Time-of-day Electricity Rates?

Pressures for change. The electric rate-structure issue has been brought to the fore by the convergence of environmental and economic pressures. These pressures are forcing a reform advocated by American economists who have long been "marginal cost"-pricing advocates. William Vickrey and others raised the issue to academic visibility in the mid-1960s, but their ideas did not go far in the policy arena. In keeping with its established policy of exploiting economies of scale, the electric power industry was building larger generating units, and electricity prices were falling. Customers of all kinds found little to complain about and still less reason to support a reevaluation of pricing practices.

But by the late 1960s economies of scale in the generation of electricity were largely exhausted. At about the same time the electric power industry, as a major regulated industry with significant environmental impact, became a focus of environmental concern. The consensus built on the record of falling prices began to disintegrate.

An early target of the environmentalists was the "declining block"-rate structure which sets lower prices on successively higher rates of consumption. Arguing that volume discounts to large users promoted not only electricity consumption but air and water pollution as well,. environmentalists advocated "inverted block" rates designed to charge larger customers higher prices per kilowatt hour.

A second focus of environmental controversy, the siting of the new nuclear and thermal power plants required by an expanding electric power industry, raised the question of how much generating capacity is really necessary and can be tolerated by the environment. That line of questioning leads to marginal cost pricing and therefore to "peak-load" pricing, perhaps the best means of imposing capacity costs on those causally responsible for the incurrence of those costs. Thus the stage was set for the reappraisal of the rationales for setting electricity rates.

How prices have been set. Since most American electric utility companies are privately owned, prices are set high enough to allow stockholders a fair return on capital. But this simple target is compatible with many rate structures and does not go very far in helping a state regulatory agency translate a utility's costs into bills to be charged individual customers—that is, into rate structures which apportion the cost of producing electricity among consumers according to their pattern of consumption.

Consequently, the fair-return objective has generally been put into practice according to a few widely accepted rules of thumb. These supplementary rules reflect long-established procedures for allocating costs and long-accepted conceptions of the costs of generating, transmitting, and distributing electricity. Bills typically are based upon total monthly consumption—and for large commercial and industrial users, upon the customer's maximum rate of energy use during the month as well. However, no account is taken of customer consumption at the time of maximum demand on the system—the key factor determining the size of the generating plant—and thus the full cost of providing service is not taken into account.

Marginal cost pricing. The marginal cost pricing doctrine seeks to apply to the public utility sector the efficiency yardstick that competition imposes in competitive private sector markets. The marginal cost rule demands that all customers be charged for the marginal, or additional, costs they impose on society, and that no customer willing to pay the full marginal cost of his or her consumption be turned away.

But how can general marginal cost rules be applied to electricity pricing? The guidelines are clear enough, given a little thought about the special characteristics of electricity. The demand for electricity changes rapidly over the daily cycle: little electricity is being used in the early morning hours, but the demands of residential, commercial, and industrial customers rise rapidly during the working day, peaking sometime during that period and then subsiding again. Clearly, generating capacity cannot be altered rapidly enough to match demand: from planning to completion, base load generating plants take about ten years to bring on line. Capacity must therefore be sufficient to meet peak-hour electricity demand. In off-peak hours, much of the capacity is unused. In summary, peak-hour users of electricity are responsible for much of the capacity cost incurred by an electric utility. Marginal cost principles do in fact require that peak-hour users pay much of this cost, in addition to the fuel costs they impose. Off-peak-hour consumers, by comparison, impose little more than the cost of the fuel burned in serving them, and should be charged accordingly. Marginal cost pricing principles lead to the prescription that electricity prices should be peak-load, or time-of-day prices.

The workability of marginal cost pricing has been demonstrated by France. Beginning in the post-World War II years the French electric power supply system charged industrial and large commercial customers marginal cost rates in an effort to moderate the peak demand and, consequently, the capacity requirements of the system. Regulatory commission decisions in Michigan, Wisconsin, and more recently in California are harbingers of a change in American practice. The wording of the California decision, rendered in October, is unambiguous: "We desire that progress be made in implementing the concept of peak-load pricing. In furtherance of that end, the respondent electric utilities should file specific proposed peak-load tariffs, by applications or advice letters, for review by our staff and interested parties."

A number of utility companies are also studying the problem, and a million-dollar project has been undertaken by the Electric Power Research Institute (with the backing of the National Association of Regulatory Commissioners and the Edison Electric Institute) to study the technology, cost, and feasibility of time-of-day pricing.

The FEA, which has actively intervened in some rate cases to encourage time-of-day pricing, has financed a number of test projects in various parts of the country. These projects combine time-of-day pricing and load management control (a technique for cutting off electricity for certain kinds of uses, such as hot water heaters, at peak-load periods).

Obstacles to reform. Environmentalist pressure was central in prompting the current broad reappraisal of electricity pricing policy, but it alone probably would not have been sufficient. Reinforcing this pressure were rapidly rising costs and prices: first, beginning in the late 1960s, the steeply rising cost of new generating capacity, and then the rapid increases in fossil fuel prices following the Yom Kippur war. As costs and prices rose, customer pressures on regulatory agencies and customer intervention in the many electricity rate cases led to a near breakdown of the regulatory process, and made the present reappraisal a necessity.

The fresh look at how to price electricity is leading to some practical recommendations. The discouraging aspect of this bright picture is the difficulty of obtaining a hearing for a sensible reform, the state-by-state piecemeal effort that will be required to approve such a change, and the time required to change users' habits and to introduce equipment that will enhance the effectiveness of the new rate structures.