Why TOU Rates Rule
APPA Business & Financial Conference
Austin, Texas
September 23-26, 2007
Ralph Carlson
Rate/Pricing Advisor
Sacramento Municipal Utility District
Sacramento, California
Bonbright,PURPA and beyond
We all use Bonbright as the ultimate authority in regulatory rate design because his criteria are common sense. I am sure that there are many responsible rate practitioners that have actually read Principles of Public Utility Rates. I am even more certain that there are many more, who, like me, have picked up a general sense of his principles through immersion in rate design classes like those provided by APPA, utility management publications and real-world experience. These criteria become instinctive and ultimately help us build a framework in which we decide what will work and what will not before making recommendations or proposals..
To an experienced rate professional, they are not surprising. We have probably all been slapped ‘sharply on the side of the head’ for neglecting one or several of his principles in our formative years. Few of use, however, would be able to formulate our job so clearly and succinctly. To a novice, these criteria may seem only words and the criteria, abstract statements with little practical meaning which is why I never read Bonbright as a novice and after some seasoning in the rate game, reading him never seemed necessary.
I earned my rate spurs when PURPA first raised its ugly head in the 70’s and my utility held it’s own evidentiary hearings to consider new Federal standards. One of these standards was Time-of-day rates. In those days Time-of-use meters were very expensive compared to conventional meters and my utility concluded that although time-of-use.rates are preferable to flat rates, the costs of metering and billing these rates for residential customers was too high. My utility,in response to the ‘energy crisis’ caused by the first middle east oil embargo, had already made time-of-use rates mandatory for commercial customers larger than 300 kW and provided optional time-of-use rates for all other rate classes. We presented our case at the hearings and also our recommendation that time-of-use rates be used whenever meter costs were low enough to be ‘cost-effective’.
Now turn the clock forward 25 years to 2005 when Congress revisited PURPA and added this direction to its section on Time-of-day rates (U.S.C. § 2625 (PURPA SECTION 115) Special rules for standards (j)):
Time-Based Metering and Communications
In making a determination with respect to the standard established by section 111(d)(14), the investigation requirement of section 111(d)(14)(F) shall be as follows: Each State regulatory authority shall conduct an investigation and issue a decision whether or not it is appropriate for electric utilities to provide and install time-based meters and communications devices for each of their customers which enable such customers to participate in time-based pricing rate schedules and other demand response programs.
This new language goes far beyond the idea of a cost-benefit analysis. First, the meter situation has changed dramatically. Meter costs have come down and the perceived benefits from Time-of-use rates have increased. In California, for example, the state’s antipathy toward building power plants relaxed slightly after the power shortages that began the millennium but has tightened again due to ever tighter emissions standards which have been applied even to out-of-state resources. Greenhouse gases have emerged as another constraint. Finally even new transmission lines to transmit ‘Green’ power are attacked by environmentalists as irresponsible.
With new generation sources appearing uncertain, California has moved past conventional time-of-use pricing to Critical-peak-pricing and has encouraged implementation of these rates by the state-controlled IOU’s by rate-basing the costs of smart (Two-way communication) metering systems. The state-controlled IOU’s are moving steadily toward more complex pricing products by buying ‘smart meters’ at a cost of billions of dollarsin order to keep electricity demand within current capacity limits for the state. Inevitably, public power will be drawn into this effort as more and more legislated control includes public power utilities in their mandates. SMUD and other California public power utilities already have their mandated targets for solar installations just like the IOU’s.
So, in this new era of more and more government directives and mandates, higher fuel costs, increasingly frenzied environmental concerns, NIMBY[1] and BANANA[2]hysteria and the legacy, entitlement mentality from ‘feel good’ regulation going back to the 80’s, what is a hip, responsible rate professional to do?
What is the ‘Prime Directive’ anyway?
Bonbright’s Criteria of a Desirable Rate Structure provide a good framework to start our analysis.
Criteria of a Desirable Rate Structure
The related, “practical” attributes of Simplicity, understandability, public acceptance and feasibility of application.
Freedom from controversies as to proper interpretation.
Effectiveness in yielding total revenue requirements under the fair-return standard.
Revenue stability from year to year.
Stability of the rates themselves, with a minimum of unexpected changes seriously adverse to existing customers. (Compare “The best tax is an old tax”).
Fairnessof the specific rates in the apportionment of total costs of service among the different consumers.
Avoidance of “undue discrimination” in rate relationships.
Efficiency of the rate classes and rate blocks in discouraging wasteful use of service while promoting all justified and amounts of use:
(a)in the control of the total amounts of service supplied by the company:
(b) in the control of the relative uses of alternative types of service (on-peak versus off-peak electricity. …..)[3]
Evaluation
The first five are, of course, critical to a rate professional because if you fail at any of them you won’t be a rate professional for very long. They have nothing at all to do with the rate structure itself. You could have the worst rate structure ( I will leave to your imagination what that might be) or the best and still be successful with them – or unsuccessful for that matter.
I have highlighted the significant words in two of the last three. I will share my opinion about each of them relative the rate-setting environment today. Please keep in mind that these are my personal judgments and not intended to represent the opinions of my utility’s management or Board. Let’s take them one by one.
Fairness
We have evolved to an enlightened view of fairness which goes far beyond anything that Bonbright envisioned. Where Bonbright’s fairness involves apportioning costs appropriately among customer classes, these days we have been trained to see fairness as providing special treatment to selected groups of customers. It is now regarded as ‘fair’ that customers who are presumed to be able to afford electricity subsidize those who are presumed not to be able to afford electricity, such as low-income customers. This is now extended to the presumption that customers who use little electricity are entitled to a subsidy as well (baseline usage tiers) or customers with medical conditions requiring special equipment or seniors on fixed incomes. Fair has become a synonym for entitlement and has lost any credence for a responsible rate professional. Since it is the stock and trade for elected officials and board members it will still be an issue but it is no longer related in any way to Bonbrights’ concept of fairness. If regulators feel compelled to burden electricity consumers with subsidy expenses, they would be better served to provide the subsidy outside of the rate structure.
Efficiency
Where Bonbright clearly means this standard to relate to the effectiveness of the rate structure in its entirety as it contributes to wise consumption of electricity, current practices, at least in California are more dedicated to the perversion of the fairness standard discussed above. Rate blocks are used to provide entitlements of below-cost electricity to protected groups of customers. Because of this practice, fully 50% of SMUD’s residential customers never get a price signal that represents a true cost of the electricity they consume. This practice further perverts the price signal by grossly overcharging the other 50 percent. Although there is certainly a conservation signal for the victims of thisrate design, it is not very useful in helping customers reduce their bills because it is unrelated to when they use power and the underlying pattern of utility costs.
Bonbright focuses on three “primary” objectives.
“They are (a) the revenue-requirement or financial need objective, which take the form of a fair return standard with respect to private utility companies; (b) the fair-cost-apportionment objective, which invokes the principle that the burden of meeting total revenue requirements must be distributed fairly among the beneficiaries of the service; and(c) the optimum-use or consumer-rationing objective, under which the rates are designed to discourage the wasteful use of public utility services while promoting all use that is economically justified in view of the relationships between costs incurred and benefits received.”[4]
It should be very clear to the reader that rate blocks which price electricity above cost discourage usage that is economically justified and thus violate at least one of Bonbright’s “primary” objectives. If, then, California-style rates fail Bonbright’s test, what would he advocate?
“Broadly speaking, if one assumes that ideal rates, viewed from the standpoint of the optimum use of service, would be rates set at marginal cost, there are three alternatives….by which one might seek to approach this optimum while imposing rates designed to meet total revenue requirements. Under the first alternative, rates for different types of service would be made directly proportional to marginal cost, each rate exceeding the correlative marginal cost by the minimum fixed percentagenecessary to cover total costs…. Under the second alternative, rate differentials would be designed to cover cost differentials as between substitute classes of service. Under the third alternative, rates would be deliberately “biased” through the imposition of higher surcharges, relative to marginal costs, for those types and amounts of service for which the demand is relatively inelastic.”[5]
His analysis takes rate design through a progression of rates beginning with a uniform price per kilowatthour, moving through a declining block rate intended to encourage usage in a declining cost environment. Next in the progression is differentiation by customer classes and finally two (demand and energy) and three (customer, demand and energy) part rates.
His only mention of “time-of-day” rates is tagged to an anticipation that all-electric homes may justify more expensive meters and the “time-of-day” rates used in Europe. No mention of any application to commercial and industrial classes.
So if Bonbright doesn’t advocate Time-of-use (TOU) rates, why should I?
Several reasons come to my mind. First, the world has changed since 1961. In 1960 the average electricity cost was 2 cents per kWh compared to nearly 9 cents per kWh in 2006.[6] Never mind that in real terms 2006 prices are slightly lower than those for 1960. Today we all live in the ‘nominal’ world and find the price increases outrageous.
More important, we are no longer in a declining cost energy environment. Every increment of every component of electric service is expected to cost more in the future than it costs today. We are given various justifications for not building power plants ranging from environmental to economic and there is enough political interference to make it impossible to determine responsibility for the higher costs.
Finally, in California, the bulk of the high costs fall in just a few hours of the year.
For SMUD, just 40 hours each year account for 400 mW of load. It is extremely costly to provide those mW for so few hours. Flat rates never give customers a clue about the costs of electricity during those critical 40 hours. Rates blocks are only marginally better and because they are based only on quantity with no relation to time, customers are likely to respond ineffectively relative to those expensive hours.Flat or blocked rates are a very poor tool to shift electricity use away from those hours. To have any hope of influencing usage during the most expensive hours, customers must see a substantial cost-based price specifically applied to the high cost hours. For this reason, SMUD is considering a dramatic redesign of its tariffs with seasons and pricing periods to target the high cost hours of the year.
What are the difficulties in implementing TOU rates?
TOU rates require a better understanding of your utilities marginal costs than a flat rate or blocked rates. They require estimation of energy production (or purchase) for each of the 8,760 hours in a year. They require a methodology to distribute generation capacity and distribution costs over those 8,760 hours as well. If these data and tools are not currently available at your utility, I suggest that you attend the APPA TOU Rate Design Class[7] this fall.
The transition to better designed TOU rates for customers currently billed with TOU rate structures is relatively easy at SMUD. Customers will receive higher summer bills and lower winter bills but the variation from old to new rates is within a 5% range for most customers on a yearly basis. The transition is more difficult for the commercial customers currently billed on flat rates but this is not because of the bill impacts. Bill change is within a 5% range as well, but the bigger difficulty is the cost and labor to install the metering infrastructure.
The biggest problem facing utilities with inclining block rates is the rate bias introduced by entitlements of below-cost electricity. When introducing TOU rates, a revenue neutral TOU rate creates automatic losers fromthe lower consumption blocks and automatic winners from the higher consumption blocks and compounds the impact from a normal rate increase. The bill impacts alone are enough to stop most public hearings in their tracks if the difficulty in justifying the price differentials were not enough.
TOU rates represent a best case reflection of costs for electric service. For me they best meet Bonbright’s efficiency criteria in discouraging wasteful use of electricity while promoting justified use. They require more information and analysis to create and depend upon more complex and expensive metering and billing systems. Increasingly, however, utilities are finding that the costs of the systems are justified from the benefits of better billing options.
The biggest barrier to implementation of TOU rates for electric utilities is the imposition of socially-engineered, below-cost pricing of electricity for blocks of consumption or customer categories.
Rate Design Progression
Average Cost Flat
Small conservation incentive
Simple to understand
Average Cost with blocks
Larger conservation incentive but only for large consumers
No Time Relationship
Subsidizes low consumption
More complex
Seasonal Differentiation
Much larger conservation incentive
More complex
No Time Signal
Time of use
Further increases conservation incentive
Links higher prices to higher cost periods
Can reduce future costs by shifting demand for energy
Still more complex
Critical Peak Pricing
Substantially increases conservation incentive
Can reduce current costs
Very Complex- hands on
Real Time Pricing
Most effective conservation incentive
Can reduce current costs
Very Complex- hands on
1
[1] Not in my backyard.
[2] Build absolutely nothing anywhere near anything.
[3] Bonbright, James C., Principles of Public Utility Rates. New York, NY: ColumbiaUniversity Press, 1961, p291
[4] Ibid, p292
[5] Ibid, p304
[6]
[7] 2007 APPA Fall Institute, Colorado Springs, CO. November 8-9, 2007