Guest Juice: Will Raising Electricity’s Fixed Charges Incentivize Electrification?

California has aggressive goals for electrifying transportation and buildings to help mitigate the impacts of the climate crisis. But the state also faces skyrocketing electricity rates and if they keep on going up, they will undo the value proposition of electrification.

Even at today’s high electricity rates, buying electric vehicles is a better proposition than buying internal combustion engine vehicles (ICEVs), because gasoline prices are so high. However, electricity rates have to be lowered to make buying electric heat pumps, which can slash a major source of home energy consumption and related emissions, a better proposition than space heating and water heating powered by natural gas.

State and federal government tax credits can offset much of the initial cost disadvantage of EVs. Utilities provide substantially lower off-peak rates to reduce the cost of EV charging. As a result, EV sales are accelerating at a rapid clip. Of course, they still have a long way to go before they will account for even a third of new vehicle sales primarily because of the newness of the technology, the fear of obsolescence, range anxiety and limited number of models that are available on the market.

The challenges are far greater for heat pumps because they cost more to buy and install and also cost more to operate. That’s why they are not recommended by the vast majority of contractors. Most customers don’t even know whether they exist.

Heat pumps cost more to operate because California has some of the highest electric rates in the country across all hours. Even the off-peak rate can be as high as 24 cents/kWh, compared to a national average year-round rate of 14 cents/kWh. During peak periods, the rate can rise to 56 cents/kWh. It’s not uncommon for customers on a simple tiered rate to pay more than 31 cents/kWh.

One way to incentivize heat pump adoption is to lower the price of electricity to equal its social marginal cost, which would be around 10 cents/kWh. Marginal cost is the cost of producing an incremental kWh of electricity and social marginal cost factors in externalities such as pollution. But that would lower utility sales revenue, and thus be opposed by the companies.

In a report for Next 10, three economists at UC Berkeley’s Hass Instituted have suggested recovering that revenue deficiency through a monthly fixed charge. But it would be a very high number, ranging from $58-74 a month depending on which of the three investor-owned utilities is being considered.

No investor-owned utility in the U.S. has a fixed charge anywhere close to that number. Most are under $20 and many have fixed charges under $20 with a few in the $5 range. Every utility would like to raise its fixed charges and move them closer to its fixed cost of service, which may be around $25 a month. Setting it at an unprecedented $58-74 a month would elicit serious customer pushback.

State law caps fixed charges of $10 a month. But actual fixed charges are lower. A fixed charge above $10 a month would require legislative action, which has been proposed. But there will still be the thorny issue of how to deal with the objection that fixed charges hurt low-income customers more than high-income customers, just as in the NEM proceeding.

Tying fixed charges to income levels

To address this barrier, the Next10 report proposes to exempt low-income customers from paying the fixed charge. For other customers, a fixed charge would be levied and rise with income, reaching values close to $200 a month for customers with the highest incomes.

This proposal is without precedent. There are a few utilities in the U.S. that vary the fixed charge with customer usage but even their highest value is far lower than $50 a month. Some utilities in Europe recover their fixed costs by basing it on the size of the connection. A few utilities in the country recover their fixed costs through a combination of a fixed charge and a demand charge. But no utility, as far as I know, recovers it via a fixed charge that rises with income.

Under the Next10 proposal, the average bill for higher-income customers will rise. These are the customers who are most likely to install heat pumps and buy EVs. But why would they do so when their bill rises even before they have increased their electricity consumption by installing heat pumps and buying an EV?

Even if these new income-based fixed charges were mandated and thus applied to 100% of customers, and assuming there was no large-scale pushback on the streets causing the CPUC to pull them back, there would still be the overriding question: will they succeed in boosting the sale of heat pumps?

Virtually no empirical research exists on the topic of customer adoption of heat pumps in response to such rate designs. Therefore, the state should consider doing pilots before proceeding with a policy that, however well-intentioned it might be, appears to be entirely premised on conjecture. The need is even greater because the California Public Utilities Commission approved $40 million more in electric hot water heat pump customer subsidies, for a total $95 million.

It’s worth recalling that a number of pilots were carried out with various forms of time-of-use (TOU) rates before they were rolled out. Even then, voluntary adoption of TOU rates has been low. TOU rates provide financial incentives for consumers to use energy at times other than during peak usage—late afternoon and early evenings--alleviating stress on the grid. While a few out of state utilities have reached adoption rates upwards of 20%, such as Oklahoma Gas & Electric, with a few reaching numbers in the 30-60% range, Arizona Public Service Company and the Salt River Project, they are in the 5% range for most utilities. In California, the adoption rate of dynamic pricing rates is a paltry 2%.

Another possible drawback of fixed-charge intensive rate design is unintended consequences. It would, for example, seriously dilute the incentive to use energy efficiently because there would be no reward for curbing consumption.

Why would most people, other than the really green customers, buy highly efficient appliances, refrigerators, light bulbs and smart thermostats, install energy-efficient windows, and insulate their roofs if the bulk of their bill will be fixed regardless of what they do?

Other policy options for incentivizing electrification should be considered .

I participated in a brainstorming session with a dozen California Public Utility Commission staff in April 2019 and several options were considered. They included: lowering the price of electricity (not by redesigning rates but by adjusting the revenue requirement), raising the price of gas (by imposing a tax), providing tax credits and rebates for heat pumps, imposing a tax on natural gas-fueled appliances, such as furnaces, water heaters, clothes dryers and cooking stoves, banning the sale of gas equipment, and, finally, arresting people selling, installing or using gas equipment.

All of these options should be considered along with an income-based fixed charge concept to reach optimal results for consumers and the environment.

The bottom line is that if California is really serious about electrification, and wants to base electricity prices on social marginal cost, it should move the bulk of utility fixed costs to the state budget, which is financed by a progressive income tax. That will significantly lower customer bills and encourage electrification.