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Efficient and Equitable Pricing for the Energy Transition

  • Sorena Rahi
  • |
  • Nov 9, 2021
Efficient and Equitable Pricing for the Energy Transition

Sorena Rahi is a PhD Candidate in Business, Economics, and Public Policy at the Ivey Business School and a Research Assistant with the Ivey Energy Policy and Management Centre. He shares the key takeaways from each panel event as part of the Centre’s annual Workshop on the Economics of Policy and Markets.

The Ivey Energy Policy and Management Centre hosted its 5th annual workshop on the Economics of Electricity Policy and Markets in October. The theme of this year’s workshop revolved around electrification as part of the transition to a clean energy economy. On October 27th, in the last of the workshop’s four sessions, Severin Borenstein, Professor at the Haas School of Business, U.C. Berkeley, and Faculty Director of the Energy Institute at Haas, delivered a keynote address on efficient and equitable pricing of electricity for the energy transition in the context of California’s electricity market. The session was hosted by Brian Rivard, Director of Research for the Ivey Energy Centre, and moderated by Guy Holburn, Director of the Ivey Energy Policy and Management Centre and Professor of Business, Economics, and Public Policy at Ivey Business School.

Borenstein presented insights from his recent study, co-authored with Meredith Fowlie and James Sallee, on electricity rates in California1. California has been on the forefront of fighting climate change for decades and has been proposing various energy standards and undertaking initiatives toward this end since the 1970s. The Global Warming Solutions Act of 20062 passed by the state’s legislature was one of the first cap-and-trade programs of its kind to set prices on GHG emissions in a wide segment of the economy. California has also been hit with various disasters such as wildfires, droughts, and floods. In response, the state has taken action to both mitigate and adapt to climate change, which requires costly investments. A portion of these costs has been paid through federal and state budgets or borne by individuals complying with environmental standards; however, a significant portion is paid through electricity rates. California’s electricity market charges high volumetric rates (i.e. per-kilowatt-hour charge) and almost no fixed charges. The state has also enacted several low-income energy support programs that subsidize electricity charges for low-income consumers through higher volumetric rates for others. Consequently, the three large electric utilities in California charge rates that are much higher compared to the average rates elsewhere in the United States and in Canada.

Why are California’s volumetric retail electricity rates so high?

Economic theory suggests that efficient retail electricity rates should reflect the time-varying social marginal cost (SMC) of consuming electricity, which means they should capture the incremental cost of electricity consumption including externality costs to society such as pollution impacts. The SMC components of California’s utilities mainly consist of energy costs, GHG costs, as well as capacity costs to the grid. A comparison between estimated social marginal costs and actual residential prices reveals that Californians pay rates that are two to three times higher than the socially efficient benchmark. Borenstein argued that this is a cause for concern for two reasons. First, high electricity rates discourage consumers from switching from high-emitting energy sources to cleaner alternatives. Pricing energy sources at their social marginal costs would change the economics of consumer choices and make technologies such as EVs and electric heating more attractive. Second, higher prices impose a large economic burden on low-income households. The California Alternative Rates for Energy (CARE) program subsidizes electricity for low-income customers, but this study shows that even CARE rates are substantially above social marginal costs.

Borenstein’s study also investigates the components of actual residential electricity rates in California. A considerable portion of per-kWh prices pay for the fixed costs of generation, transmission, and distribution. Generation fixed costs are related to investments in renewable, nuclear, and natural gas generation. These costs have declined over time as capital expenditure costs for earlier costly investments have been recovered. Transmission fixed costs pertain to recovering the costs of investments in upgrades to the system that accommodate renewables and adapt to climate change disasters, such as protecting against wildfires. Finally, distribution fixed costs comprise the largest chunk and are expected to increase over time as the distribution system adapts to incorporate distributed electricity resources. Even though dynamic pricing models can ensure hourly variations in social marginal costs are reflected in the retail price, they cannot be used to effectively recover fixed costs. Furthermore, net metering for rooftop solar panels exacerbates the fixed cost recovery issue by shifting the cost burden to utilities and other customers.

Distributional effects of high electricity rates

Data from the Consumer Expenditure Survey (CE) from the U.S. Bureau of Labor Statistics (BLS) shows that even though the highest quintile income households in California earn seventeen times more than those in the lowest quintile, they spend only twice as much on electricity. In other words, lower-income households in California spend a larger share of their income on electricity. Furthermore, even low-income households are paying rates that are considerably above efficient prices. Revenues generated through charging higher rates are being used to pay for infrastructure fixed costs, climate change adaptation, and public service subsidy programs. Therefore, the current pricing framework in California works in a way that is equivalent to charging a volumetric tax on electricity that is more regressive than a sales or income tax.

In terms of policy implications, Borenstein suggests a few potential solutions. One would be to pay for these costs through the state budget rather than doing so through market mechanisms. This approach is supported by many stakeholders in California, including environmental groups, low-income rate payer advocates, as well as utilities. However, state legislators are less supportive of this approach as it would compete with a variety of other programs for the state budget. An alternative solution could be to pair income-based fixed charges with efficient volumetric rates that reflect the social marginal cost. The study examines alternative ways of implementing these fixed charges, such as involving the state tax authority to provide information about each customer’s income to the utility or setting default fixed charges based on customer location.

As an example, based on the 2019 rates for the Pacific Gas and Electric (PG&E) utility company, income-based fixed charges that are as progressive as a sales tax would collect a monthly fixed charge of approximately $150 from customers with an annual income over $150,000 but would not charge customers in the lowest income quintile. In comparison, a uniform fixed charge would charge all customers around $75 per month. The total monthly bill impact of income-based fixed charges would not be as much for wealthier households because they pay lower marginal costs compared to others. Using the same example, the total monthly payment for a customer with an annual income of over $150,000 would only increase by around $60. The lowest-income customers, on the other hand, would benefit from savings of up to around $90 per month. Lastly, Borenstein argued that income-based fixed charges would probably not induce wealthy customers to invest inefficiently in distributed alternatives to avoid paying for network costs because that would come at the cost of giving up the reliability benefit of the grid.

View Borenstein’s presentation here

[1] Borenstein, Severin, Fowlie, Meredith, and Sallee, James “Designing Electricity Rates for An Equitable Energy Transition” (February 2021) | WP-314