Recovering Network Costs in Rate Design: The State of Play in California

The provision of electric service to customers has three major components: generation, transmission and distribution. All three have a capacity cost element in them. Generation also has an energy component in it.

Rates for non-residential customers come the closest to recovering these cost components. They include many components, containing at a minimum three elements: a fixed charge (for recovering the costs of connecting the customer to the grid, metering, billing and customer service), a demand charge (for recovering the capacity costs of generation, transmission and distribution) and an energy charge.

Sometimes these rates have more than one demand charge in them: a non-coincident peak demand charge and a coincident peak demand charge. The energy charge may be flat but often it varies with time of day. Sometimes it also has a dynamic element, which, in the extreme case, would be an hourly price.[1]

For residential customers, the bulk of the costs are recovered through a volumetric rate, or an energy charge. The energy charge includes capacity costs as well as energy costs.

There is also a fixed charge, which attempts to recover the cost of the meter, billing and customer service. Sometimes it also includes an element for recovering the cost of the transformer that connects the customer’s meter to the power lines. The fixed charge does not attempt to recover any portion of the capacity costs associated with generation and transmission or even the capacity costs associated with substations.

As a practical matter, the fixed charge does not even fully recover the elements identified above. Most utilities in the US would be happy if they were granted a fixed monthly charge of $25 a month, which is their estimate of the fixed network cost. A few approach that number, as show in the charts that follow. Most don’t. That’s the national picture.

In California, state law allows a fixed charge of up to $10 a month. However, two of the three investor-owned utilities don’t have a fixed charge at all. The third has a nominal fixed charge of $0.99 per month. By contrast, SMUD, a municipal utility that serves the state capital, has a fixed charge of $23 a month (low-income customers get a $10 discount). This number has been reached gradually over several years

LADWP, the largest municipal utility in the US based in the city of Los Angeles, has a three-tiered fixed charge that rises from $2.30/month to $7.90/month to $22.70/month based on the customer’s usage. It also varies across two climate zones.

FIGURE 1

Year after year, utilities continue to file proposals to increase their fixed charges. The figure below shows the status as of the fourth quarter, 2020. As the figure shows, most utilities do not get the amount they requested. California’s utilities continue to show no changes at all.

FIGURE 2

In California, electrification is a major priority but high electric rates are a barrier. A proposal has been made to set electric rates equal to marginal costs (around 9 cents/kWh) and to recover the balance through a fixed monthly charge ~$70 a month (since electric rates are ~30 cents/kWh). Since that would raise monthly bills for low-income customers, the proposal would exempt low-income customers from paying any fixed charge and levy the new fixed charge on all others in a manner similar to the state’s progressive income tax schedule. They would end up paying far more than $70 a month, with some at the upper end of the income distribution paying a number in the vicinity of $175 a month.

There are several issues with this proposal. First, as far as I know, there is no precedent in rate design for levying fixed charges that vary with income, let along in proportion to the state income tax. Second, nor is there any precedent for giving utilities access to customer incomes. And third, as of this writing, there is no evidence that pricing electricity in this manner would encourage electrification.[2] There is substantial empirical evidence from California that customers respond to the average price, not to the marginal price.[3]

The other major policy issue in California that pertains to recovery of network costs is the rise in the penetration of solar panels. The state has now some 1.5 million homes which have installed solar panels on their roofs.

On March 15, 2021, the California Public Utilities Commission (CPUC) held a virtual workshop on how to reform the net energy metering (NEM) that governed how customers with solar panels would pay for importing and exporting power to the grid. Under the current rules, NEM 2.0, import and export compensation were equal to each other and based on existing retail rates as long as they were one of the existing time-of-use rates being offered by their utility. A variety of proposals were submitted for reforming NEM.[4]

On December 13, 2021, the CPUC issued its Proposed Decision (PD) on NEM 3.0. It singled out the cost shift being created by the installation of solar panels and called it regressive, alleging it flowed from low income to high income customers. The PD would have imposed a grid access charge of $8/kW on homes that would solar panels.[5] This would have doubled or tripled the payback period for installing solar panels, drastically slowing their adoption.

The PD was surprisingly one sided and not that different from the utility proposals that were aired at the March 15 workshop and later submitted as testimony. Such a one-sided decision had not been observed anywhere else in the country.

It stirred a hornet’s nest, with many calling it a classic instance of predatory pricing by a regulated monopoly.[6] There were several problems with it.[7]

First, the grid access charge ran afoul of the state mandate to install solar panels on all new homes. Second, it belied the state’s need to create virtual power plants. When customers pair solar panels with battery storage at their homes, they can help reduce the stress on the grid during heat waves, as was seen in early September 2022, especially on September 6. Finally, the cost shift argument was disingenuous since it ignored the myriad cost shifts that are present in California’s rate designs, and it also ignored the cost shifts created by when utilities spend $1.5 billion on energy efficiency subsidies.[8]

Conclusions

California definitely needs to reform its residential rate designs. Recovering network costs via energy charges is sub-optimal. Fixed charges should be raised from their currently abysmally low values, but they should be raised gradually, and they should not go past $25 a month. Finally, they should apply equally to all customers and not just be imposed on upper income customers or customers with solar panels.

Given the state’s strong commitment to reaching Net Zero status in a few decades, it should do everything to encourage electrification as well as installation of distributed energy solutions that would enhance the affordability of electrification. Rooftop solar panels paired with batteries should be incentivized, not de-incentivized. Instead of imposing a grid access charge, customers should be offered a rebate for installing these systems.[9]