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Cross-Subsidies: Getting the Signals Right

Fortnightly Magazine - December 2004
  • substantial cross-subsidization if the class encompasses a broad range of sub-segments that pay significantly different prices for similar utility services ().
  • So, are any of these existing cross-subsidies categorically bad? The answer ultimately depends on the answers to two questions:

      1. Are the benefits created by the subsidy larger or smaller than the subsidy itself (e.g., does the presence of the subsidy create a macroeconomic benefit)?

      2) Can the costs be better allocated to those who realize the benefits (, is the subsidy fair)?

    These questions are easy to ask, but they can be intellectually and politically difficult to answer. Intellectually, how does one put a dollar value on the benefits of renewable energy? Politically, what level of rate support for low-income families is too high?

    What the Industry Should Do

    To help regulators address these issues in a more logically coherent and politically constructive way, we offer the following recommendations:

    Recommendation #1

    Consider a hierarchy of cross-subsidy value.

    As has been demonstrated herein, there is no simple answer to the question of whether cross-subsidies are good or bad. However, there are a few cases where one can still be dogmatic. When first considering a potential for cross-subsidization, regulators should assess which of the following three categories the cross-subsidy falls into, and they should respond accordingly.

      1) Beneficial cross-subsidies. These cross-subsidies exist to create a value that would otherwise be missed by purely market-driven companies. These are easy to identify in theory but hard to pin down in practice. For example, while no one would argue that one should not provide lower-cost electricity to low-income customers, reasonable people might disagree about the best mechanism to achieve those goals. Other examples of such cross-subsidies include system benefits charges to support renewable energy technologies. We recommend that regulators treat such subsidies as beneficial, but revisit them on a regular basis to ensure that they are always using the best regulatory tool to achieve a given objective.

      2) Harmful cross-subsidies. Two cases exist in which a cross-subsidy is universally bad for society: in the case of discriminatory pricing 1 and in the case where the cross-subsidy benefits a utility's shareholders at the expense of their customers. The former describes any circumstance wherein a given customer class is given a higher rate than other customers with identical cost structure. This describes most standby rates, which are calculated based on the cost of a grid outage, but do not apply equally to other customers with comparably peaky load profiles (, the standby rate creates less financial impact on the utility than the variance already tolerated as part of intra-class cross-subsidization). The latter describes any situation where the rate increases utility profits at their customers' expense. This describes all cost-plus rates, which gives utilities a vested interest in increasing their cost of service.

      3) All others. If the cross-subsidy cannot readily fit into one of the two categories above, one cannot justifiably take a dogmatic position in support of, or opposition to, the cross-subsidy.

    Recommendation #2

    Use market-based mechanisms to encourage good behavior wherever possible.

    The best regulations