Severin Borenstein “The Economics of Fixed Cost Recovery by Utilities” (Revised July 2016) (Revised version published in The Electricity Journal, 29(5): 12, 2016) | WP-272R

Standard microeconomic analysis makes clear that economic efficiency (i.e., total economic value) is maximized when the prices of goods are set equal to their full societal marginal cost, which includes both the producer’s private cost and any external costs imposed on others. Applying this theory to electricity pricing implies that volumetric price should vary over short time intervals and should reflect both private costs and externalities, regardless of whether the supplier has to pay for those externalities. Setting electricity prices below efficient levels encourages customers to use electricity even when their value of it is low — in the short run, for example, running an electric clothes dryer when electricity is scarce, or in the long run failing to invest in cost-effective low-energy lighting. Setting prices above efficient levels discourages substitution away from other energy sources (for example, natural gas heating or gasolinepowered transportation fuels) when it would create economic value for society.

However, efficient pricing of electricity will in many cases fail to cover all of the provider’s costs, for multiple reasons: much of grid infrastructure cost is fixed, utility revenues are expected to cover some public purpose programs whose costs are not marginal (subsidies for low income customers, energy efficiency programs, distributed renewable generation incentives, among others), and recent declines in electricity demand accompanied by growth in near-zero marginal cost generation that has pushed down system marginal cost in many hours.

In this policy paper, I review the guidance that economics provides policymakers when they must cover a profit shortfall using one or more of the common revenue-generation options: raising volumetric retail prices, tiered pricing, fixed charges, minimum bills, demand charges, and frequent rate adjustments. I conclude that there is no ideal policy, but that balancing efficiency and equity suggests using a combination of fixed charges and increased volumetric prices. I argue that economics does not support the use of demand charges or minimum bills and that frequent rate adjustments do not address the systemic revenue shortfall that will often result from efficient volumetric pricing.