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Cross-Subsidies: Getting the Signals Right

Fortnightly Magazine - December 2004

selling more power (and thus burning more fuel) while on the other encourage emissions reduction through end-user conservation. When environmental stimuli take the form of demand-management programs, there is a truly perverse cross-subsidy created wherein the utility's cost-plus pricing encourages the maximum sale of the least efficient generation, and the profits are then used to support reduced consumption by their customers.

These inconsistencies constrain the state's ability to realize its policy objectives, and they all too frequently lead to utility rates that encourage exactly the opposite behavior sought by other state agencies.

Recommendation #4

Make a conscious effort to include benefits created by ratepayer actions in ratemaking proceedings.

Given their focus on ensuring utility cost recovery, ratemaking proceedings tend to ignore or understate the benefits some ratepayers provide to the system. From load shedding to VARs support, customers can and often do take numerous actions that reduce utility costs. Unfortunately, these actions are rarely if ever considered in rate proceedings. Nobel laureate Vernon Smith has spoken frequently on this topic, and notes that it is a flaw common to virtually all regulated industries. 2

By failing to include benefits in their calculus, these rate proceedings guarantee that unfair cross-subsidies will be created because customers will be penalized for the costs they impose but ignored for the benefits they create. This type of regulatory failure is particularly prevalent in rates associated with on-site generation, since the benefits resulting from load congestion, emissions reduction, and power-factor correction are almost never factored into cost-based proceedings.

This Achilles' heel makes regulators at best blind to, and at worst discriminatory towards, customers who seek to create benefits for the system. Regulators can overcome this limitation by clearly defining the benefits sought, identifying technical means to create those benefits, and ensuring such technologies are encouraged-or at least not discouraged-in subsequent rate proceedings.

Recommendation #5

Recognize that "cross-subsidization" is a charged term, and its use diverts attention from more important socio-political objectives.

As described earlier, cross-subsidies are neither categorically good nor bad, but serve as a means to achieve social, economic, and political objectives. They are an inherent feature of utility ratemaking, and exist by virtue of compromises made in the creation and maintenance of electric utility regulation. Discussion of cross-subsidization without discussion of those socio-political objectives is diversionary at best and deceitful at worst. Regulators are encouraged to disallow such testimony in their proceedings to steer participants toward a more relevant focus on the issues at hand.

This is not to suggest that regulators should ignore the issues surrounding cross-subsidies. From a purely economic perspective, there is an economic inefficiency inherent in any system with cross-subsidization, but society did not create regulated utilities out of a desire to achieve economic efficiency. We created such entities out of a desire to achieve a broad slate of socio-political objectives, and cross-subsidies are to be opposed only to the degree that they interfere with our ability to realize those goals.


  1. Here and throughout, we use the term "discriminatory pricing" in the regulatory law context, as opposed to the economic context.