
Financially viable prudent utility
Economically efficient (e.g., efficient competition,
reasonable operating costs)
Incentives for innovation (e.g., expected returns
commensurate with risk)
Incentives for advancing public policy objectives (e.g.,
energy efficiency)
Public acceptability
Rate stability
Costello NRRI
4
Why Pricing Is Important
 Covers revenue requirements, cost allocation and rate design, each of





which affects the welfare of individual stakeholders and the public at large
Helps to achieve important regulatory/social objectives, which
prominently include the financial viability of utilities, the efficient use of
electricity and the deployment of socially-desirable new technologies
Affects the economics of DG and other emerging technologies, both on
the benefits and costs side
Affects existing utility customers who remain as full-requirements utility
customers
Faulty pricing can lead to problems like undue price discrimination,
inequity, uneconomic bypass, financially stressed utilities
Additional costs from faulty pricing in a more competitive electric
industry
Costello NRRI
5
Current Concerns with Ratemaking
 Harm to utilities from lower sales
 Deficient utility compensation to
given the current rate design of
recovering most fixed costs
through volumetric charges
Inappropriate rates and rate
design for DG and fullrequirements customers
Pricing of surplus power (e.g., the
net metering rate) is not costbased like with CHP
Cost-shifting to full-requirements
customers
Non-robust utility incentives for
innovation
DG customers for the value they
contribute to the utility grid
Deficient DG customer
compensation to the utility for
standby and other grid services
Uniform prices across all time
periods
Overall, impediments to meeting
traditional and new regulatory
objectives (e.g., “fair and
reasonable” rates)
Lag in using advanced meters for
more intelligent pricing




Costello NRRI




6
Reasons for New Rate Mechanisms
 Questioning of the tenets and
underlying assumptions of
traditional ratemaking
 Much of the push comes from
stakeholders (e.g., utilities,
environmentalists, consumer
advocates) with diverse interests
 Incidentally, throughout the
history of public utility
regulation, stakeholders have
petitioned commissions to revisit
old rate mechanisms and consider
new ones (e.g., late 1960s and
early 1970s)
Costello NRRI
 Added regulatory objectives over
the past several decades,
including the advancement of
energy efficiency and renewable
energy, and utility service
affordability
 New market and operating
conditions (e.g., rising average
costs, slowdown of demand
growth)
 Large capital expenditures, some
of which is non-revenue
producing
 The challenge for commissions is
to evaluate whether new rate
mechanisms are in the public
interest
7
New Rate Mechanisms: Grouping by Objective
Objective
New Rate Mechanism
Reduce utility financial risk
Cost trackers, infrastructure surcharges, riders
Reduce regulatory lag
Future test years, CWIP, multiyear rate plans, cost
trackers, formula rates, infrastructure surcharges
Reduce the frequency of rate cases
Formula rates, multiyear rate plans, future test years
Eliminate utility disincentive for energy efficiency by reducing the risk of
revenue erosion
Revenue decoupling, straight fixed-variable rates, lost
revenue adjustment
Make utility service more affordable to all customers
Inverted rates, discounted rates, percentage-of-income
mechanisms
Promote renewable energy
Net metering rates, feed-in tariffs, green pricing
Prevent uneconomic bypass and ease the ability of the utility to compete in
certain markets
Flexible rates, special contracts
Optimize energy usage over different times
Time-of-use rates, critical peak pricing, real-time rates,
seasonal rates, demand charges
Lessen the rigidity of regulation
Price caps, flexible rates
Avoid rate shock
Infrastructure surcharges, CWIP, phase-in
Promote specific activities
Special incentives for energy efficiency, pipeline capacity
release, off-system sales, distributed generation
Costello NRRI
8
Challenges for Commissions
 Multiple regulatory objectives
 Balancing act (more
stakeholders than before)
 Conflicting objectives and
inevitable tradeoffs
 Objectives difficult or
impossible to quantify, and
impossible to identify
empirically the contribution
of individual objectives to the
public interest
 No consensus on the
definition of the public
interest
Costello NRRI
 Uncertainty of outcomes
 Dealing with cost




socialization and subsidies
Encourage DG/DER but don’t
give away the store
Fairness to non-DG
customers
Difficulty of interpreting
diverse information
Prevention of a “death spiral”
condition
9
Evaluation of Individual Rate
Mechanisms
 Within the context of regulatory objectives (e.g., realtime prices can make customer bills highly volatile)
 Expected outcomes based on economics and real-world
experiences (e.g., revenue decoupling removing
disincentives for utility-initiated energy efficiency)
 It is not clear whether a particular rate mechanism is in
the public interest
 All rate mechanisms have mixed outcomes from the
perspective of the public interest
 Regulators must use judgment to assess their overall effect
Costello NRRI
10
New Ratemaking Proposals under Review
 Demand charges
 Prices for unbundled
 Demand response





pricing
Performance-based rates
(e.g., energy efficiency)
Surcharges for new
investments
Minimum bill
SFV/modified SFV
Flexible pricing
Costello NRRI





and new value-added
services
Revenue decoupling
Value of solar tariffs
Net metering
PURPA-type pricing for
surplus power from
rooftop solar customers
Time-varying rates
11
Rate
Mechanism
Positive
Negative
General Comments
Traditional ROR
ratemaking
• Emphasis on due process
• Pricing rigidity
• Strongest justification under
• Focus on utility prudence
• Disincentives for promoting
• Simple for public to understand
certain social goals, such as
utility-initiated energy
efficiency
• Excessive regulatory lag
under high inflation and
stagnant sales growth
• Inefficient average-cost
pricing
• Mismatch of utility costs
and rate structure
• Weak long-term utility
incentive for cost
management
• Weak utility incentive for
innovations (assuming rigid
profit controls)
• Frequent rate cases in a
dynamic environment
• Incentive for excessive
capital investments (“A-J
effect”)
stable market and utility
operating conditions
• Problems arise in a dynamic
environment
• Throughout its history,
traditional ROR ratemaking has
endured attacks from different
stakeholders
• Although undergoing changes
around the edges, traditional
ROR ratemaking still dominates
state utility ratemaking
• Most other countries reject
U.S.-style traditional ROR
ratemaking
• Perception of fairness
• Avoidance of undue price
discrimination
• Rate stability
• Strong utility incentive for cost
management between rate cases
• Long-standing core ratemaking
paradigm
Costello NRRI
12
Rate
Mechanism
Positive
Negative
General Comments
Straight fixedvariable rate
• Matching of different utility costs
• Adverse effect on low-
• SFV is less popular than revenue
and rate structure
• Good price signals for customers
• Enhanced utility-earnings stability
• More uniform utility bills across
seasons
• Positive hedging effect on utility
customers
• Removal of utility disincentives for
energy efficiency
• Mitigation of inequities caused by
intra-class subsidies
• Consistent with the pricing of
many other goods and services
usage customers, some
of whom may be lowincome households
• Weaker incentive for
price-induced energy
efficiency
• Questionable public
acceptability
Costello NRRI
decoupling in removing utility
disincentives for energy efficiency
• For electricity, a three-part tariff
with a demand charge may be
more rational
• Generally, SFV faces intense
opposition by different groups ,
namely, small consumers, solar,
low-income, environmentalists
• Although not endorsing a SFV
rate design, over the past several
years many commissions have
allowed an increase in the
customer charge
• SFV can have an “equity”
problem by causing some
customers to see dramatically
higher bills
• Strong opposition to SFV has
triggered interest by utilities in
demand charges for residential
customers
13
Rate
Mechanism
Positive
Negative
General Comments
Demand
charge (e.g.,
charge for
utility’s
readiness to
serve on
demand)
• Alignment with an ideal rate
• Lack of customer
information to manage demand
• Perception as a utility scheme
to guarantee recovery of its
fixed costs
• Reduction in incentive for
energy efficiency (with the
lowering of the commodity
charge)
• Barrier to rooftop solar PV
• Effects will vary widely
because of diversity of
residential customers, with
some customers potentially
being much worse off
• Lack of capability for
customers to manage their
monthly demand
• The three major criticisms seem to
design: volumetric charge based on
variable cost, customer charge based on
customer-specific fixed costs (billing,
metering) and a demand charge based
on system-wide fixed costs
• Incentive for customers to lower
their KW demand and better manage
their electricity bill
• Equity advanced in terms of who
should pay for utility’s embedded
capacity costs (at least from a
retrospective perspective)
• Reduced cross-subsidies currently
provided to low load-factor
customers
• Improved economics for energy
storage
• Improved load factors
Costello NRRI
be: (1) some customers could see
much higher bills, (2) a reduction in
the marginal price signal diminishes
the incentive for energy efficiency,
and (3) the difficulty for customers to
know when and how they can manage
their KW demand to lower their bills
• Need to address the regulatory
objectives of gradualism and public
acceptability (pilots, optional)
• Education, education, education
• Number of design challenges
• Essential for customers to have the
enabling technology
• Similar issues in acceptability as
time-variant rates
• Scarcity of real-word empirical
evidence on outcomes
14
Rate
Mechanism
Positive
Negative
General Comments
Revenue
decoupling
rider
• Enhanced utility earnings stability
• Reduced frequency of general
rate cases
• Mitigation of utility disincentive
for energy efficiency initiatives
• Fairness to utility in recovering
prudent fixed costs
• Lessened controversy over sales
calculations in a general rate case
• Skeptical public
• Second-best approach
to addressing utility
disincentives for energy
efficiency
• Cost-shifting to all
customers
•Weakened incentive
for sales growth per
customer when
warranted by market
and utility operating
conditions
• Most popular in the natural gas
sector but increasing in number
for electric utilities
• Most commissions prefer
revenue decoupling riders over
its closest rivals, SFV rate design
and lost revenue adjustment
mechanisms
• Revenue decoupling seems to
not seriously violate any core
regulatory principles and is
compatible with the “balancing
act” aspect of public utility
regulation
• Empirical evidence have shown
typically small annual rate
adjustments, with many
decoupling plans adjusting rates
downward as well as upward
Costello NRRI
15
Rate
Mechanism
Positive
Negative
General Comments
Time-variant
pricing (e.g.,
RTP, critical
peak, TOU)
• Economically efficient
• Downward pressure on wholesale
power prices
• Improved utility load factor
• Need for less utility capacity
additions over time
• Improved load factors
• Avoidance of subsidies to high
peak-use utility customers
• Promotion of demand-side actions
to allocate utility costs
• Improved economics for EV,
storage and some DG
• Aggravation of high
utility bills during peak
periods
• Skeptical public
resistant to new pricing
scheme
• Potentially large
adverse effect on non
price-responsive
customers
• Majority of customers
could be worse off
• Revenue instability for
utilities
• Likely revenue
declines for utilities
when voluntary
• Strong economic rationale for
them but uncommonly applied,
especially for residential
customers
• Several obstacles to timevariant pricing from three
perspectives: (1) regulatory, (2)
utilities, and (3) consumers
• Question of opt-in or opt-out
option
• Preference for demand
response pricing
• Regulatory concern about some
consumers being worse off –
e.g., losers would include
consumers not shifting their load
to lower-cost periods
• Smart meters should expand
the use of time-variant pricing
• A hallmark of utility regulation,
however, is average cost pricing
and resistance to unstable prices
Costello NRRI
16
Rate
Mechanism
Positive
Negative
General Comments
Net energy
metering
• Convenient
• Simple to measure
• Critical “jump starter” for solar
• Booster for behind the meter
competition
• Contrary to PURPA
principles of avoidedcost pricing
• Payment of the retail
price to DG customers
for essentially wholesale
energy
• Failure to account for
the time-dependent
value of DG energy
• Lack of a rational
economic foundation
(e.g., not cost or value
based)
• Overall, an unfair and
regressive cross-subsidy
(e.g., a small percentage
of customers, usually of
above-average income,
benefiting at the
expense of other
customers)
• NEM is under review in a
number of states
• Alternatives include LMP and
value of solar tariffs (VOST)
• Solar advocates see replacing
NEM as a potential “killer”
• Utilities have lived with NEM
until recently when they fear it
could jeopardize their financial
condition and hurt full
requirements customers
• Consumer groups haven’t taken
a unified position but generally
seem to oppose NEM
Costello NRRI
17
Ten (Tough) Steps for Evaluating a New Rate
Structure
1.
Does the current rate structure have shortcomings that need to be
addressed?
2. What explains the current interest in a new rate structure for
residential customers?
3. How would a new rate structure differ from the current rate structure
for residential customers?
4. How would a new rate structure advance regulatory objectives?
5. What are the different rate structures that regulators can consider?
6. How well would they work to overcome the problems with current
rate structures and advance regulatory objectives?
7. What are some of the criticisms raised against new rate structures?
8. Is there evidence that new rate structures will benefit residential
customers?
9. How do regulators weigh the positive and negative aspects of each
rate structure to arrive at a decision?
10. What are the best ways to implement a new rate structure for
residential customers?
Costello NRRI
18
Appendix
Costello NRRI
19
What Is Ratemaking and Its Goals?
 Ratemaking (or pricing)is a 3-step process:
determining revenue requirements, cost allocation, and
rate design
 Four primary goals of ratemaking
 High economic efficiency
 Sound utility financial condition
 Equity or fairness
 Advancement of social objectives (e.g., energy efficiency,
affordability, promotion of clean energy)
Costello NRRI
20
Historical Evolution of Utility Ratemaking
 Legal underpinnings
 Evolution of utility rate mechanisms over the past several
decades
 Objective of state utility commissions to achieve a
“balancing act”
 Commission adaptability to a changed market and
political environment
 Constant challenges for state utility commissions to
advance the public interest
 Changing perspective of “just and reasonable” rates and
no definite criteria except for “boundary” conditions (e.g.,
no confiscation of investors’ property, no undue price
discrimination)
Costello NRRI
21
Features of Traditional Ratemaking
 Objective of giving utilities sufficient returns on prudent








capital costs
Rates based on cost of service
Average-cost pricing
Predominant venue for utility cost recovery is a general
rate case
Fixed base rates between rate cases
No utility entitlement to the authorized rate of return
Robust incentives for cost reductions between rate cases
Rates attempt to balance the interests of different
stakeholders
Outside-of-rate-case cost recovery only under restrictive
conditions (e.g., large cost item, hard-to-predict costs,
costs largely outside the control of a utility)
Costello NRRI
22
The Balancing Act: The Underlying
Principle of Ratemaking
 Symmetry of consumer and
investor interests



Consumers want fair and reasonable
prices
Investors want to earn a return
commensurate with risk
Other stakeholders want to advance
their agenda (e.g., energy efficiency,
renewable energy, affordable utility
service)
 Balancing can involve regulatory
objectives rather than stakeholder
interests, although both tend to
overlap
 Commissions balance the
interests of different stakeholders,
given their legal mandates and
the political environment, so as to
advance the public interest
Costello NRRI
 Commissions implicitly identify
the objectives of ratemaking,
weigh those objectives, and make
the inevitable tradeoffs
 The public interest reflects the
composite indicator of the public
well-being by combining the
individual effects of an action
 The challenge for commissions is
to identify the public interest
amid the diverse information
received from different quarters
23
Traditional and New Regulatory
Objectives
 Affordable utility service
 Energy efficiency
 Power diversity that





includes renewable
energy
Fostering of
innovation/new
technologies
Reliable service
Safe service
Price predictability
Fairness
Costello NRRI






Price stability
Revenue stability
Timely cost recovery
Economic efficiency
Clean environment
Level playing field in
competitive markets
 Infrequent general rate
cases
24
Three Basic Steps for Good
Ratemaking
 Defining the public interest in
terms of the regulatory
objectives
 What are the underlying regulatory
objectives for ratemaking?
 The public interest relates to regulatory
objectives and the weights ascribed to
each
 Understanding the effect of each
ratemaking proposal on the
different objectives
 Regulators should have access to
unbiased information
 Otherwise they will react to biased
information by making incorrect
decisions even when they are fairminded
Costello NRRI
 Processing all the
information systematically
 For example, regulators have to
account for the inevitable tradeoffs
in addition to assessing the publicinterest effect of individual rate
mechanisms
 A regulator’s decision is akin to
purchasing a car, where a person
must balance power, safety, fuel
economy, appearance, maintenance
costs, purchase price, reliability and
other features to reach a decision
that maximizes her well-being
25
Costello NRRI
26