Rate Design Is the No. 1 Energy Efficiency Tool

Rate Design Is the No. 1 Energy Efﬁciency Tool

It is one thing to understand the theory of efﬁcient pricing and another thing to actually implement it. However, the job is getting easier, as wholesale markets simplify the task of estimating marginal generation and transmission costs, advanced metering infrastructure makes time-varying pricing feasible, and the industry recognizes the value of straightforward, easy-to-understand prices.

Hethie Parmesano

Hethie Parmesano is Senior Vice I. Energy Efficiency efficiency measures in the President at NERA Economic Makes Headlines, but electricity sector. Typical Consulting, where she focuses on Too Little Attention to recommendations include costing, pricing, and regulation of the Rate Design reinstitution of integrated electric, gas, and water utility resource planning (IRP),1 new industries. She also directs NERA’s Headlines in the national appliance and building Marginal Cost Working Group, a media, not to mention the trade standards, subsidized investment group of utility companies interested in sharing research and ideas on press, have been documenting the in efficiency-enhancing marginal costing and its use in new focus on energy efficiency. equipment, standby or buy-back applications such as pricing, Global climate change concerns, rate or interconnection subsidies planning, and retail access efforts to remove barriers to for distributed generation (DG),2 implementation. In addition, she has development of renewable energy and revenue ‘‘decoupling’’ conducted studies related to electric 3 sources, concerns about meeting mechanisms. utility strategic planning, including pricing strategy. growing demand for electricity, ften lost, or and efforts to make new O underemphasized, is the electricity markets more fundamental role of economically competitive all point to an efficient electricity pricing in enhanced role for energy eliciting energy efficiency

18 1040-6190/$–see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.06.002 The Electricity Journal activities by energy users. For cost incurred by the utility to efficient are rates that change as example, in a March 2007 report supply the extra kilowatt-hours, system and market conditions to Congress, the U.S. Department thenshewillbemakinga change. Examples include critical of Energy listed rate design as the decision that is not only right for peak pricing (CPP) and real-time final of 10 recommended her, but also efficient in terms of pricing (RTP). mechanisms for enhancing society’s resources. This requires CPP charges a pre-set high energy efficiency (and tempered an electric rate design that price for energy consumed dur- that recommendation with the charges for the extra ing hours declared (usually a day note that ‘‘this goal must be consumption at the utility’s ahead) to be critical, in terms of balanced with other ratemaking marginal cost, and recovers costs high cost, reliability, or both. objectives.’’)4 In fact, rate design that do not vary with usage in RTP charges prices that vary should be at the top of the list. fixed charges or some bill hourly, depending on system or Efficient rate design is an component (such as an early market conditions, and are set essential starting point if the goal typically either a day ahead or an is to maximize the cost- hour ahead. effectiveness of other efficiency Unfortunately, the nfortunately, the prices efforts. U most U.S. consumers pay There is nothing new in the prices most U.S. are not well-correlated with the theory of efficient pricing; consumers pay are not marginal cost of providing consumers make economically well-correlated with the electric service. As a result, the efficient energy-related decisions marginal cost of reductions in electricity bills from when they face prices equal to reducing electricity use, or shifting marginal cost. What are new are providing electric use from peak to off-peak periods, affordable metering and service. do not match the costs the utility communication technologies, (and more generally society) better information about avoids when less energy (or less marginal costs, an peak-period energy) is used. understanding of the importance energy block) that is not likely to of clear price signals, and a significantly affect consumption. sense of urgency. ate designs that relegate III. Efficient Electric Rate R local distribution and Design Supports Other customer-related costs that do not Energy Efficiency II. Economically vary with consumption to fixed Initiatives Efficient Electricity charges (e.g., a monthly customer Pricing charge or charge per unit of Recent legislation, state energy contract capacity or design plans, and stakeholder reports When a consumer is demand) and recover generation, have identified a number of considering cranking up the air transmission and upstream initiatives that are designed to conditioning on a hot summer distribution costs that do vary improve energy efficiency. In afternoon, she should be with usage in charges that vary by many cases, improving the weighing the extra charges on season and time of day result in efficiency of electricity rates the next electricity bill against more efficient consumption would complement these other the value of the extra comfort decisions than traditional rate activities. Consumers may still that afternoon. If the effect on structures with low or no fixed need help identifying her bill of that extra charges and no time- opportunities for improving consumption matches the extra differentiation.5 Even more energy efficiency in their homes

July 2007, Vol. 20, Issue 6 1040-6190/$–see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.06.002 19 or businesses, or coming up with CPP programs) increases the Appliance standards and building the initial investment, but they do benefits of energy efficiency codes help buyers make efficient not need a subsidy if the savings activities, promotes load choices by screening out on their electricity bills match or shifting (from high-cost to inefficient options. However, the exceed the cost of making the low-cost periods), and improves standards and codes must be changes. system reliability without carefully set, based on estimates ne initiative is to encourage requiring investment in new of marginal costs and expected O DG investment, particularly capacity. use over the life of the appliance/ projects using renewable Many utilities have (or used to building. technologies. Simply reforming have) direct load control programs equirements to consider regular rates to reflect the under which the utility R both supply and demand- structure of marginal costs can controls off particular electrical management investments when improve the cost effectiveness of equipment (such as air developing plans to meet future DG. Rate structures with high electricity requirements is known demand charges tied to as integrated resource planning maximum level of use (sometimes Even (IRP). When customers face over an entire year or more) efficient prices, they will reduce the cost-effectiveness of with efficient undertake cost-effective demand- investing in self-generation that price signals, side investments on their own, may not be available in all hours. consumers provided they have sufficient Time-differentiated marginal may not make information. Thus, a component cost-based rates encourage design of demand-response becomes and operation of DG facilities that cost-effective embedded in the load forecast maximize electricity production equipment choices. that the utility is planning for, and in the critical on-peak hours. less investment (demand- or Rates with energy charges that supply-side) is required than reflect marginal energy costs would otherwise be the case. provide a signal to consumers to conditioners and water heaters) Even with efficient price install and operate their own during critical hours, and signals, consumers may not make generating facilities when the cost rewards participating consumers cost-effective equipment choices. For of doing so is less than the utility’s with bill reductions. Setting the example, individuals may have marginal cost of supplying that bill credits to reflect the utility’s difficulty assessing costs and energy. avoided costs helps maximize the benefits over multi-year time Another efficiency-promoting efficiency of the programs. periods, and firms often require policy is to encourage short-notice OfferingRTPandCPPprograms investments with a two- or three- demand response to enhance may reduce the need for direct year payback. However, with the system reliability and counteract load controls, as consumers will financial incentives in place in the market power by generators have the incentive to control their form of efficient rates, energy bidding in the wholesale energy own electricity use during the efficiency programs can market. Customers respond to high-costperiods.However,itis concentrate on providing electricity prices by changing unlikely that all customers will information and even up-front their behavior, appliance stocks, have the metering and funding. There is no reason for and building characteristics when communication equipment other consumers to provide the prices warrant such changes. required for RTP and CPP, and subsidies; instead the programs Introducing marginal-cost-based direct load control programs help can be designed so that the time-of-day rates (and RTP and fillthatgap. recipients repay the up-front

20 1040-6190/$–see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.06.002 The Electricity Journal funding with the savings on their studies to ensure that marginal The next key step is to use bills. cost estimates reflect current marginalcostsasthebasisfor If a utility collects unavoidable market structure, fuel price rate structures. Metering costs in rate components that forecasts, and technological constraints, of course, affect the vary with usage levels, it loses options. The updated marginal degree to which this goal can be money when consumers cut back costs will also be available to achieved. The prices of simple on electricity use. Various analyze the cost-effectiveness of time-of-use meters have fallen mechanisms have been other energy efficiency initiatives. dramatically over the past developed to ‘‘decouple’’ In the revenue allocation step, decade or so, meaning that revenues from kilowatt-hour class revenue requirements standard TOU rates should be sales to remove the utility’s ideally should be based on class cost-effective for virtually all disincentive to promote energy marginal cost revenues. This may customers. In addition, the efficiency in the presence of such a require using an equal percentage numerous operational and other rate design. For example, rates benefits that smart meters might be adjusted annually to provide to the system mean that maintain a particular amount of the complex metering and revenue per customer. Various mechanisms communication systems Redesigning rate structures can have been developed to required for RTP and CPP no eliminate or significantly reduce ‘‘decouple’’ revenues longer must be justified solely on the need for complex decoupling from kilowatt-hour sales the basis of customer response to mechanisms, which tend to have these special rates.7 As a result, unintended consequences. to remove the utility’s all customers should face disincentive to promote seasonal rates, and most energy efficiency. customers should face some IV. Steps in the form of time-of-day rates, all Implementation of More based on marginal costs. Efficient Rate Structures mart metering and markup above or discount from S associated communications It is one thing to understand the full marginal cost to match the capabilities also greatly expand theory of efficient pricing and total revenue requirement, or a the potential for direct load another thing to actually differential class adjustment if controls, and allow customers to implement it. However, the job is necessary to reflect differences in automate their own response to getting easier as wholesale demand elasticity by customer CPP and RTP prices. Recent markets simplify the task of class.6 If the goal is efficient experience proves that demand estimating marginal generation pricing for all customer classes, it response is greatly enhanced and transmission costs, advanced does not make sense to use when consumers have the right metering infrastructure makes embedded cost results to set class equipment to, for example, time-varying pricing feasible, and revenue requirements. Doing so automatically manage their air the industry recognizes the value introduces another constraint conditioning, space heating, and of straightforward, easy-to- that will make efficient pricing water heating demands as understand prices. that much more difficult. If electricity prices change.8 Implementation involves a series moving to a marginal cost-based Marginal capacity costs are of key steps and, often, some revenue allocation would result in usuallyestimatedonanhourly compromises. very large cost shifts among basis. If prices could vary from The first step is to update classes, it may need to be done hour to hour, these capacity costs marginal cost methods and gradually. could be recovered on a per-kWh

July 2007, Vol. 20, Issue 6 1040-6190/$–see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.06.002 21 basis.9 When pricing periods maximum demands in the billing more qualitative approach that include multiple hours, as in period and in previous billing takes metering constraints into standard time-of-day (TOD) periods. Demand charges (and account and includes the rates, the marginal costs in the particularly those with ratcheted following general guidelines11: hours making up the period billing demands) obscure the Making adjustments to the must be aggregated in some price signal and give the fixed components of the rate is a way. Marginal energy costs impression that capacity is free in first step, because consumers are typically averaged over anyhourwhenthecustomer are least likely to change their the hours in the period.10 believes it has already set its consumption due to distortions in Marginal capacity costs can be billing demand for that billing the fixed monthly charges. treated the same way and cycle. As a result, rate designs Blocked rates are a good added to marginal energy with capacity costs recovered on solution for some customers, costs, eliminating the need a per-kWh basis tend to send particularly those without TOD for a demand charge billed metering; the first block can be on metered demand. set above or below marginal Alternatively the hourly Ideally every cost to close the gap, with marginal capacity costs within the tail block set at or close to a period can be summed to customer should marginal cost. This leaves yield time-differentiated face a price for the price signal for marginal demand charges. marginal consumption at marginal cost, tilities tend to favor consumption provided that the size of the U demand charges because first block is lower than the total they are considered to provide that is equal to consumption of most greater revenue certainty than marginal cost. consumers.12 energy charges, but the An inverted block structure concept of demand charges is may work as a proxy for TOD actually a remnant of energy charges; setting the tail embedded cost pricing in an era more efficient and effective price block at on-peak marginal cost when TOD metering was not signals. and the earlier blocks at lower feasible. Typically, embedded deally every customer should levels may be the best available capacity costs are allocated on I face a price for marginal way to get the on-peak price thebasisofsomemeasureof consumption that is equal to signal to large residential class contribution to system marginal cost. Normally, customers, who may have the peak. These costs are then charging marginal cost for all most elastic demands and tend to collected from customers within units of sale does not produce the user higher-than-average shares a class based on their own approved total amount of of their energy in the on-peak monthlypeakdemands,under revenue; prices for some rate hours. the assumption that the components, or some units sold, Inverted rate structures with individual customer’s maximum or some customers must be block sizes set for specific ranges demand is closely related to its adjusted to hit the revenue target. of kWh consumption are contribution to the class peak Theoretically, the inverse generally not equitable for used as the allocator. Demand elasticity rule dictates optimal commercial customers because ratchets, which provide even adjustments, but inadequate kWh usage various widely more revenue certainty for the information about relative within the class. An inverted utility, recover capacity costs elasticities (and cross elasticities) block structure with the first based on some combination of within a class usually requires a block set based on

22 1040-6190/$–see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.06.002 The Electricity Journal some percentage of an individual management programs, customers taking default service customer’s use in a base period complying with environmental pay prices that are above the and the tail block’s price set at regulations, and financing efficient level when market prices marginal cost gives the efficient construction of new generation are low and below the efficient price for marginal use by all andtransmissionplant level when market prices are high. customers in the class. between rate cases are all It is not clear that this approach For rates with metered examples of costs that are being achieves the optimal balance demand charges, comparable recovered in adjustment clauses. between the need for efficient adjustments to energy and However, many of these costs do energy use and the desire for demand charges will avoid not reflect changes in marginal stable prices. Such price distorting the relative signals for cost, and a flat adjustment to per- smoothing tends to make it energy and capacity. difficult for competitive Consistent absolute (not per- suppliers to attract customers centage) adjustments to time-of- from default service (or to use charges within a season will keep them when default prices avoid distorting the incentive to fall below market prices) shift load from one pricing period and tends to keep a large to another. segment of the demand side of nother key step is the the market from reacting to A design of rate adjustment high market prices, thus mechanisms. Efficient price leaving the energy markets less signals established in a rate case efficient. can be undone if poorly designed adjustments are subsequently applied to base V. Conclusions rates. It is important to design kWh prices for changes in pass-through rate adjustments such costs may move price Electric rates that reflect carefully so they do not distort signals farther away from marginal costs and include the the marginal cost signals efficient levels. Careful maximum amount of time- incorporated in base rates. Fuel analysis is required to determine differentiation consistent with and purchased power the best way to allocate and metering can go a long way adjustment clauses have a long recover these costs between toward promoting efficient history, but it is only relatively rate cases. energy decisions by consumers. recently that serious attention Several states have gone to Rate design should be the first has been paid to time- great lengths to establish energy energy efficiency tool employed differentiating the adjustments.13 auctions or other energy because, at a relatively low cost Furthermore, today’s market contracting processes for and without raising issues of structures put more costs out of overlapping periods so that cross-subsidy, it can achieve utilities’ control and create a customers not choosing a significant efficiency gains. This rationale for including more than competitive supplier of means keeping marginal cost fuel and purchased power costs generation service will face prices studies up to date (including in the adjustments. Costs of for default service that are an reflecting market conditions), hedging fuel prices, paying average of market prices for using class marginal cost administrative and congestion several periods of years. These revenue calculations in setting charges imposed by an ISO, processes ensure that the class revenue requirements, implementing demand-side (usually) large numbers of creating rate structures that

July 2007, Vol. 20, Issue 6 1040-6190/$–see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.06.002 23 mirror marginal cost interested in programs customers’ maximum loads relationships, and carefully that provide financing, expected over the life of the designing rate adjustment with repayment coming from equipment – should be recovered mechanisms to preserve efficient the energy savings created by in a fixed monthly payment based price signals. the new appliance. on design demand. These n spite of concerted efforts Programs aimed at develo- facilities are marginal when I to improve the efficiency of pers and landlords may be service is first extended to the electric rate structures, it is needed to solve the problem of the neighborhood and whenever it likely that some customers will developer/landlord incentive to has to be replaced, but (if the still not face optimal RTP and install low-cost equipment with design demands were accurately CPP rates, or even if they do, high energy consumption because predicted) not with minor they may not have the changes in demand by one or information or inclination to more of the customers using respond. Certain energy them. efficiency programs can overcome these barriers to Customer-Related Costs energy efficiency, but can be on Similarly, metering, billing, a smaller scale and at a lower and customer accounting and cost than if electric rate service costs that vary with the structures are not reformed: number of customers being Programs that help consu- served should also be recovered mers figure out ways to control on a fixed monthly basis, since their electricity bills by changing they are not related to the amount appliances and behavior are of energy used. important. Appliance labeling, building the home buyer/renter pays the Distribution Substations and codes, and informational pro- electric bills. Trunk Feeders grams, including easy tools to let n addition, there may be consumer compare the alterna- I ‘‘infant industry’’ arguments Distribution capacity beyond tives, can help to overcome the for providing subsidies to the local network is used by problem of customer myopia particular efficiency technologies many customers and is expanded about the energy costs associated to kick-start a promising industry. as load grows. The marginal with their appliance and Such situations may call for non- costs of these facilities should building purchasing or renting rate energy efficiency programs be recovered in time- decisions. by utilities (or separate agencies differentiated charges. Changes Customers without the set up by government). in load outside the peak load metering and other equipment hours on this equipment do not needed to participate in critical affect the need for distribution peak pricing and other dynamic Appendix A. Elements capacity, but changes in load rate programs may be of Marginal Cost of in peak hours do. The annual candidates for direct load control Electricity Service marginal cost should be time- programs. Local Distribution Facilities differentiated based on an Customers who are not estimate of the relative able to come up with the extra The marginal cost of the local likelihood that load growth upfront funds to purchase energy distribution network – based on at the substation level will efficient appliances may be the sum of a relatively few require capacity additions.

24 1040-6190/$–see front matter # 2007 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2007.06.002 The Electricity Journal Transmission programs, maximize efficient 5. See the appendix for a detailed description of the components of the price signals. However, rates that marginal cost of electricity service. For a utility that is a member of change by season and more an RTO/ISO, marginal financial 6. The inverse elasticity rule or general time-of-day pricing ‘‘Ramsey Pricing’’ states that prices transmission cost is a function of periods are far superior to rates should be adjusted away from FERC-regulated charges for use that apply in all hours.& marginal cost in inverse proportion to of the transmission system the elasticity of demand. and for services provided by 7. Austin Energy is installing smart Endnotes: the RTO/ISO. A utility with a meters for 100 percent of its more than 360,000 customers. http:// FERC-approved Open Access 1. Typical IRP processes treat projects powermarketers.netcontentinc.net/ Transmission Tariff (OATT), but that reduce demand on an equal newsreader.asp?ppa=8knpp%5E% not in an RTO/ISO, has a financial 5BllfnwrnUSigy30qbfem%5E%21. marginal cost defined by the 8. See, for example, Michael J. King, network service rate in its OATT. Kathleen King and Michael B. Rosenzweig, Customer Sovereignty: Although such a utility does not Why Customer Choice Trumps write itself a check for Administrative Capacity Mechanisms, transmission service, its share of ELEC. J., Jan.–Feb. 2007, at 38–52. the transmission revenue 9. A kW for an hour is a kWh. requirement is determined by its 10. Some analysts use a load- use of the system and the FERC weighted average, although this produces an efficient price signal only formula for the network service if the loads used as weighting factors 14 tariff. The transmission charges are class loads, and only if demand should be time-differentiated elasticity for the class within a period based on the relative likelihood increases with load. that load growth in a given hour 11. The specific situation of a utility or will affect the cost of transmission individual class may require a footing with investments that meet different approach. service, given the structure of the demand growth, and seek to develop a OATT or other applicable charges. least-cost plan that involves both types 12. A special form of blocked rates of investment. sets the first block at a ‘‘base-line’’ level, and charges (credits) any Generation 2. Distributed generation comprises deviations from the baseline level at relatively small electricity generators, marginal cost. This structure, typical Marginal generation cost for typically renewables or combined of RTP rates, prices all marginal a utility that regularly participates heat and power facilities consumption by all customers at in the wholesale energy market is (cogeneration), that deliver power to marginal cost. This approach can also the distribution grid. They are be used for non-RTP rates. See, for the market price. Depending upon typically owned and operated by non- example, Making Every Electricity the organization of the regional utility entities. Consumer a Market Participant (Putting market, this may be a single price Demand Back in the Equation),ELEC. J., 3. These mechanisms aim to protect April 2003. per kWh, or a combination of a utility profits when consumption is per-kWh price from the energy reduced as the result of conservation 13. Oklahoma Gas and Electric’s 2005 market and a separate price per efforts, thus removing what would rate case includes a time-differentiated otherwise be a disincentive to fuel adjustment clause. Xcel Energy kW based on reserve-sharing rules encourage such reductions. has time-differentiated energy cost and the cost of capacity in the adjustments. 4. State and Regional Policies That region. Naturally these market Promote Energy Efficiency Programs 14. The marginal resource cost may be prices will vary by hour, and rates Carried Out by Electric and Gas Utilities: different from the marginal financial that change with market A Report to the United States Congress cost in either of these situations, but Pursuant to Section 139 of the Energy the former is difficult to estimate when conditions, such as real-time Policy Act of 2005, USDOE, regional transmission planning is pricing and critical peak pricing March 2007. involved.