Fixing Retail Electricity Prices

Prof. Richard Sweeney

Overview

• So far we have been talking about electricity markets in the context of generation (wholesale) markets.
• Consumers do not purchase power directly from these markets. Instead, they purchase electricity from retail utilities.
• In this module, we will discuss issues surrounding the prices retail consumers face.
  • Today: Time varying prices
  • Next Thursday: Fixed costs
  • Following Tuesday: Rooftop solar

Four Fundamental Goals of Rate Design

(from Severin Borenstein)

1. Economic Efficiency of Consumption: encouraging additional usage when – and only when – it is valued more than the full additional cost to society (need P = MC)
2. Cost Recovery: allowing suppliers to recover costs, including the opportunity cost of capital
3. Equity: distributing costs among customers in a way that is consistent with societal views of fairness
4. Ensuring Access: ensure that everyone is able to consume quantities necessary for basic needs

Time varying prices

How it should work

Problem: Most people face a single price

I pay the same price per unit regardless of when I use it.

This is economically inefficient

Reminder: Consumption at peak hours is very costly

• some plants only operate a few hours
• if consumers faced these costs during those hours, could we avoid needing some of these “peaker” plants?
• answer depends on how elastic demand really is

If D inelastic, avg price won’t distort Q much

Are consumers really that inelastic?

• Most consumers face a flat price (no sure how responsive they are)
• Some utilities charge higher prices during peak-pricing events … But even then, people don’t change their behavior much

• Is this people’s true preference?
• Think of when you lived off campus? Did you know how much electricity you used?
  • If you got a big bill, would you know what to change?

Hypothesis: People are not even aware of how much they use

Jessoe and Rapson (2014)

Explain the experimental setup in your own words

What is the research question in this paper?

1. How much will people conserve if we impose higher prices during peak events?
2. Will they respond more if they have real-time information on their electricity use?

How were people recruited?

• To be eligible a customer needed to reside in a townhouse or single family home, have a broadband Internet connection, and sign and return an end-user agreement indemnifying UI against litigation risk.
• Participants offered $40 to complete two surveys
• Emailed 60,000 customers enrolled in paperless billing (likely presence of internet).
• Approximately 7,000 households opened the e-mails.
• Recruited 1,152 households (approximately 1 in 6) to participate in the project
• 437 selected into the final sample.

Sample Groups

Control Group: A total of 207 households were assigned to the control group. These received a mailing that notified them they were in the pilot, informed them of their group assignment, and contained an energy conservation pamphlet documenting “101 Ways to Conserve Electricity.”

Price-Only Treatment Group: The 130 households in this group experienced pricing events that varied in the magnitude of the price increase and the timing of event notification. Two event days:

1. Day Ahead (DA): told the day before that price of electricity would be increased by $0.50/kWh (250 percent increase)
2. Thirty Minutes (TM): sent notification thirty minutes before a $1.25/ kWh increase

Price + IHD Group: The 100 households get the price treatments above, but also get real-time information on their energy use via in-home display (IHD)

Here are the pricing events

What does the display really tell users?

Customers view in real time the quantity of power being consumed, the price of electricity, and their estimated monthly bill-to-date.

What do we learn relative to the price only group?

Since treatment groups randomly assigned, can see they are the same

We know this isn’t all the \(X\)’s that matter, but if these are “balanced”, we infer that randomization worked.

[Note this paper also has some attrition that they have to deal with.]

JR compare usage across groups on event days

Largest effects were on day 5 and 6

What might be going on there?

With an RCT, can just compare means

• Price-only group usage declines by 0 to 7 percent.
• IHD group usage declines by 8 to 22 percent.

Having established a difference, authors then explore the mechanism

• Doesn’t seem to be “salience” (ie people just more aware an event is happening)
• People seem to plan more for day ahead event (usage changes in hours before / after)
• Some evidence of habit formation. A result they emphasize is that usage declines in non-event hours more among this group as well.

Summary on time varying prices

• Costs vary a lot over time. Economic efficiency demands prices should reflect this.
• How much this will actually effect quantity depends on how elastic demand is.
• Historically, people not aware of what the price is or even how much they are consuming.
• IT changing that.
• Many subsequent experiments have looked at various interventions. My rough take is that a simple programmable thermostat and peak pricing on the worst events gets you most of the social benefits.

Recovering fixed costs

Overview of power system

• What are marginal costs here?
• What are fixed costs?

Cost breakdown

Marginal costs:

• cost of production
  • plus line losses (approx 7%)

Basically everything else is a fixed cost.

How should we setup electricity prices and bills to recover these fixed costs?

How much should your utility charge you per kWh?

• Efficient price = MC

Most utilities recover fixed costs volumetrically

This leads to inefficiently high prices

More than half of the marginal price I pay (per unit of electricity consumed) covers non-marginal costs.

Problem: If the only price consumers face is volumetric, then efficient prices cannot recover fixed costs.

• Total costs (Q) = Fixed costs + Variable costs(Q)
• Marginal cost = d Variable costs / dQ
  • For now, assume MC = constant
• Efficient price = MC
• What will the firm’s revenue be if they charge this price?

• Problem: If price = MC, profits are negative
  • this is a problem because the firm will go bankrupt and exit the market.

Problem setting Price = AC generates DWL

Average cost = Total costs / Q = Fixed costs / Q + MC

So these are declining in Q (Natural monopoly) Natural monopoly: LRAC declining.

Efficient solution: Recover fixed costs with fixed charges

• Imagine I had to pay $50 each month just to get any electricity.
• But then only paid the true marginal cost for each kWh.
• That would restore efficiency on the margin, and avoid structural losses.

What are some concerns with this?

Problems with fixed charges

• Some consumers might leave the market
  • ie if I get less then $50 surplus (draw this)
• Not equitable
  • Why should customers who use very little electricity pay an equal share of the system costs?
• Income concerns, conditional on usage

Example: Two households

• Monthly costs: $100 fixed costs; marginal cost = 10¢/kWh.
• Usage (held fixed): A uses 200 kWh/month; B uses 800 kWh/month.
• Average-cost pricing: Spread $100 over 1,000 kWh, adding 10¢/kWh. Charge 20¢/kWh.
• Fixed charge: Charge each household $50/month + 10¢/kWh.

Monthly bill	A: 200 kWh	B: 800 kWh	Total
Average-cost pricing	$40	$160	$200
Fixed charge + marginal cost	$70	$130	$200

Both recover $100 variable costs + $100 fixed costs at these quantities.

Who pays the fixed costs? A pays $20 and B pays $80 under average-cost pricing; each pays $50 with the fixed charge.

Incentive: An extra kWh costs the utility 10¢, but households pay 20¢ vs. 10¢.

Decreasing block prices rarely observed. But increasing prices often are

Example from SoCal Gas & Electric.

Why do you think some utilities setup prices this way?

Are consumer prices really too high?

• Previous section discussed marginal cost as if it was social marginal cost.
• Electricity production causes large external costs (on the margin) as well.
  • Local air pollution: PM, ozone, etc
  • Climate change: CO2
• Since these are generally unpriced, simply setting price equal to private marginal cost would mean consumer prices would be too low

What is the net effect? Are prices too low or too high?

Borenstein and Bushnell (2022): Both

B&B look at data from 2014-2016

Summarize wholesale prices at NERC region

Avg wholesale prices much lower than avg retail rates

Avg line losses \(\sim\) 7%; Marginal losses are larger

Estimating external costs

• For each of the four major pollutants from electricity generation (CO2, SO2, NOx, and PM2.5), create a variable that is total emissions damages by hour of the three-year sample for each of the nine regions, incorporating the operations of each fossil fuel power plant and the damages associated with emissions from each plant
• To map local damages to money, use a widely used model (AP3)
• Assume social cost of carbon of $50/ton
  • This is way too low now
• Run hourly regressions to translate these average emissions into marginal costs associate with consumption in each utility.

• external MC ~ 2X private MC ..
• but on average prices are too high (\(\sim\) 8%)
• still many places they are far too low

Ramsey pricing

• If we must recover fixed costs volumetrically (on the margin), how should we do it?

• Should different consumers pay different prices?

When will the deadweight loss from pricing above MC be largest?

• consider two different groups of consumers
• one has very inelastic demand, the other very elastic demand
  • could be residential vs commercial, rural vs urban, rich vs poor, etc
• which group generates more DWL?

Solution: Ramsey pricing

If you must raise revenue from marginal pricing, its efficient to target the most inelastic consumers

What groups of consumers do you think are most inelastic?

• What type of households?
• Businesses vs residential?

• This is why commercial and industrial consumers often get lower marginal rates: They argue that they will move their business elsewhere.
• What do people think about this?

Residential rates exceed Com and Ind

Summary on fixed cost recovery

• Electric power consumption relies on a complex system of generation, transmission, and distribution. Many of these costs are fixed.
• Recovering fixed costs through marginal pricing leads to inefficiently low consumption.
• Fixed consumer charges and, to a lesser extent, Ramsey pricing can help reduce the losses, but each has problems.
• Might hope that this sort of offsets missing externality prices … but empirical evidence suggests in many places the prices are too high.

Distributed Solar Power and Retail Pricing

What happens when consumers can produce their own electricity?

• To combat climate change, need to transition to renewables asap
• Solar will probably be the dominant source of electrictiy generation in the future
  • Solar energy hitting earth > 10,000 X total energy use
• A large share of this solar is actually distributed on rooftops of homes and businesses
• How efficient will this approach be?

Grid scale vs distributed solar

What are some pros and cons of distributed relative to grid scale?

Pros of distributed generation

• No line losses (7-9%)
• Cheap real estate
  • your roof is unused space anyways (may even provide shade)
• May reduce need for new transmission /distribution lines
• Spreading panels around reduces ‘risk’ of clouds
• “Freedom” / independence from the grid etc
  • strange coalition of environmentalists and anti-government types has emerged to support PV

Source: Severin Borenstein

Cons of distributed generation

• Design and maintenance is MUCH more expensive
  • Lose all economies of scale
  • GS panels often move throughout the day to track sun
• DG installed where consumers choose, not grid operators
• Also a lot of controversy over the true cost of DG and how it should be promoted

Source: Severin Borenstein

Where should we put solar?

If you were a social planner, where would you put solar panels? and Why?

• Sunny places (low LCOE)
• High demand places (high value)
• Places with lots of polluting plants

Where will solar actually be installed if it’s up to individual consumers?

What factors will make some consumers more likely to install solar panels than others?

• High (marginal) electricity prices
• Subsidies
• Environmental preferences

The private economics of solar PV adoption

• Consumers have utility from electricity consumption \[U=\sum_{h}(u_{h}-p_{h})e_{h}\]
• \(u\), \(p\), \(e\) represent utility and electricity consumption in hour \(h\)
• most consumers face a flat price for electricity (\(p_h=p\))

Installing solar panels reduces the need to buy electricity from the grid by the output of the panels (\(s\)).

\[U_{s}=\sum_{h}(u_{h}e_{h})-\sum_{h}p(e_h - s_h) +\omega-F\]

• \(\omega\) represents the “green glow” of going solar and \(F\) is the fixed cost of the installation.
  
• Ignore discounting for now.
• Then it makes sense to adopt if: \(\sum s_{h}p+\omega>F\)

Who adopts in this model?

Adopt if, \(\sum s_{h}p+\omega>F\)

• consumers with high \(p\) and \(s\)
  • if can’t sell back, consumers with high usage too
• “environmentally conscious” consumers (high \(\omega\) )
• consumers that face low fixed costs (\(F\))
  • possibly due to subsidies

• These factors explain the patterns in following map.
• They also reflect policy options

Reminder: High marginal prices due to recovering fixed costs volumetrically

CA has steep increasing block pricing

• Goal: Recover fixed costs equitably.
  
• Result: Large consumers have a huge incentive to reduce marginal consumption.
• This put CA on top of PV, and also made adoption highly correlated with income.

Source: Severin Borenstein

Major problem

As PV owners buy less electricity, the burden of those fixed costs will be shifted onto other households

• That increase in prices will incentivize even more households to install PV…..
• This is the utility “death spiral”

One solution is to charge consumers a large fixed cost just for being connected to the grid

• What do people think about this?

What if you produce more than you consume?

Common policy: net energy metering (NEM)

• NEM allows PV owners to sell power back to the grid
• This breaks the temporal cap on solar (\(s_{h}<e_{h}\))
  • Most places in the US still require \(\sum_{h}s_{h}<\sum_{h}e_{h}\)

When customers sell solar back to the grid, what price should they receive?

• In the bill we looked at, I paid $0.217/kWh
• If I reduce consumption by 1 kWh, I save $0.217
• If I sell power back to the grid, what price should I receive?

Solar production and consumption generally not aligned

Wholesale cost avoided varies over time

In CA we often have too much solar mid-day

The price on your bill includes fixed costs

• I paid $0.217/kWh, but only half of that was for generation.
• Fixed charges \(\approx\) total system cost independent of quantity consumed, divided by anticipated sales.

So what’s the answer?

How should we compensate / encourage solar PV?

• efficient solution would
  • charge a fixed fee for everyone that uses (or may use) the grid
  • incentivize people to reduce consumption at times when it is more valuable
    • but that value is the wholesale price
• pricing externalities makes subsidizing solar irrelevant

Summary on Solar

• Solar value proposition closely related to subsidies, sun, and the price you pay for electricity.
• Subsidies have been generous, not obviously correlated with social value, and very volatile.
• Letting people sell back to the grid makes sense, but at what price?
• When large parts of the population install solar, we need to rethink how we cover the fixed costs of a reliable power system.