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Cross-Subsidies: Getting the Signals Right

CROSS-SUBSIDIES:
Fortnightly Magazine - December 2004

claim that cross-subsidies are uniformly good or bad. They are put in place to achieve certain economic, social, and political ends. While we might disagree with the application of a particular cross-subsidy, our opposition is based not on the cross-subsidy , but rather on our judgment about the worthiness of those socio-political goals. To put it bluntly, one cannot be categorically opposed to cross-subsidies and categorically in favor of regulated utilities. The latter exists to provide the former.

Since utilities were founded to create cross-subsidies, it's not surprising to see an on-going creation and maintenance of cross-subsidies throughout electric rate structures. Many cross-subsidies receive little objection or notice from the general public, showing just how prevalent they are. For example:

  • Geographic diversity within the same rate class. Utility rates often cover all customers in large swaths of geography. Similar to postage stamps, the price of service is the same if the end-user is located in an urban center or rural county. The rates are constructed and applied without regard for the higher system costs in congested urban areas and higher maintenance costs in remote rural areas. Thus, low-cost, high-profit customers are implicitly subsidizing high-cost, low-profit customers.
  • No real-time prices. With a few notable exceptions, users do not pay for the actual wholesale market price of generation but rather for the average costs over a year. While many users have divergent on- and off-peak rates, this is set in advance and does not have any direct bearing on the actual costs of service at any given time. Thus, consumers who demand more power during peak hours when only the most expensive generators are available (and line losses are at a maximum) are being directly subsidized by those who consume most of their power during shoulder or non-peak pricing periods.
  • System-benefits charges. Many states have created system-benefits charges, assessed to all consumers so as to fund a variety of energy-efficiency and renewable-power projects. Many ratepayers contribute to these programs, but the select few who gain access to the funds realize the primary financial benefit.
  • Standby rates.
  • Standby rate proceedings for on-site generation are theoretically based on the costs imposed by the generator on the grid, but they rarely, if ever, take into account the benefits created for the grid by the generator (, reduction in grid congestion, reduced demand for power plant fuels, etc.). By ignoring one side of the ledger, these rates are guaranteed to overcompensate the regulated utility at the expense of the ratepayer with on-site generation.

  • Inter-class subsidization. It is widely known that the profitability of commercial customers tends to be higher than residential or industrial rate classes, since commercial classes do not have the political leverage of residential interest groups, nor the financial leverage of large industrials that can self-generate and leave the system if rates get too high. Such differences imply a cross-subsidy among these rate classifications.
  • Intra-class subsidization. Since all rate classes are devised from the average of many customers, there is necessarily a subsidization that exists between customers on either side of this average. This can create