The heightened interest in fixed and demand charges for residential electricity customers has sprung largely from the flaws in the prevailing rate design for residential electric service; namely, volumetric rates, especially as those failings have been magnified with recent developments in electricity markets and public policy.

Major reasons for this longstanding perverted rate structure seem to be the following: (1) the perception that alternative rate designs like fixed charges are unfavorable to vulnerable customers, like low-income households; and (2) less-than-definitive rules for allocating fixed or common costs to different customers and services. 

Volumetric rates, which place much of a utility’s fixed costs in the usage (KWh) charge of a tariff, have created a number of social problems as they relate to economic efficiency and equity. These problems have become more serious with the latest developments in the electric power industry. They include the following:

1. A significant incongruity exists between a utility’s costs and its rate structure, with excessive fixed or network costs recovered in the volumetric charge; the damage of that has amplified with the advance of self-generation like distributed generation. A more rational rate design that features the cost-causation principle of rate setting can prevent cost-shifting and uneconomic switching of customers to self-generation.   
2. Time- and location-invariant volumetric rates assume that each kWh consumed — irrespective of the time or the location — imposes the same cost on a utility; one obvious reality is that both energy and capacity costs in the real world are higher during system-peak periods.
3. Self-generating customers avoid their fair share of fixed costs; when they self-generate, the utility recovers less fixed costs even though they were beforehand approved as prudent by the regulator and the self-generating customer still relies on the grid for both importing power from the grid and exporting power to the grid, and for other grid services; connection to the power grid, whether the customer self-generates or not, is akin to purchasing a 24/7 call option. The upshot is that the utility usually continues to recover its fixed costs but from non-self-generating customers who, on average, are less well off than self-generators. 
4. Cross-subsidies occur as customers whose demand is relatively constant across hours are subsidizing customers whose demand is “peakier.” For those customers with relatively high kWh consumption but a relatively small contribution to system peak demand, their bills will likely decrease with a fixed or demand charge.  For those customers with low consumption but a relatively high contribution to system peak demand, their bills will likely increase.  
5. When a customer cuts back on kWh consumption they can avoid paying their fair share of grid service; that is, they are not paying for what they use or is available for them to use.
6. Customers receive wrong price signals from an excessive volumetric charge that causes customers to under-consume electricity.  Setting volumetric rates greater than short-run marginal cost creates what economists call a deadweight loss by impeding welfare-enhancing electricity consumption.
7. There is an added incentive for uneconomic bypass aggravated by opportunities for self-generation. Uneconomic bypass not only reduces economic efficiency, it also causes cost shifting, likely from wealthier customers to low-income customers. 

Why a new rate design?

One pertinent question is: how would fixed or demand charges in residential tariffs advance regulatory objectives and achieve “just and reasonable” rates? Specifically, how can utilities recover their fixed costs and from whom?

Utility pricing has typically reflected cross-subsidies benefitting certain residential customers at the expense of other residential customers (i.e., intra-class cross-subsidies).  This pricing was sustainable — although highly inefficient and unfair — as long as utility customers depended on their utility for virtually all of their electricity.

With growing competition at the retail level from self-generation and other sources, it has become more critical to align prices with costs. This is analogous to the demands placed on the U.S. railroad and telecommunications industries when they started to face increased competition.

Volumetric rates have become less justified by the increased diversity of residential customers in terms of their load profile. When full-requirements customers convert to solar customers, their load factor drastically declines. Somewhat because of rooftop solar PV, the correlation between domestic consumers’ use of electricity and their maximum demand, which has underlain rate design in the past, has increasingly broken down.

For example, with the intermittency of the solar generation, these consumers may still be drawing on the network to the same maximum extent at peak times, so the utility’s costs in relation to those consumers are therefore likely to have gone down less than their revenue.

One could make a good argument for grouping solar customers, as well as other self-generating customers, in a separate rate class because of their much different load profile than the average residential customer and the additional costs that a utility has to incur in serving them.  Otherwise, non-solar customers are subsidizing them under the current, defective rate design.

A fixed or demand charge would certainly lower the volumetric (sometimes referred to as the energy or usage) charge and could also lower the customer charge. The prime objectives of modifying rate design should be to have customers face proper price signals that enhance economic efficiency, bear their fair share of the utility’s fixed costs, in addition to assuring that a prudent utility remains financially healthy.

Fixed/demand charges face regulatory hurdles

Regulators look more kindly upon a new rate design when the public accepts it and no single group of customers is severely harmed. Regulators like to avoid negative public reaction to their decisions, as this places them in a negative light that could trigger legislative intervention.

History has shown that perceived distributional effects trump economic efficiency in terms of public acceptability. This implies that even if fixed or demand charges are shown to increase economic efficiency and redress some of the other problems with volumetric rates, that may fall short of gaining public support or deflecting opposition from interest groups.

One obstacle has been the widespread perception that rate reform in the form of moving a utility’s fixed costs to a fixed or demand charge would disproportionally hurt low-income households. The best studies have shown that this is not necessarily the case: the distributional effects of adding a fixed or demand charge in tariffs are devoid of generalization but, instead, depend on system characteristics, customer demographics, and energy-usage patterns.    

Regulators should not discard a rate design outright because it would hurt low-income households. Affordability is a legitimate concern but regulators should support the most efficient, rational rate design where all customers receive the right price signals and treat the affordability concern separately.

For example, utilities could offer low-income households a rebate or some lump-sum assistance, or even a lower fixed charge. This would have a lesser effect on economic efficiency than persisting with volumetric rates that are economically irrational and antithetical to society’s welfare.

The past has illustrated that regulatory approval of a new rate design is no guarantee even if evidence and logic show that it is the right thing to do from an economic and “fairness” perspective. Decisions by regulators over the past several years clearly reveal that they frown upon large, one-time increases in fixed charges.

Utilities would therefore have more success with a gradualist approach that reflects incremental changes in these charges over a specified time frame; inevitably, there are winners and losers. The burden should fall on those who want to maintain the status quo in rate design, especially in view of the availability of changing market conditions and new public policies. 

One impediment to a new rate structure is the “right to the status quo” or the right to current entitlements, even when the present pricing structure violates sound economic principles. Opposition to new ideas often utter the expression "if it ain't broke, don't fix it." But the present rate structure needs serious repair.

No need to wait for rate-design reform

One political benefit from a fixed or demand charge comes from the realization that as more customers switch to rooftop solar PV — induced by volumetric rates — the burden of recovering a utility’s capital costs would disproportionally fall on low-income households. Evidence shows that customers investing in solar PV have, on average, higher incomes than other customers and that relatively few low-income customers invest in solar PV systems.

That creates the opportunity for making the strong case that maintaining volumetric rates not only jeopardizes economic efficiency but also fairness; namely, that higher-income customers investing in rooftop solar PV are benefitting at the expense of lower-income customers left behind. In effect, lower-income customers are subsidizing other customers who have the resources to invest in self-generation options.

Shouldn’t that be enough evidence to persuade regulators and stakeholders like consumer advocates that it is time to cast-off volumetric rates and accept a more rational rate design that can advance both economic efficiency and fairness? We should hope so but don’t hold your breath.      

One Nobel laureate economist remarked about 60 years ago that the application of the correct concept in the pricing of electric service “is not merely a minor adjustment to rates, but a major change in ratemaking philosophy.” It is high time for that to happen in today’s electric power industry - the sooner, the better.