INTRODUCTION TO UTILITY RATE DESIGN © Janice A. Beecher, Ph.D. (2014) INSTITUTE OF PUBLIC UTILITIES  MICHIGAN STATE UNIVERSITY ipu.msu.edu | [email protected]

Please do not distribute by electronic or other means or cite without permission. Revised 7/22/2014

MICHIGAN STATE UNIVERSITY

Introduction  “If all goods were free, like air and water, any man could get as much as he wanted without harming others,” David Hume (1739)  Because utility services are not “free,” we exact a price for their provision 





Accurate cost-based prices communicate value, induce efficiency, and enable “selfrationing” (consumer sovereignty) Even well-regulated prices may not reflect the true economic or environmental value of utility services Price is necessary but not always sufficient for inducing desirable production and consumption behavior

 A pricing paradox: should their essential nature make public utility services cheap or expensive? “Price is what you pay. Value is what you get.” Warren Buffet, 2008

Beecher – rates2014

2

Competing conceptions of utility pricing To ensure and stabilize cash flow To promote end-use efficiency To shape demand or system load To internalize environmental externalities To provide a social safety net

Beecher – rates2014

3

The dynamic role of price

System design: optimization

Demand for service: efficiency

Cost of service: viability

Price of service: affordability Beecher – rates2014

4

Demand or “load” varies: base, average, and peak  How demand varies    

From year to year From month to month (seasonal) By day of week By time of day (hourly & “needle peaks”)

 Demand as an engineering (system-design) issue  

Solve from the bottom up How to meet load with appropriate reserves?

 Demand as an economic (rate design) issue    

Solve from the top down How to assign capacity costs to peak users? Constraints: reliability standards, persistent peaks, anomalies, and demand hardening Prudent utilities manage load and promote efficient capacity utilization (average to peak)

Beecher – rates2014

5

Load monitoring: past and present

1919 load curve

2010 MISO contour map http://www.midwestmarket.org/page/LMP+Contour+Map+(EOR) Beecher – rates2014

6

Hourly demand: user and operator perspectives

http://www.fcgov.com/electric/harmonylib/images/46.jpg

http://www.ferc.gov/market-oversight/mkt-electric/midwest/elec-miso-dly-rpt.pdf

Beecher – rates2014

7

Demand and system design (water)

Maximum-hour (hourly peak) demand

• Max-day plus fire-flow requirements (codes, insurance) • Treated water storage, distribution mains, pumping stations

Maximum-day (daily peak) demand • Water treatment plants • Major transmission lines

Average-day demand

• Source-of-supply facilities, including raw water storage, such as reservoirs

Beecher – rates2014

8

Demand and system supply (electricity)

http://www.ieso.ca/imoweb/siteshared/charts/energy-by-fuel-type_200902.gif

http://www.megawattsolar.com/wp-content/themes/megawatt/img/applications/peak-demand-chart.jpg

Beecher – rates2014

9

Changing load v. shifting load  Factors that are decreasing load   

Price-elasticity effects and long-term behavioral change Net durable gains from efficiency standards and process improvements Permanent off-grid technologies (self-supply)

 Factors that are increasing load  

Electricity for transportation Other new usages for electricity

 Load shifting methods   

Real-time and dynamic pricing Off-peak appliance cycling Storage methods, including vehicle batteries

 Issues  

Residual “needle peaks” Setting reserve margins after load shifting

Beecher – rates2014

 10

Price elasticity of demand  Demand curve reflects the consumer’s marginal willingness to pay 

Incorporates ability to pay (income effects)

 Responsiveness or sensitivity of usage to price for individual, system, or market

 Measured as: (% in quantity demanded) / (% in price)  

Represented as an absolute or negative value A value of 1 (or -1) is unitary elasticity (e.g., price up 1%, usage down 1%)

 Demand is more price elastic for: 

Discretionary goods; luxury goods; goods with reasonable substitutes (choices); longer time frames; competitive markets

 Demand is less price elastic for: 

Necessities, such as utilities; goods without reasonable substitutes (choices); very inexpensive goods; shorter time frames; noncompetitive markets

 Elasticity in the real world: Netflix, Verizon billing fee, airport baggage fees

Beecher – rates2014

 11

Price elasticity for utilities  Utility services are relatively price-inelastic  

Price increases may not induce significant usage reductions System price elasticities vary by customer class, type of usage, time frame, rate structure, price level, customer information

 Price-response issues 

    

For low-income households, inelasticity raises concerns about regressivity, affordability, and quality of life (e.g., heat and cold) For high-income households, price signals may “fall on deaf ears” Monthly bills improve timeliness of price signals, but lessen the effect of the total bill Budget and combined billing (gas/electric, water/wastewater) also mute prices Role of other elasticities (income, weather) Bill elasticity – consumer responsiveness to the total utility bill (v. rate)

Beecher – rates2014

 12

Price engineering  Using price strategically based on sensitivities   

“Ramsey pricing” allocates more costs to inelastic usage (welfare economics) “Conservation-oriented” pricing allocate more costs to elastic usage (resource economics) “Dynamic pricing” may shift elastic demand but extract more rents from inelastic customers who cannot reduce or shift

 Limited by price levels, inelasticity, and opportunity costs  Demand reductions may affect prices via associated changes in supply

Beecher – rates2014

 13

Other demand elasticities for goods and services  Usage is affected by factors other than price  

Income, wealth, weather, economic conditions, and other influences on demand curves Weather matter less with less outdoor water use

 Income elasticity defines different types of goods   

Normal goods: positive income elasticity (most goods, including utilities) Luxury goods: high positive elasticity (expensive cars and jewelry) Inferior goods: negative elasticity (paycheck services, ramen noodles)

 Cross elasticity: change in price for one affects demand for another   

Coke and Pepsi Coal, gas, and renewable resources Gasoline prices and hybrid cars

Beecher – rates2014

 14

Elasticity estimates for water and energy

Notes: • For increasing-block rates structures, price elasticity is higher; income elasticity is lower. • For decreasing-block rates, price elasticity is unaffected but income elasticity is higher. • For higher income areas, price and income elasticities are higher.

Beecher – rates2014

 15

Why elasticities matter in ratemaking  Price elasticity for utilities is not zero – and difficult to estimate 



For inelastic demand: price increases will increase revenues and result in excess earnings if revenues exceed costs For elastic demand: price increases may result in under-earning absent a “demandrepression” adjustment in rate setting

 If utilities are a major production input, industrials will be efficiency oriented   

Highly price-sensitive may bypass (shop, fuel switch, self supply, relocation) May free up capacity for other economic sales Bypass may harm remaining customers through loss of scale and stranded costs associated with excess capacity

 Permanent (including “creative”) demand destruction or loss of load may  

Alter the utility’s operational economies and financial health Result a “death spiral” of price increases and falling usage

 Price elasticity also plays a role in load management (demand response)

Beecher – rates2014

 16

Prices v. programs  Price (incentives) v. programs (command-and-control)   

Pricing: metering and rates that move usage along the curve (demand-response) Programs: information, subsidies to accelerate adoption and alter/shift the entire curve Technological standards: may alter demand with mixed efficiency effects

 Empirical evidence of efficacy is stronger for pricing than for programs  Over time, programs, information, and technologies (e.g., prepaid meters) can work with price to change consumer culture (much like recycling)  Increased availability (supply technology and demand efficiency) may promote more usage (Jevons paradox) Change in usage (price)

Beecher – rates2014

Change in demand (program)

 17

Why water prices may matter more today  Water rates are rising much faster than inflation generally or for other utilities  Water usage is relatively price inelastic but not perfectly so  Discretionary (outdoor) use is more elastic (price responsive)  Could be entering a more price-elastic segment of the demand curve  Emerging evidence suggests responsiveness to marginal prices as well as to the total bill

 Well-designed prices (increasing block, seasonal rates) can help close the peak-to-average ratio

Beecher – rates2014

 18

Rate shock  Big rate increases can induce economic reactions 



A growing concern due to cumulative infrastructure and other costs Effect on usage may or may not be “durable” – can be transient with “rebounding” or “backfiring”

 Big increases also induce political reactions, especially with respect to inelastic usage  

Pricing requires a “willingness to charge” Social media play a role in rate politics

 Gradualism in rate changes and frequent billing can help mitigate these effects

Issue-attention cycle

Beecher – rates2014

 19

What stakeholders want from the ratemaking process

Utilities • Reasonable certainty and a fair return to ensure financial viability and attract investors Customers • Safe, adequate, reliable, and accessible service at fair, reasonable, stable, and affordable rates Regulators (Society) • Utility services that promote the public interest in terms of investment, performance, and other social goals

Beecher – rates2014

 20

Criteria for evaluating utility rates  James Bonbright (Principles, 1961)          

Revenue recovery for the utility  Efficient resource use (static efficiency) Fairness in cost allocation (consumer equity)  Practicality (understanding, acceptance) Interpretability (non-controversial) Revenue stability to the utility Rate stability to the customer Avoidance of undue discrimination among customers Promotion of innovation (dynamic efficiency)* Reflection of future private and social costs (externalities)*

 Each raises questions about interpretation (e.g., what’s “fair”?)  Significant tensions are found among the criteria (e.g., equity and efficiency)  Some relevant criteria are excluded (e.g., affordability and sustainability) Beecher – rates2014

 21

Pricing and revenue recovery  Revenue requirements specify the size of the pie and rate design slices it up 

Getting the revenues (numerator) and usage (denominator) right

 U.S. regulation emphasizes full-cost ratemaking and associated principles   

Burdens follow benefits Due v. undue price discrimination Just and reasonable rates

 Cost-based rates recover prudent capital and operating costs   

Approximate competitive market rates for efficiency purposes Sustain operations over time for meeting service obligations Lifeline, economic development, usage-budget rates depart from cost of service

 Rate design should be revenue neutral   

Cannot compensate for misestimated revenue requirements Should not be used to “generate” (new) revenues Rate blocks and tiers (unit prices) should be informed by cost analysis

Rates = Revenue requirements Sales Beecher – rates2014

 22

Pricing and resource efficiency  Resource economics focuses more on cost allocation than welfare economics    

Cost-based prices promote efficient resource allocation and sustainability Underpricing relates to perceived waste (demand side) & scarcity (supply side) Timely price signals are essential and should be allowed to work Perfectly efficient rate is elusive – the goal is improvement

Prices too high

Undue deprivation Drag the economy Excess reserves Transfers Abuse of monopoly

Prices too low

Excessive/wasteful usage Excess capacity investment Inadequate reserves Subsidization Financial failure Beecher – rates2014

 23

Pricing and externalities  True economic value reflects resource depletion, cost escalation, and environmental externalities (e.g., climate change) 



 

Externalities are difficult to quantify and generally not well reflected in prices (marketbased or regulated) Society can “charge” these costs (e.g., extraction fees, development fees, penalties, taxes) but often does not Individual action can be arbitrary, inequitable, disadvantaging Arguably, positive externalities should also be considered

 In the absence of an authoritative policy mandate, utilities should not charge excessive prices to captive customers 

Prices at economic or environmental value can exceed accounting costs and lead to excess revenues and earnings that enrich the monopoly

 Utilities can address externalities to some extent through  

Prudent risk management resulting in cost reduction Efficiency-oriented rate design (marginal costs, scarcity pricing)

Beecher – rates2014

 24

Pricing and equity  Regulatory economics tends to define equity in economic v. social terms   

Cost causers should pay to promote efficient resource allocation Cross subsidies should be minimized Prices (and policies) should be just and nondiscriminatory

 Three types of equity 





Horizontal equity – intra-class • Same costs, same rates Vertical equity – inter-class • Different costs, different rates Intergenerational equity • Should not force one generation to subsidize another (incl. externalities) • Challenging issue for capital intensive, long-life assets • How and why depreciation and financing matter

Beecher – rates2014

 25

Pricing and fairness  The “just and reasonable” standard commends consideration of “fairness”   

An inherent tension exists between equity and efficiency, as well as perceptions of fairness Fairness concerns escalate with rising prices Values and perceptions about equity can vary by culture, place, conditions and over time

 Some cost differences typically are ignored 

Old v. new customers, distance from central plant

 Different approaches reflect different conceptions 

Prepaid service, usage-budget billing

 In practice, rate design is a mix of art, science, and politics 

“Who gets what, when, and how”

Beecher – rates2014

 26

Pricing and affordability  “Water is cheap for those who have it” (Consumer advocate, Mexico)  Affordability and universal service are complex policy issues  

  

Utility rates are regressive and rate changes have distributional consequences Rates must be high enough to cover costs but also low enough to be affordable so that customers can support the system over time Affordability and good payment behavior are good for business Unaffordability leads to unhealthy and unsafe choices and behaviors (negative externalities) Economic development is a consideration too (business, jobs)

 For “shrinking cities” and isolated systems policy options are limited    

Sacrifice service quality Subsidize cost via taxes Abandon service Relocate the service population

 Emerging technologies (prepayment, dynamic pricing, service limiters)  See IPU note on utility expenditures and income Beecher – rates2014

 27

Pricing and sustainability  Sustainable systems live within tolerances   

Ecological (natural boundaries) Economic (financial boundaries) Equity (political and institutional boundaries) Expenditures relative to optimal service level Price revenues relative to expenditures

< 1 expenditures are below optimum (“cost avoidance”)

= 1 expenditures are optimal

> 1 expenditures are above optimum (“gold plating”)

< 1 price revenues are below expenditures (“price avoidance”)

Deficient system

Subsidized system

Budget-deficit system

= 1 price revenues are equal to expenditures

Underinvesting system

SUSTAINABLE SYSTEM

Overinvesting system

> 1 price revenues are above expenditures (“profit seeking”)

Revenue-diverting system

Surplus system

Excessive system

Beecher – rates2014

 28

Simpsons on ratemaking

Beecher – rates2014

 29

Key steps in ratemaking and guiding principles

Revenue requirements: determine the total prudent cost of service or budget for a given test year – “fullcost pricing:” Beecher – rates2014

Cost allocation: link costs to usage based on customer contributions to system load – “nondiscriminatory pricing”

Rate design: construct revenueneutral tariffs to recover costs from customers through rates and charges – “just and reasonable pricing”

 30

Procedures for adjusting rates  Typically, a rate case is filed by the utility to establish “base rates” and other charges that make up “tariffs”   

Preferred and default option A largely reactive process Burden of proof is on the utility

 Other methods as allowed     

Rate reviews initiated by regulators “Automatic” adjustment mechanisms (e.g., fuel or energy) Special-purpose surcharges (e.g., DSIC for capital costs) Rate indexing for periodic adjustments based on inflation or other metrics Formula rates for periodic adjustments based on returns outside of a predetermined band

Beecher – rates2014

 31

Key cost concepts  Total costs   

Fixed costs – do not vary with usage Variable costs – vary with usage Average total cost – the sum of average fixed and variable costs

 Short-run and long-run costs  

In the short run, many costs are fixed In the long run all costs are variable – unless mandated (fire protection)

 Sunk costs are unrecoverable if operations cease  

Economists say we should “ignore sunk costs” Regulators struggle with “stranded costs”

 Marginal cost of production 

Incremental cost (i.e., applied marginal cost)

Beecher – rates2014

 32

Marginal-cost pricing  Market theory argues for setting prices at marginal (or incremental) costs   

Equals cost of the next unit of production Competition drives prices to marginal costs When P=MC, market share is gained through innovation

 Marginal-cost pricing relates to resource efficiency    

Supply constraints, network congestion, and dynamic pricing Marginal costs vary by time frame (short-run and long-run) Encourages efficient usage by sending forward-looking price signals Consistent with forward-looking test year for revenue requirements

 Efficiency gains are achieved through the tail blocks of any rate 

Example: the value of gasoline you use in your car is not what you last paid to fill it but what you will pay to refill it

Beecher – rates2014

 33

Cost-allocation process  Revenue requirements (costs) are allocated to customer classes (groups)      

Allocation is based on the impact of their usage on facilities Alternative methodologies are used Cost-of-service studies support the process Allocation is based on “revenue-producing” activities (sales) Direct costs are assigned directly to cost causers Rules are needed for common or joint costs

 Traditional ratemaking involves a degree of cost averaging    

Within customer classes, spatially, and temporally Individualized rates generally are not used Special or negotiated contracts are an exception (large-volume) Time-of-day rates reduce peak/off-peak averaging

Beecher – rates2014

 34

Cost-allocation considerations  Importance of cost knowledge – uniform systems of accounts (USOA)  Billing determinants are the inputs resulting in the bill     

Quantity (volume) consumed Quality differentiation (including reliability) Spatial or “zonal” considerations (distance) Temporal considerations (hour, day, season) Social and environmental impacts

 Key steps in cost allocation:     

Functionalize Classify Allocate by usage Assign by customer class Rate design (tariff)

Beecher – rates2014

 35

Cost functionalization, classification, and allocation

The Prime Group Beecher – rates2014

 36

Cost classification Customer costs • Do not vary with usage - For example: meters, customer services

Capacity (demand) costs • Fixed in the short term (availability or readiness to serve; facilities) - Includes capital and O&M • Vary with aggregate usage over time • For example: distribution, treatment, storage

Commodity (resource) costs • Variable in short term and continuously with usage over time • For example: cost of energy, water, and other inputs Beecher – rates2014

 37

Customer classes and billing distribution analysis (traditional) Residential Single family

140

Multi-family

120

Nonresidential*

Industrial Wholesale

Number of customers

Commercial

100

80

60

Agricultural

40

Public authorities

20

Special use (street lighting, irrigation, public and private fire protection) Beecher – rates2014

0 1

6

11

16

21

26

31

36

Water consumption (ccf)

* For water, customer classes and tariffs are differentiated by meter size.

 38

Sales revenues and average prices by class

Beecher – rates2014

 39

Cost-allocation methods  Functional or average use  Base-extra capacity or average-excess  Peak responsibility (coincident or non-coincident)  Commodity-demand  Embedded-direct  Fully-distributed  Marginal-cost

Beecher – rates2014

 40

Cost allocation and subsidization  Potential for real or perceived subsidies in ratemaking   

Interclass (residential, commercial, industrial) Urban, suburban, and rural High income and low income

 Eliminating subsidies (general or inter-class) is usually controversial  

Differences in price elasticity will affect response Rethinking customer classification may be in order

 Restructuring was aimed in part at perceived embedded subsidies  

Re-balancing (telecommunications) De-skewing (energy)

Beecher – rates2014

 41

Metering and billing  Metering is needed for volumetric usage-based pricing (v. “too cheap to meter”)   

Can induce short-term usage drop - “metering elasticity“ is about 30% Submetering and second meters may be justified under limited circumstances Net metering allows customers to sell what they produce back to utility

 Most utilities bill monthly (some quarterly)   

Monthly provides more timely price signals Quarterly brings more attention to total bills Administrative costs and acceptance are considerations

 Meter accuracy and maintenance are important – aging can favor customers 

Recalibrating/replacement can boost sales revenues – needs regulatory review

 Automatic meter reading (AMR) v. advanced metering infrastructure (AMI)     

AMI adds two-way communication and control capabilities – making it “smart” Can improve real-time monitoring, load management, demand response Benefits depend on meter and data-management capabilities Sunk costs, operability standards, service life, obsolescence are concerns Rates, appliances, and usage can be smarter without smart meters

Beecher – rates2014

 42

Smart grid and advanced metering (electricity)  Potential benefits to utilities            

Opportunities for ratebase investment Opportunities for sales (EVs) Shift labor to capital (AJ, +RB/-O&M) Improved meter accuracy Improved billing systems and timing Revenue enhancement and stability Tampering and theft reduction Prepayment options (lower arrearage) Remote shut-off capability System monitoring and loss control Outage management and recovery Improved power & load management, and capacity utilization depending on participation (TOU, dynamic pricing)

Beecher – rates2014

 Potential benefits to customers   

Timely usage and price information Technology deployment (controls, cars) Customer benefits are contingent on • Lower cost of service (utility benefits) • Infrastructure and information costs (grid, meters, data storage and use) • End-use technology costs & payback • Participation rates (affected by price differential & elasticity) • Opportunity costs & personal sacrifice (privacy, convenience, control) • Allocation of costs to participants and nonparticipants • Avoided cost of inputs and capacity based on foregone or shifted usage

 43

Smart technologies: cost, information, & privacy issues  Progression of metering   

Conventional metering: amount of utility usage during a period of time Advanced metering: when utilities are used in the home Smart technologies: how utilities are used in the home

 Customer response is an ongoing experiment   

Behavioral economics will aid evaluation Opt-out provisions are controversial Privacy is a legitimate issue (creepy or cool?)

Beecher – rates2014

 44

Smart grid and advanced metering for water  Water is not electricity Water is storable by producers and consumers (and makes use of gravity)  Limited benefits of load shifting (some energy costs not energy or water)  Water system pressure must be maintained  Peaks can be managed through rates and regulations  Water flows one way (no net metering) 

 Advanced water metering facilitates     

System monitoring, pressure regulation, and loss control Labor-cost reduction (meter readers) Cost-of-service studies (data collection) Drought management (system-rationing) Prepayment (self-rationing)

 However, water systems should be on time-of-use electricity rates

Beecher – rates2014

 45

Regulatory and ratemaking issues associated with metering  Net benefits and flow through to rates in test-year revenue requirements   

Net reductions in costs (e.g., labor savings); efficiency gains (e.g., loss reduction, capacity utilization); revenue enhancements and stability Allocation of costs and distributional consequences Effect on financial risks and earnings

 Infrastructure investment issues   

AJ incentive effect and shift to from labor capital Prudence and opportunity costs Treatment of contributed capital (including grants)

 Consumer acceptance, privacy, security, and opt-out provisions  Asset life, obsolescence, premature retirement, and stranded cost  Use of trackers (are costs substantial, recurring, volatile, and uncontrollable?)  Cost and revenue forecasting (net effects)  Revenue neutrality under dynamic pricing rate design  Standards for just and reasonable rates Beecher – rates2014

 46

Fixed v. variable charges  “Customer charge” makes me feel like I'm being charged for the opportunity to be your customer” (Student)  Fixed and variable tariff charges may not match fixed and variable costs   

Many utilities recover some fixed costs through variable charges Improves price signals about capacity requirements Consumer and environmental advocates both prefer higher variable charges, although consumer advocates also worry about higher bills

 Straight fixed-variable pricing   

Used for restructured gas markets; growing interest in electricity More problematic in water due to very high fixed costs Alternative pricing means may be needed (e.g., capacity costs based on property value) Fixed charges

Customer costs

Beecher – rates2014

Variable charges Capacity/demand costs

Variable commodity costs

 47

Fixed v. variable charges: tradeoffs  In the short run, many costs are fixed  In the long run, all costs are variable

Beecher – rates2014

 48

Variations in water pricing (water) Rate per 100 CF at various usage levels $20.00

$8.00

$18.00

$7.00

$16.00

$6.00

$5.00

$12.00 $10.00

$4.00

$8.00

Rate per 100 cf

Fixed charge at 0 cf

$14.00

$3.00

$6.00 $2.00

$4.00 $1.00

$2.00

$0.00

$0.00 0 CF

500 CF

1k CF

3k CF

50k CF

1,000k CF

2,000k CF

Note: fixed minimum charge may include usage allowance

Beecher – rates2014

 49

Other types of charges appearing on bill  Operating-cost adjustments or trackers    

Fuel (for energy production) Purchased energy and water (wholesale) Uncollectible expenses Other major inputs that meet criteria

 Capital-cost adjustments or surcharges (more recent) 

System-development or improvement charges

 Other charges         

Taxes and regulatory fees Environmental surcharges (e.g., carbon tax) Renewable energy costs Direct charges (e.g., connection, hook-up) Maintenance fees (e.g., home wiring, plumbing) Penalties (e.g., late payment) Outside-city mark-up Charges for unbundled services Voluntary contributions for social or public-benefit programs

Beecher – rates2014

 50

Cost-adjustment mechanisms or trackers  Meant to prevent substantial financial hardship between rate cases based in “extraordinary circumstances” and variable operating costs that are  

Substantial, recurring, volatile, and largely outside of utility’s control Adapted recently for various capital costs (e.g., pipes, wires, smart meters) - form of CWIP

 Capital cost trackers – key issues       

Weak incentives for cost control with strong investment incentive (Averch Johnson) Automated recovery with inadequate regulatory review (prudence, used & useful) Net impacts - accounting, tax deferral, and risk/return issues Capital additions may result in operating savings Asynchronous (mismatched) revenues relative to actual costs Asymmetrical emphasis on costs/inflation/additions v. savings/deflation/retirements Should be considered within a capital improvement plan

 Regulators should not be “cost takers” – i.e., “cost-plus ratemaking”  

Trackers shift risks from investors (most able to manage) to ratepayers (least able) Rate case should be the default practice and an earnings-sharing mechanism may achieve the major objective (K. Costello)

Beecher – rates2014

 51

Charges for unbundled services  Utilities can “unbundle” rates for services that present particular costs  

Restructured markets separate charges for generation, transmission, and distribution Allow for special optional offerings and product differentiation or enhanced services

 Some services may be deregulated   

Ancillary and competitive services Segregation and separation Risk management

Beecher – rates2014

 52

Cost assignment: the user’s bill  Informed customers make better choices  Fixed charges (do not vary with usage)  Variable charges (vary with usage)  Other charges and taxes  Information for customers – usage trend, comparison usage, conservation ideas, assistance programs  Privacy issues – usage details, comparison with neighbors, marketing and consumer contact issues

Beecher – rates2014

 53

Sample bill: water

Beecher – rates2014

 54

Sample bill: electricity

Beecher – rates2014

 55

Sample bill: natural gas

Beecher – rates2014

 56

Sample bill: telecom

Beecher – rates2014

 57

Evolution of rate-design options  Collected from property taxes by publicly owned water systems  Unmetered charges   

Flat fees or charges (vary only in aggregate usage) Fixtures (water), occupancy Property values (UK)

 Metered rates   

Uniform by volume Block rates (decreasing and increasing) Time-of-use and dynamic rates

 Monthly rate plans  

Telecom – do time and location matter? Energy – budget billing, prepaid, decoupling, fixed-rate contracts, “free nights”

Beecher – rates2014

 58

Do consumers prefer simplicity and predictability?

Beecher – rates2014

 59

Rate-design variations            

Lifeline rates Usage-budget billing Prepaid service Restricted/limited service Seasonal rates Excess-use rates Interruptible (curtailment) Stand-by rates Negotiated rates Property-value based Value-of-service pricing Economic-development rates

Beecher – rates2014

 Spatially differentiated (zonal, district, inside/outside)  Spatially equalized (single-tariff)  Quality differentiated (e.g., water treatment, electric reliability)  Drought or emergency pricing  Peaking-factor rate  Critical-peak pricing  Time-of-use pricing  Real-time and dynamic pricing  Net metering  Feed-in tariffs

 60

Ratemaking standards: Public Utility Regulatory Policies Act (PURPA)

PURPA 1978 • • • • •

Cost of service Block rates Time-of-day rates Seasonal rates Interruptible rates

PURPA 2005 • • • • •

Net metering Fuel sources standard Fossil fuel generation efficiency standard Smart metering with time-based rate schedules Interconnection standard

Beecher – rates2014

 61

Uniform rate or uniform rate by class

Price/ unit

Residential customer

Industrial customer

Quantity consumed Note: peaking factors are an alternative means of customer classification Beecher – rates2014

 62

Lifeline rate and universal service  Limited by policies and practices related to price discrimination, subsidies  Programmatic discounts to qualified customers (low-income, seniors)  Low-priced first block, sometimes including a quantity allowance

Price/ unit

marginal cost

Quantity consumed Beecher – rates2014

 63

Block rates: decreasing and increasing

Note: rate blocks can be understood like income taxes, that is, rates usually are incremental or marginal and the customer’s bill reflects cumulative calculations. Beecher – rates2014

 64

Rate design for water systems over time

Beecher – rates2014

 65

Combination block rate Louisville Water (2007) $3.00

$2.50

$2.00

$1.50

General Elevated

$1.00

$0.50

$0.00 First 6 Beecher – rates2014

Next 6

Next 388

Next 2,600 Next 7,000 Next 10,000 Over 20,000  66

Seasonal rate

Peak season

Price/ unit

Off-peak season

Quantity consumed

Beecher – rates2014

 67

Incremental-cost pricing (water)

S3

Price/ unit

S2

Note: tail blocks could also vary by time, location, or incremental supply costs High cost Mid cost Low cost

S1 S = supply option

Quantity consumed

Beecher – rates2014

 68

Peaking-factor rates (customer classification)

Beecher – rates2014

 69

Pricing for load shifting (electricity)

Beecher – rates2014

 70

Time-of-use rate (electricity)

Beecher – rates2014

 71

Dynamic or real-time pricing and demand response  Policy case for smart grid is clearer than for smart meters and dynamic pricing     

Pricing relies on an economic v. engineering model for load management Capacity for load reduction or shifting varies (LBL study of large-volume users) Results depend on customer preferences, technologies, opportunity & avoided costs Alternative technological means may be as effective (passive v. active) Who should have granular knowledge re usage – customer, utility, third-party vendors?

 A smooth or constant baseload will mediate price differentiation (arbitrage)

Beecher – rates2014

 72

Allocation, excess-use or usage-budget rates (water) Rate blocks and tiers for four water-budget billing scenarios ($/100 cf) $8.90

$9.00 $8.00 $7.00

Price/ unit

Excess use/use above budget allotment, which may or may not account for geographic or demographic characteristics

$4.86

$6.00 $5.00

$2.71

$4.00

$1.48

$3.00

$4.86

$2.00 $1.00 $0.00 1

6

11

16

21

26

31

36

Hundred cubic feet HH5, large lot, summer

HH3, small lot, summer

HH5, large lot, winter

41

46 HH3, small lot, winter

Raises issues of “fairness” and consistency with cost-of-service ratemaking principles

Quantity consumed Beecher – rates2014

 73

Multi-objective water pricing  Multi-objective rates can help achieve both equity and efficiency   

Lifeline rate at lowest block for affordable access to meet basic needs Graduated capacity charge based on property value (related to fire protection) Increasing block rate based on usage to encourage efficiency $0.024

$100

$0.022

$64

Monthly commodity charge (variable based on usage)

$0.020

Monthly capacity charge (fixed based on property values)

$80

$56

$70

Monthly customer charge ($4 fixed per customer)

$0.016

$47 $60

$0.014

$50 $33

$0.010 $0.008

$0.006

$30

$21

-------------Lifeline rate-------------

$24 $20

$16 $0.004

$13

$4

$4

$4

$4

$4

$4

$4

Next 1,000 gal. = 8,000

Next 1,000 gal. = 9,000

Next 1,000 gal. = 10,000

$10

Next 1,000 gal. = 7,000

$11

Next 1,000 gal. = 6,000

$4 $4

$9

Next 1,000 gal. = 5,000

$4 $4

$7

$20

$16

Next 1,000 gal. = 4,000

$5 $4 $4

Next 1,000 gal. = 3,000

$4 $4 0 gal.

$0.000

$10

Next 1,000 gal. = 2,000

$0.002

Beecher – rates2014

$40

$27

First 1,000 gal.

Per gallon commodity charge

$40 $0.012

Total monthly water bill

$0.018

$90

$0

 74

Benefits of end-use efficiency (“negawatts” and “negagalloins”)  Efficiency lowers costs and revenue requirements  

Short-run: avoid variable operating inputs – including energy Long-run: extend asset life and resize, postpone, or avoid new capacity

 Efficiency improves water system operation and management  

Prudent capacity utilization through reductions of peak demand Reduced revenue and earnings volatility (risk)

 Efficiency cannot avoid all system costs – particularly in the replacement cycle 

Hyper-efficiency may have deleterious consequences for systems and customers

Source: Hunter, et al (Opflow, May 2011) Beecher – rates2014

 75

What is a conservation-oriented rate?  Many rate variations can reflect costs and achieve efficiency goals   

Any metered rate where more usage leads to higher bills sends a signal re value Different designs may be consistent with cost-of-service studies Policies may define (e.g., PURPA for energy, Minnesota for water)

 Some conservation rates raise serious issues  

Usage-budget billing (efficiency and equity) All-variable rates (revenue stability)

 Price efficiency can be improved     

Usage Rate

Differentiating prices according to usage and contribution to load Seasonal rates that focus on more discretionary usage (outdoor irrigation) Pricing based on long-run marginal capacity and commodity costs Refine customer classes (e.g., peaking factors) Revisit fixed v. variable costs and charges (including fire protection)

 Falling sales and rising rates create a “conservation conundrum” for utilities

Beecher – rates2014

 76

Rates may rise due to efficiency but bills rise due to costs Revenue requirements

Rate ($/unit)

Bill ($/customer)

Usage Usage decline (other things equal near term) Economic demand management Uneconomic demand management

neutral  

  

neutral  

Costs Rising infrastructure or operating costs Supply-side efficiency

 

 

 

Market Customer additions (gain scale) Customer losses (lose scale)

 

 

 

Rate design Price elastic usage Price inelastic usage Cost reallocation

neutral neutral neutral

  

  

Full-cost pricing Subsidy Transfers or loss of subsidy

 

 

 

Condition

Beecher – rates2014

 77

Efficiency and volatility (water)  Gross sales volatility is primarily a function of weather-sensitive outdoor use  

Indoor usage is less responsive (elastic) relative to price and other changes Rising variable prices and bills could drive down outdoor usage significantly

 Trends in indoor and outdoor usage determine the weather effect on water sales 

Supply-side (leak control) and indoor efficiency will lower base-load usage, although only the latter will affect sales revenues

 Sales and revenue volatility remain a function of outdoor water usage 



If maximum (outdoor) use persists or rises, volatility will increase due to the larger disparity between peak and off-peak usage If maximum (outdoor) use falls, volatility will decrease due to narrowing of peak to off-peak

Beecher – rates2014

 78

Are utilities threatened by a “death spiral”?  Perceived existential threat to utilities 



End-use efficiency requires cost recovery over fewer sales units Self-supply (solar panels, water recycling) also affect revenues

 True disruption depends on price elasticity and reasonable substitutes  As long as utility networks serve social purposes, costs must be covered  In the long run, regulation does not protect utilities from market forces

Edison Electric Institute

Beecher – rates2014

 79

Revenue assurance mechanisms: decoupling  “We don’t have excess capacity, we have inadequate demand.”  Decoupling detaches sales from revenues and profits   

An adjustment mechanism that creates a revenue cap A form of fixed-fee pricing – denominator is no longer a unit of consumption Similar to weather normalization or other revenue-related (v. cost-related) mechanisms

 Purportedly addresses the utility’s “throughput incentive” (to sell more)    

Maintains overall or per-customer revenues (revenue neutrality) Compensates utility and neutralizes sales incentives Does not provide positive incentives to reduce sales Rationale varies historically and by utility sector

 Implementation issues    

Full or partial decoupling Segregating underlying causes (economic forces) Need for performance incentives, earnings adjustments Should only purposive or mandated reductions qualify?

Beecher – rates2014

$/customer

use per customer

 80

Concerns about revenue assurance and decoupling  Problem is real, but decoupling is not the only solution    

Presumes utility role in conservation and need for special incentives (see water) Demand reduction may be due to recession, price elasticity, other forces Utilities enjoy higher sales but can do little to actualize them, except under-price Private utilities are more motivated by investment opportunity than sales

 Decoupling conflicts with     

Price signals about value and consumer sovereignty Concept of capacity costs (tends to perpetuate legacy costs) Preference for variable and dynamic pricing (looks very “ fixed”) Incentives for utility efficiency and performance (including effect of regulatory lag) Risk allocation under the social compact and traditional economic regulatory model

 Decoupling and publicly owned systems  

Risk and reward issues are less controversial Less needed because rates can be easier to adjust

Beecher – rates2014

 81

Alternatives to decoupling       

“Organic” decoupling with more efficiency over time (i.e., do nothing) More frequent rate cases to address “utility lag” in recognizing change Prospective (forward-looking) test year for both revenues and sales Evidence-based rate design (rate blocks) to provide stability from base usage Demand-repression adjustments to account for price elasticity effects Cost or revenue adjustment mechanisms (with prudence, performance, earnings checks) Improved demand forecasting and modeling (beyond moving averages)

Beecher – rates2014

 82

From passive to active forecasting and modeling (water)

Actual Water Demand and Past Forecasts 360 340

Actual Annual 1967 SWD Forecast 1973 RIBCO Forecast

320 300

1980 Complan Forecast Medium 1980 Complan Forecast Medium-Low 1985 Complan Forecast-Medium 1993 WSP Forecast 1997 Revised Forecast 2001 WSP Forecast

280 260

Annual MGD

240 220

2003 Official Forecast 2006 Draft Forecast

200 180 160 140 120 100 80 60 40 20 0 1950

1955

Beecher – rates2014

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

 83

Goals and values in rate design  Many rate options can fulfill revenue requirements (multiple objectives)   

Values can and do play a role – but with little explicit attention Efficiency, conservation, resource scarcity, energy independence, global climate change Values cannot replace evidence–based analysis of preferences and behavior

 Rate-design choices reflect consumer and social criteria and policy tradeoffs   

Customer preferences and acceptance about rates may vary widely Simplicity and stability v. more control over utility bills Different options present different opportunity costs

 Social ratemaking departs from cost-of-service principles   

Sacrifices efficiency in resource allocation to achieve social goals Reflect community values, as well as regulatory authority and discretion Examples: lifeline rates (residential), economic-development rates (commercial), conservation and usage-budget billing (rationing)

Beecher – rates2014

 84

Goal orientation for a sample of rate-design options Type of rate

Policy goal

Uniform

Simplicity

Blocks

Load management

Zonal

Spatial cost allocation

Locational (LMP)

Congestion relief

Lifeline

Affordability

Marginal cost

Allocative efficiency

Single-tariff

Regionalization

Negotiated

Economic development

Dynamic pricing

Demand response

Scarcity

Emergency management

Beecher – rates2014

 85

Complexity in rate design  Rate design need not be overly complex to recover costs and promote efficiency improvement  A smarter rate is not necessarily a complex rate

 An overly complex rate structure is generally undesirable – potential issue with dynamic pricing  Customer understanding and acceptance are important for price responsive behavior  Benefits of rate design and its implementation should outweigh costs  Resources are available for basic ratemaking (e.g., professional training and manuals)  Rate structures can and should evolve with changing utility and social values, needs, and goals

Beecher – rates2014

 86

Implementing a change in rates  Follow sound principles and practices for cost-based ratemaking  Communicate policy goals clearly  Provide opportunities for stakeholder input  Explore a full range of rate-design options  Avoid excessive complexity and unnecessary confusion  Recognize impacts and trade-offs explicitly  Phase-in big changes with gradualism  Amplify price signals with information, education, social media  Approach empirically and experimentally

 Monitor and evaluate marginal and net benefits and costs  Modify based on impacts, outcomes, and evolving conditions

Beecher – rates2014

 87

Rates, revenues, risks, and returns  All utilities today are concerned about revenue sufficiency and stability 

  

Higher fixed charges may provide revenue stability (volatility risk) but undermine affordability and long-run price signals (capacity) Well-designed rates provide symmetrical risk relative to returns (upside/downside) Careful analysis and design of rate blocks can enhance revenue stability Revenue volatility will decline with more stable and predictable usage

 Rate design can shift risks between ratepayers and investors 

Suggests the need to revisit the cost of capital and authorized returns within the context of a rate review and other policy decisions

 Increased efficiency will make sales and revenues more stable and predictable

Beecher – rates2014

 88

Totality of a rate case  Regulatory policies and rate case decisions   

Impose, mitigate, and allocate risks and rewards Each of these decisions relates to incentives No issue can be considered in isolation (single-issue ratemaking)

 Regulators should consider the totality of regulatory treatment          

Test year (historical or future) Treatment of construction costs (pre-approval, CWIP) Cost-adjustment mechanisms Revenue-assurance mechanisms (decoupling) Recovery of operating expenses Depreciation practices and rates Demand (load) projections Cost allocation and rate design Authorized rates of return Timing of cases and decisions

Beecher – rates2014

 89

Thanks!

Beecher – rates2014

 90