Inverted Power Rates?

A persistent refrain among environmentalists is that we must reduce our demand for electricity in order to moderate the environmental consequences of its production and distribution. In many actions they have attacked the utility industry for its promotional practices, ranging from advertising to pricing—especially the volume discount offered on price per kilowatt-hour to large users. With the environmental concern reinforced by power shortages over the past year or two, the regulatory authorities also have begun to look at means of restraining demand. For what may be the first time, these considerations appear to have influenced an electricity rate decision in 1971. The New York Public Service Commission required Consolidated Edison to raise its rates to large industrial users by a greater percentage than for small industrial users in New York City. Other commissions initiated studies or issued warnings during the year but have not changed rate structures.

Heretofore, electricity rate structures have generally featured per kilowatt-hour rates that decline as monthly consumption increases. The implied criterion is that there are economies of scale in electricity production and distribution, which this rate structure reflects. The cost standard is not strictly adhered to, however, for cost differences between peak and off-peak power rarely are recognized in rate structures; the far more costly peak power generally is sold at the same rate as off-peak power.

However, if pricing is intended to restrain consumption, electricity rates need not reflect costs of service to different categories of customers at all (so long as total revenues are sufficient to match costs); the way is cleared to penalize large users by higher rates, rather than giving them volume discounts. This idea, called an inverted rate structure, has found a number of supporters. It also raises a number of questions.

One major issue is whether inverted rates will be effective in reducing demand. Recent studies indicate that over time the responsiveness of demand to price changes may be greater than once believed. This may be due in part to the increased role of electric home heating, which competes with oil and gas. Air conditioning and other uses also may be price elastic over the longer term, though further analysis is required to determine the extent.

Opponents of inverted rates tend to focus on industrial users and on shorter-run effects in arguing that electricity consumption will not be responsive to moderate price changes. For industrial users, power cost is a small part of total costs in most cases, and they would be slow to reduce consumption. Where it is a larger component, they might be tempted simply to relocate elsewhere if rates became too high. Householders also might not reduce their consumption much, especially at peak periods. Moreover, increased consumption by small users might partially offset the decline by large users. Opponents also argue on equity grounds that inverted rates place an unfair burden on those who already have invested heavily in electric heating and appliances. This concern probably could be met by giving special consideration to such customers. A power system's capacity—and therefore some of its environmental consequences—must be built to satisfy peak demand. But inverted rates may not be very successful in restraining peak demand. People are unlikely to turn off their air conditioners on the hottest days in response to higher rates—more likely they will cut back during off-peak periods, thereby reducing the system's load factor and raising overall costs.

Even if consumption of electricity can be retarded by inverted rates, one must ask what becomes of the suppressed demand. It may simply be diverted to other forms of energy, in which case we most compare the relative damage to the environment of electricity and other energy forms. Or if rates are too high, large users might be tempted to generate their own electricity, even if less efficiently and at some environmental cost. Perhaps both of these diversions could be prevented by regulation or taxation, but, unless they are, the net environmental effect of inverting electricity rate structures becomes uncertain. Critics of rate inversion would argue that it is more sensible to deal directly with the environmental impact of each project and to impose direct charges against damaging pollutants rather than to rely on inverted rates to accomplish improvement indirectly.

Proponents of rate structure inversion have not dealt systematically with these considerations. The major element in their thinking is that many uses of electricity are needless luxuries, although they do not attempt to establish the case in careful detail. Their argument is simply that consumption must be limited and a change to inverted rates is in the right direction for restraining demand. Since pollution damage probably increases more than proportionally as consumption rises, the inverted rates are a kind proxy for the pollution taxes we have failed to impose. Moreover, an inverted structure would not encourage use during peak periods as the present one does. Proponents also may argue that the change will have favorable income distribution effects, since smaller (poorer) users would pay less than larger (richer) ones. This proposition is a deceptive oversimplification, however, since large users include the New York subways (which serve the poor) and many single-meter apartment buildings where higher rates would be passed on in rental charges to poor tenants.

Economists tend to grow uncomfortable whenever price deviates too far from cost. There are real cost advantages to larger scale both in the production and distribution of electricity, and from the economists' standpoint it is appropriate that these be reflected in price. By the same token, the failure of existing structures to take into account the higher real cost of peak power is not defensible. While inverted rates might discourage some peak use, a more logical response would be to charge more to those actually using power during peak periods, leaving large off-peak users free to claim the cost advantages of large blocks of power. Moreover, many economists would feel that the income redistribution resulting from inverted rates, if a desired goal, might better be achieved in other ways. In general, it seems dubious practice to seek arbitrary restriction of demand. If the price of power is made high enough to correct the environmental costs of its production, then there is less basis for limiting power output. If, however, we become determined to ration electricity use, inverted rates will appeal as a means of equalizing distribution of the supply.