More Fixed Cost Thoughts

A researcher in the energy policy field recently asked me:

Dear Karl:

I am doing some research on current proceedings on fixed charges and net metering reform, and trying to place these issues in historical context. So I was interested in your comment that there is no economic justification for attempting to align customer bills with cost causation and hoping that you can elaborate.
My interpretation of the current proceedings around the country is that utilities present cost of service studies, which are prepared by their consultants, to justify a rate structure that aligns with their financial incentives. The common refrain from the consultants, utilities, and PUCs is that aligning rates with the costs of service sends appropriate price signals to customers.  This justification seems consistent with Alfred Kahn and other economists who have argued that rates should be set at marginal cost.
I’m a bit skeptical of whether this logic applies to residential rates because demand is somewhat inelastic and consumers are not going to react in an “economically efficient” manner to electric rates. Nonetheless, I find it difficult to argue with the established economic mantra.
The missing link in the utility’s arguments, and the point which seems to lack any economic basis, is determining which costs should be recovered through fixed charges and which should be included in variable rates. I can’t find anything in economic literature on this.  The utilities’ studies are self-serving, and PUCs seems to recognize that cost of service studies are more art than science, but nonetheless they often go along with them.    
Does this short sketch of the process match your take of the current arguments?  Or are there other utility justifications that lack any economic basis? I would have wanted to hear you speak more on these proceedings, but I suppose NCRA was interested in other issues.

I wrote back:

We agree, and I make additional arguments.
1. The textbooks on ratemaking properly assert that rates should REFLECT costs. That means that the costs properly attributable to a class should be collected through the rates for that class. The fallacy is extrapolating that argument to suggest that RATE STRUCTURE should reflect COST STRUCTURE. For that argument, I find zero support in the economic literature. This proposed symmetry in rate and cost structure is appealing to the ear and the flaccid mind, but contributes nothing to inform rate design in a world in which, as you recognize, customers have few tools to manage customer charges, demand charges, and variable charges independently and with precision (meant to reflect fixed customer costs, fixed production costs, and variable production costs) and separately. 
I use the Starbucks example, but many others abound. Starbucks is very high fixed cost, and they would be out of business if they didn’t REFLECT those fixed costs in their “rates.” But they price on pure variable prices because that is what works for customers who want to buy coffee. I know they try to sell higher cost items with more mark up, but the core biz is variable priced product. If economic efficiency demanded symmetry between cost structure and price structure, they should be out of business. But it doesn’t, and they are doing pretty well. Note also that if Starbucks tried a fixed charge business model, they would be quickly beat to a pulp in the market place. 
You might ask - does having a monopoly mean it is more efficient for prices to have a high fixed component? Yes, but only if your goal is to strengthen the monopoly, insulate it from market place competition, and allow it to collect uneconomic rents. In this, the largest, most successful free market democracy the world have ever known, we should be challenging every monopoly we grant every day.
Consider what happens if utilities were allowed to put all their “fixed” costs into fixed charges - the ultimate in what they purport is economic efficiency? Since all costs are variable in the long run (as all are fixed in the very short run), putting today’s fixed costs into fixed charges removes the market impact of long-run elasticity (the only kind that we have evidence for in the residential sector). It also reinforces the overbuilding that has characterized the utility industry for the last several decades. (The ratemaking formula is bad enough--see the Averch-Johnson effect.) It confuses fixed costs with sunk costs and guarantees the recovery of the latter without due regard for ratemaking principles such as “used and useful,” and “prudent,” and “just and reasonable.” Nice work if you can get it--but they shouldn’t get it.
Note that a competitive market would not tolerate the high fixed charges, and regulators are supposed to be a substitute for competition. We should make them where a bracelet - WWCMD - What Would Competitive Markets Do?  (This is the itch people are trying to scratch when they say: “This is the Uber of the XX sector.”)
2. Moreover, the adoption or increase of fixed charges does a huge amount of damage to powerful and important policy objectives — relating to the conservation and efficient use of energy. So it is not just that elasticity is very low, but fixed charges mean that as we gain tools to manage our energy use, we are sending signals that increase consumption. This is a point not lost on utilities whose revenues have stagnated of late. We should design rates to encourage the consumption behavior we desire; fixed charges are just an argument for monopoly rents.
3. It is not lost on me that there could be a model where high fixed charges would be a desirable model: (1) where the distribution utility is a pure platform provider, without a profit model driven by increased sales (and no, most decoupling regimes do not, in fact, make utilities completely indifferent to the consequences of reduced volume of sales, and especially not to reduced demand for capital investment). Or (2) where the utility is a comprehensive provider of all kinds of supply and demand resources with a performance objective of ensuring customers have the most affordable BILLS possible. I am skeptical that the old dogs will learn new tricks, but I am willing to imagine such a world. RIIO?
4. Fixed charges are regressive. This is as much a function of failure to adequately segment among customers as anything, but low income customers are weighted in the low consumption bins. In the absence of a compelling argument for economic efficiency or other strong public policy goal, high fixed costs are therefore predatory and immoral. (I mean that last word exactly.)
5. The characterization and allocation of costs does not come from God on stone tablets. I often quip that I have only done a few hundred rate cases. But what I have learned is that there is a great deal of subjectivity in the allocation of costs to “energy” or “demand”--which ultimately leads to the variable vs. fixed labeling of the charges. This debate offers nothing regarding joint and common costs, which are always subjectively allocated. Nor does it deal with the fact that costs associated with large industrial customers are typically off the books in competitive contracts or under “load retention” or “economic development” rates that usually fail to pay their fixed costs fully, and sometimes at all. 
Nor does it deal with the econo-babble that is the argument about how a 1CP is better than a 4CP is better than a 12CP in allocating costs to customers, especially when there is compelling evidence that a modest effort at customer segmentation would reveal that many low income customers have very un-peaky demand curves due to their energy poverty. Still, many utilities have been simultaneous bucking the competitive market trend toward segmentation and even have been consolidating customers into bigger and bigger classes with huge ranges of customers. How fair is it that the peaky Yuppie in the McMansion (I have been one) should drive the cost allocator for the poor family with a window unit, box fan, refrigerator that all run constantly? How fair is it to then impose the costs under that allocation disproportionately on the low users?
And even if these efforts to assign virtually all peak to residential and small commercial customers made “sense,” the logic that customers need to be sent a price signal rings hollow when the utility simultaneously fights to reduce or avoid programs that empower customers to address their peak AND seeks to weaken the only meaningful price signal they receive today--the volumetric energy charge.
In the end, the utilities who are doing so seek to guarantee revenues (rents) in a time of revenue uncertainty. I understand them trying, but am really ashamed of them for it and for the regulators who mindlessly serve those wishes without consider the alternatives, much less use this moment to drive much-needed transformation.
Hope this helps!
Karl R. Rábago

Executive Director
Pace Energy and Climate Center
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