There is an ongoing debate in the media and before regulatory commissions on the use of fixed charges in electric utility rates to properly recover the costs of serving customers who have installed distributed generation (DG) resources, such as solar. 

While most of the media debate appears to reflect partisan supporters staking out positions that directly benefit their financial interests, the concepts underlying the use of fixed charges, and even the definition of fixed charges, have not yet been adequately discussed.

The purpose of this post is to define the parameters of the debate about the use of fixed charges and to demonstrate that both economic efficiency and achieving the least cost alternative for a safe and reliable utility grid dictate that modern rate designs include the recovery of a utility’s fixed costs through fixed charges. This is not just a single customer charge as is traditionally designed, but also includes multiple demand charges for the pricing of different services.

To begin, it is useful to understand the significant change in the structure of the electric industry as the result of DG options such as solar now being readily available to a utility’s smallest customers. 

Why many utility rate designs have not changed since the 19th century

Historically, electric utilities served full requirements customers whose load patterns varied with the end uses served by electricity. The electric utility competed with gas, oil and propane for loads such as heating and water heating. If they lost those loads to a competitive energy source, the customers’ requirements for plant investment were simply reduced as a result of their lower maximum load requirements. Alternatively, the capacity resources were reallocated to serve the growth in electric load from other customers. 

Rates were designed to recover costs for the residential class based on differing load profiles using a declining block rate structure that recognized the higher unit costs of smaller kWh use customers. Even in that era, it is likely that larger customers within a rate class subsidized smaller customers in the class.  Those subsidies are exacerbated with flat or inclining block rates today.

In contrast, partial requirements customers do not change their demand profile for distribution and may not change their requirements for production and transmission. However, they do change the amount of electricity they use (resulting in reduced kWh) and thus limit the ability of the utility’s consumption-based rates to fully recover its fixed costs to serve such customers. 

With the advent of DG and particularly PV solar, the nature of the utility model and the services it provides has fundamentally changed.  The new industry structure is now a mixed monopoly and competition model. DG customers are a class of partial requirements customers because they still require a variety of services from the utility while also providing energy or kWh competition for the generation portion of the electric system. So long as these customers remain connected to the utility, they continue to take other services from the utility. The ancillary services they require typically include starting capacity to meet the in-rush current requirements for starting motor loads such as air conditioning compressors, supplemental services when solar is not available at night, and frequency services to maintain power quality.

For most electric utilities, current rate designs have not changed since the 19th century. Those rates were developed to recover costs from full requirements customers whose electric use was homogeneous. Partial requirements customers no longer look like or use electric services the same way as full requirements customers. In a mixed monopoly and competitive market model, the solution for efficient cost recovery is to unbundle utility rates and charge customers directly for only the services they actually use. This means changing from the 19th century block rate structure to a more efficient rate design. An efficient rate design requires recovering fixed costs in the utility’s fixed charges to ensure customers are incentivized to make economically rational energy decisions.

Why fixed charges may not be what you think they are

The concept of a fixed charge within a utility’s rate structure is much more than its traditional monthly customer charge. To be clear, the definition of a fixed charge as used herein does not equate to the concept of a customer charge. Rather, it also includes a variety of demand charges to recognize the different utility services provided to partial requirements customers. Attempting to recover fixed costs for all of the utility services used by partial requirements customers through a single fixed charge is not feasible, and could never produce a reasonable result. Moreover, a single fixed charge cannot provide efficient price signals for customers whether they are partial or full requirements customers. 

With the advent of the mixed monopoly and competitive model, the “one size fits all” prescription for rate design must be discarded because the impact of competitive entry is to drive out subsidies where those subsidies are otherwise recoverable in charges for the service that is competitive. In this case, such charges consist of the utility’s usage-based kWh charge.

The often cited California rates where solar has achieved significant penetration provide a perfect example of the cross subsidy in usage-based utility rates. The current fixed charge for Pacific Gas & Electric Company (PG&E) is about $4.50 per month. This charge will typically not compensate the utility for more than the meter and service line. As such, there is no rate revenue remaining to recover the costs of customer services and the fixed investment in facilities at the customer’s location (e.g., the smallest size of transformer). All of the other costs are collected through the utility’s inclining block rates that have a charge in excess of $0.33 per kWh in the highest rate block. In fact, the cost for this rate block is over 60% higher than the average unit rate. There is no question that the charges for the higher rate blocks subsidize the lower tiers and the subsidy provides added incentives to customers for the further adoption of the competitive market alternative.

To the extent the utility’s net energy metering tariff allows the customer to use zero net kWhs each month, the resulting bill would be equal to about $4.50 per month for all of the services used by the DG customer. Absent investment in storage for excess generation and excess capacity in the DG investment sufficient to be able to start motor loads (somewhere between 2 and 8 times the rated load of the motor), the customer will require use of the utility’s generation, transmission and distribution system to serve its load when solar is not available and to allow the solar generation to serve motor loads when it is available. Essentially, the solar customers will have the same fixed distribution costs that they had before installing solar, and potentially they may cause the utility to incur incremental costs after installing DG to provide the types of ancillary services described earlier.

Why fixed charges send the right message

The utility must have a ratemaking mechanism to recover the fixed costs that it incurs to provide delivery service to its partial requirement customers. These costs are fixed costs based on the maximum demand of the customer whenever that occurs (i.e., the maximum non-coincident demand). These costs cannot be recovered through usage charges simply because the revenue generated from these charges could be zero if the customer achieves net-zero energy consumption during the month through its DG resource.  Moreover, these fixed costs cannot be recovered through a fixed customer charge because such costs will differ from one DG customer to the next due to their unique load characteristics. 

The rational and efficient method to recover distribution system costs is through a fixed charge based on the maximum kW demand whenever it occurs subject to a 100% ratchet based on that demand level. (A ratchet is a billing option that allows for a demand charge to be based on the higher of the current month’s demand or the demand that occurred during the ratchet period in a previous month.) 

Since the utility’s service obligation is to have available the delivery capacity to meet the customer’s maximum demand, this fixed charge results in a proper matching of the costs incurred to serve the customer and the revenues the customer generates for the separate or unbundled distribution service. The use of unbundled rates results in price signals to use the utility system more efficiently. This same conclusion relates to separate fixed charges for generation capacity and for transmission capacity. The chart below is illustrative of this issue.

An unbundled rate design also needs to reflect time varying energy charges so that customers who use DG are incentivized to maximize their energy output at the times when energy costs are highest, or to use storage to minimize their total energy costs. Contrary to the claims of some solar advocates, fixed charges will not cause customers to, “lack clear signals to act more efficiently, adopt appropriate technologies, or utilize DER to improve the grid for others.” 

Instead, a utility’s fixed charges will create the proper price signals to incent customers to make more efficient and cost-effective energy investment decisions. The resulting decisions will be made in light of the costs of the actual monopoly utility services that the customer requires relative to the customer’s own competitive energy and production capacity costs. If the customer’s DG resource also reduces other costs such as the utility’s transmission or distribution costs, those savings will also accrue to the DG customer as reduced fixed charges, but they can never be zero as long as the DG customer requires the grid for partial requirements service.

The use of fixed charges to recover the fixed costs of unbundled utility services in the new mixed monopoly and competition model produces the best possible economic outcome for all customers — both now and in the future. Smart rates that include fixed cost recovery through fixed charges for the pricing of a utility’s monopoly services assure that safe, reliable and high quality grid services continue to be available at the most reasonable cost for consumers. Markets work so long as price signals are efficient — and the fixed charge concept is fully supportive of that important outcome.