Ratemaking and the Campaign Against Rooftop Solar

Ensuring that rates are just and reasonable and not unduly discriminatory is at the core of regulatory oversight of electric utilities. These ratemaking standards were codified and initially interpreted by public utility commissions during a different era, when the industry's rapid expansion was the goal that aligned utility profits with the public interest. 

This article examines these terms in the context of ongoing debates about utility rates and rooftop solar, as well as parallel episodes in the industry's history. It concludes that regulators should ensure that changes to rate design seek to balance consumer and utility interests. Rates that are intended to insulate utilities from economic and technological change while providing no benefits to consumers ought to be considered unjust, unreasonable, and unduly discriminatory.

Faced with revenue challenges due to flat demand, many utilities are arguing that misalignments between their costs and revenue collected from residential consumers must be corrected with revised rate designs. These utilities assert that unfair rate designs enable residential consumers who use less to pay less than the utility's measure of its cost to serve them.

They are urging regulators to eliminate cross-subsidies in residential rates that allegedly flow to consumers who have adopted rooftop solar and other technologies, from those who have not. Their proposed remedies include higher fixed fees and lower rates for distributed generation, which reduce ratepayers' incentives to adopt new technologies, or to otherwise buy less electricity from their utility.

The debates about these utility proposals reflect underlying tensions between regulatory goals. Just and reasonable rates must balance consumer and utility interests. While providing utilities with opportunities to profit during a period of flat demand is a legitimate end, increasing fixed fees weighs in favor of the utility, with little or no benefit accruing to ratepayers.

Rate regulation is intended to serve as a substitute for competition, but raising fixed fees and reducing rates for energy provided by alternative sources, such as rooftop solar, only reinforces the incumbents' position. These reforms blunt technological and business model innovations and consumer behavior trends that are ostensibly incompatible with the industry's century-old, top-down, cost-based revenue collection system.

The utility rate case is the primary forum for balancing consumer and utility interests. Ratemaking is intended to produce the rate that would result if electricity distribution were not a monopoly. Such a competitive rate permits a utility to recover its operating expenses, plus a reasonable rate of return on its investments. 

This amount, commonly called the utility's revenue requirement, ties total utility costs to revenue earned from consumer rates. To be considered just and reasonable, the resulting rates may neither be too low so as to be considered confiscatory, nor too high to permit the utility to earn monopoly rents.

The prohibition on undue discrimination is a second linchpin connecting rates to utility costs. A utility may not play favorites among its customers by charging different rates to similarly situated consumers that cost roughly the same to serve.

Connecting rates to costs also provides a framework for setting rates for various classes of ratepayers. So-called cost-of-service studies assign to each class of ratepayers the share of total costs that the utility incurs to serve that class.

The regulatory process allows utilities, ratepayers, and other interested groups to present competing studies that demonstrate that each group's preferred rate design matches its allocation of utility costs to ratepayer classes.¹

Naturally, each study reflects the financial goals of its sponsor. Just as each group's lawyers zealously advocate their client's position before the commission, so too, engineers and economists fine-tune their results to meet client objectives. 

The manipulability of these studies is well recognized. Writing in 1961, James Bonbright concluded these studies, "lack any objective standard of rationality," and an analyst's choice of cost allocation formula reflects, "whatever rate structure is advocated for non-cost reasons."

Thirty years later, NARUC's Electric Utility Cost Allocation Manual noted that, "costing methodologies have inspired numerous debates on applications, assumptions, and data." And that results are a function of an analyst's considerable judgment. 

Many regulatory commissions and reviewing state courts have recognized the limitations of cost-of-service studies, finding that they are subjective, and useful as a guide only, because they are not accurate enough to establish the precise cost of providing service to any class. Even the U.S. Supreme Court has found that "cost allocation has no claim to an exact science."

That is why courts reviewing commissions' rate design decisions are particularly deferential. Rate design is more a matter of policy than law.²

Utilities' recent and pending requests to remedy cross-subsidies are premised on cost allocations that go a step further than usual. Cost-of-service studies typically output cost allocations to each class of ratepayers, resulting in rates for individual consumers that are based on the cost to serve an average ratepayer in that class.

Any claim about a specific subsidy between ratepayers in the same class ignores the fact that costs to serve individual ratepayers depart from the mean based on numerous factors. The largest cross-subsidy relates to individual households' consumption patterns.

While economists have been arguing for time-of-use pricing for decades, nearly all residential ratepayers still pay flat rates. Instead of aiming reforms at on-peak users, utilities portray lower-consuming ratepayers as freeloaders who are not paying their fair share of the utility's revenue requirement. 

Utilities attempt to justify higher fixed fees by connecting the supposed cross-subsidies to an under recovery of fixed costs. This result is grounded in an allocation between fixed and variable costs that is often at odds with the utility's own past practice³ and an unjustified assumption that fixed costs ought to be recovered through fixed fees.

One utility in Missouri candidly admitted to the commission that while it was once indifferent about whether costs were characterized as fixed or variable, flat demand has made it "increasingly difficult for the company to accept this risk of immediate under-recovery."

Accepting this utility's rationale would insulate it from short-term risks while providing no benefit to ratepayers. Not surprisingly, a range of interest groups, particularly companies marketing rooftop solar, have disputed these studies, and presented alternative cost allocations.

Whichever allocation regulators select, cross-subsidies, an inherent feature of utility rates, will remain. The issue is what the effects are of those subsidies, and whether they appropriately balance the public interest with private profit. Ironically, utilities have been on both sides of debates about cross-subsidies.

In the 1950s and 1960s, the industry's golden age, electric utilities competed with oil and natural gas distributors for market share in American homes. To convince people to heat their homes and cook their meals with electricity, and to induce builders to construct homes wired for increased consumption, utilities offered discounts and incentives, such as lower rates for customers who adopted electric heat and free underground connections for construction of total electric homes.

Utilities recovered the costs of these promotions from all ratepayers. Consumers that did not or could not directly benefit from these programs, paid through their rates for unrecoverable rebates that benefited participating customers or subsidized residential construction.

Competitors that provided oil and natural gas for home use complained that rates that provided for cost recovery of these promotions were unjust, unreasonable, and unduly discriminatory because they included cross-subsidies that flowed from captive ratepayers. Utilities typically responded that subsidies were beneficial to all ratepayers because, for example, increasing the use of electric heat would utilize utility assets in the winter that would otherwise sit idle until the summer peak.⁴

Regulators tended to side with the electric utilities, concluding that there was nothing unduly discriminatory about cross-subsidies. As examples, in approving cost recovery of expenses to wire new homes, Georgia regulators explained that "the fact must be accepted that seldom will any new action or step taken in the utility business be of immediate benefit to a hundred percent of the citizens of Georgia."

The New Jersey commission noted with approval that promotional incentives date back to the industry's earliest days, when companies offered free replacement light bulbs paid for through utility rates. In New York, regulators issued guidelines for future promotions, requiring that costs be recoverable in a reasonable period of time through expected increased sales.

The industry was infused with a culture of growth, exemplified by these incentives and promotional rate structures. With declining block rate designs, then an industry norm, a ratepayer's volumetric rate decreased as it consumed more.

With utility sales growing by ten percent per year, and economies of scale still being unlocked, the connection between private profit and the public interest appeared to be as strong as ever. However, by the 1970s, that connection had to be fundamentally reevaluated. A range of factors, some specific to the industry and others affecting the whole economy, created a perfect storm.

Utility costs increased sharply, demand growth slowed, and residential rates ballooned. The industry appeared to be caught off guard. Because utilities had overestimated demand growth, they were investing in thousands of megawatts of unneeded and expensive capacity. 

In response, and often over utility objections, regulators reformed utility rate designs. As the Wisconsin commission explained in a landmark 1974 decision, the days of encouraging growth are gone, probably forever.

To replace promotional rates, Michigan regulators took a broad view of just and reasonable rates and concluded that they must "look beyond the revenue-producing aspects of a rate structure if it is also to meet the requirements of a sound public policy. Rate structure[s] must be designed to enhance basic public policy objectives in areas of consumerism, environmental protection, public health and safety, and conservation of natural resources."

In many states, utility-run conservation programs complemented new rate designs. Like the costs of promotions, the costs of conservation programs were spread across all ratepayers, potentially enabling non-participating ratepayers to subsidize participants' energy savings.

To minimize the harm from this so-called paradox of conservation, regulators developed cost-benefit analyses, and allowed for cost recovery only of programs that met certain thresholds. Regulators rationalized both promotional and conservation incentives on the grounds that they benefited the utility system, even though direct benefits flowed to only a few ratepayers.

Contrast that result with the recent decision in Nevada, now on review in state court, that sharply reduced the rate paid to ratepayers with solar. The commission concluded that rates must be "based on the actual, measureable costs of providing service," while the "benefits/values of [net energy metering] should be evaluated in the resource planning process."

This policy choice to ignore one side of the cost-benefit equation in rate design is at odds with how regulators have approached similar issues in the past. However, in general, regulators' decisions on rate designs are matters of policy, and not clearly compelled by legal doctrine. 

The requirement that just and reasonable rates must balance consumer and utility interests typically applies to the revenue requirement, not the rate design. Nonetheless, the classic ratemaking standards can, and indeed should, inform rate design.

A principled approach to rate design is warranted because a commission's rationale for adopting a particular rate design may set precedent that it can reinforce in subsequent rate cases, and that state courts can enshrine into law when tasked with reviewing a rate case.

While facts may change, regulatory and legal decisions can have long-lasting effects. Commission decisions today could set the industry's course for decades to come.

Without other reforms, the policy choice to set rates that do not account for the benefits of solar fails to meet the classic definition of just and reasonable.

If both the utility and residential ratepayers are economically rational actors that respond to price signals communicated by utility rates, the benefits of solar would not need to be computed because they will be captured as an inevitable consequence of efficient market activity. But this textbook result requires, among other things, that ratepayers have perfect information about the costs of consumption and the value of investment self-generation, that there are no significant market barriers or regulatory incentives that impede efficient behavior, and that rates accurately reflect externalities and utility costs.

Current regulatory structures fall well short of achieving these economic ideals. Simply reducing the rate for solar to a rate that reflects only short-term utility generation costs protects the utility without providing any benefit to ratepayers, and is therefore unjust and unreasonable.

That does not suggest that existing rates are necessarily just and reasonable. Rather, as the historical examples illustrate, a just and reasonable rate should capture the value to the utility system. Any cross-subsidies that flow to solar adopters will be justified by system-wide benefits.

Similarly, fixed fees protect incumbents and limit ratepayers' abilities to be more efficient. They leave the largest cross-subsidies in place and do not move regulation closer to sending meaningful price signals. Regulators would be on solid ground in concluding that high fixed fees weigh too heavily in favor of utility investors and are therefore not just and reasonable.

Unjust and unreasonable rates that protect the utility from competitive forces are also unduly discriminatory. Undue discrimination is historically rooted in preventing anti-competitive practices, such as favoring a particular ratepayer. This connection between discrimination and the economic self-interests of monopolists was a key component of FERC's argument to advance competition in wholesale generation.

Prior to the wholesale reforms of the 1990s, utilities were using their transmission tariffs, which were approved by regulators, to block competition in generation. FERC concluded that these unduly discriminatory practices were "denying consumers the substantial benefits of lower electricity prices."

The commission found that "utilities owning or controlling transmission facilities possess substantial market power; that, as profit maximizing firms, they have and will continue to exercise that market power in order to maintain and increase market share, and will thus deny their wholesale customers access to competitively priced electric generation."

Moreover, FERC reasoned that "the incentive to engage in discriminatory practices is increasing significantly as competitive pressures grow in the industry." FERC's remedy was to require transmission owners to offer open-access transmission tariffs that provide comparable access to all customers. FERC has since expanded the applicability of its undue discrimination analysis, finding that it is necessarily required to take notice of the general developments in the electric industry in deciding what generic reforms may be needed to ensure that tariffs do not unduly discriminate against any class of customers.

Similar logic applies to the distribution system. FERC concluded that transmission-owning utilities were monopolists who would "inevitably act in their own self-interest to favor their own generation." These are the very same utilities that today are using the state regulatory system to insulate themselves from the growth of rooftop solar and the decline in consumer demand, and thus deny captive ratepayers access to competitively priced alternatives.

Following the path blazed by FERC, one remedy at the distribution level is an open-access tariff.⁵

Like FERC's version, a distribution-level tariff would allow any person to transact for power on the same terms as any other person and provide transparent information about system conditions and prices. 

This new paradigm would reform utility incentives and compensate ratepayers and new market entrants based on prices that vary by time and location for providing services to the grid. While a few states are moving in this direction, some commissions may lack the legal authority to mandate these dramatic reforms without legislative authorization.

Alternatively, the prohibition on undue discrimination can be oriented towards procedures, rather than a specific substantive remedy. For instance, moving the terms and conditions for distributed generation out of a utility rate case may remedy undue discrimination.

Constrained by decades of past practice and legal precedent, a ratemaking case is designed to scrutinize the utility's measure of its short-term costs and its proposed allocation of those costs among customer classes. As discussed, the utility can mold a cost-of-service study to meet its financial goals, and the utility has numerous advantages in these proceedings.

A separate proceeding provides proponents of the resource with an opportunity to frame the issues, rather than being forced to react to utility proposals. It provides for consideration of long-term costs and benefits, treats generators and other resources as service providers rather than service takers, and focuses on providing value to ratepayers, not revenue for utility shareholders.

The results of such a proceeding can either establish a tariff for distribution-level resources, or can be an input into the utility's next rate case.⁶ A non-discriminatory process guarantees only fairness to nascent entrants, not a particular substantive outcome.

As technology offers new possibilities for ratepayers and utilities, rate designs ought to be just, reasonable, and not unduly discriminatory. These core ratemaking standards are rooted in protection of consumers, not the utility. They require that amidst uncertainty, regulators find a balance between ratepayer and utility interests and be vigilant about remedying anti-competitive practices and procedures.

Endnotes:

1. These groups may also dispute the revenue requirement, arguing that certain utility costs should not be recoverable from ratepayers.

2. Historically, courts, economists, and regulators focused on the revenue requirement determination, and spent far less time and resources evaluating the rate design. Courts use different legal standards when reviewing a commission decision about a revenue requirement as compared to a rate design, because the revenue requirement determination involves constitutional considerations.

3. One Connecticut utility recently told state regulators that "all distribution costs are fixed." The logical conclusion of that approach, combined with the argument that fixed fees should reflect fixed costs, is that distribution service should be entirely paid for through fixed fees.

4. While the industry often rationalized promotional expenses because they increased utilization during off-peak seasons, it seems likely that homes receiving subsidies consumed more energy throughout the year. These houses often used electricity for cooking and heating water, and some also included connections for more electrical appliances and lighting. The Department of Energy's first Residential Energy Consumption Survey, conducted in 1979, found that homes with electric heating also consumed two to three times more electricity for air conditioning as compared to other homes. In total, these homes used nearly three times as much electricity. This spillover effect was often ignored, and would certainly be difficult to measure and account for in designing promotional rates.

5. For further discussion, see Joel Eisen, "An Open Access Distribution Tariff: Removing Barriers to Innovation on the Smart Grid," UCLA Law Review, 2014. Professor Eisen discusses a FERC-regulated, open-access distribution tariff, but similar principles could be applied to state-level tariffs.

6. Many commissions and state courts have adopted prohibitions on single-issue ratemaking. The Illinois Supreme Court has explained that the prohibition "recognizes that the revenue formula is designed to determine the utility's revenue requirement based on the aggregate costs and demand of the utility. Therefore, it would be improper to consider changes to components of the revenue requirement in isolation." Business & Professional People for the Public Interest v. Illinois Commerce Communication, 146 Illinois 2d 175, 244, 1991. If setting a rate for solar violates a state's single-issue ratemaking prohibition, a proceeding to analyze the costs and benefits of a particular technology or service could be styled as an investigation, and set parameters that inform the utility's next rate case.

Lead image © Can Stock Photo Inc. / ArtesiaWells