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Inclining Toward Efficiency

Is electricity price-elastic enough for rate designs to matter?

Fortnightly Magazine - August 2008

costs is the dominant concern, then get data that shows how costs move with usage. If the desire is to conserve energy, then identify the magnitude of the energy-efficiency goal.

Third, determine the number of blocks in the rate design. Two or three blocks usually suffice to get the message on rising costs through to customers, provided the message is conveyed clearly on the monthly bill. If a rate re-design is envisioned, it would make sense to signal it clearly. It would make little sense to create a new rate where the second block only applies to a small fraction of customers, or to apply the second block to usage that exceeds last year’s usage or some other historical baseline.

Fourth, determine the height of the blocks. The height between the blocks should be significant or it won’t be noticed by customers. Nationally, many existing inclining block rates are much too mildly differentiated and are unlikely to lead to any energy efficiency. A notable exception is California, where the rates are much too steeply differentiated, are not cost-based and have caused numerous equity problems.

Fifth, assess the distribution of bill impacts across the full range of customers. This is a fairly straightforward exercise and can help identify how low-use customers will see a drop in their bills and how high-use customers will see a rise in their bills. The assessment initially should assume no price response and then be repeated with an assessment of likely price response, after the next step has been performed.

Sixth, assess the impact of the rate re-design on utility sales and revenues. This will require knowledge of the price elasticity of demand.

Estimating Elasticity

EPRI recently surveyed the vast literature on price elasticities, 8 concluding that residential short-run price elasticity ranges between -0.2 and -0.6, with a mean value of -0.3. Long-run elasticities range between -0.7 to -1.4 with a mean value of -0.9.

One of the studies surveyed by EPRI is noteworthy because it contains customer-level price elasticities. These are estimated using cross-sectional data on California households from the mid to late 1990s. 9 In aggregate terms, it reports a residential price elasticity of -0.39. The study finds that 44 percent of customers have no price elasticity. The price elasticity varies across households, as low as -0.08 for households with no electric space heating or central air conditioning and as high as -1.02 for households with electric space heating. Since the elasticities are derived using cross-sectional data, there is some issue concerning whether the elasticities are short run or long run in character.

The study simulates the effect of California’s transition from two tiers to five tiers that took place in the wake of the energy crisis of 2000-2001. Inclining block rates first appeared in California in the late 1970s following the two oil shocks with baseline provisions providing for reduced rates for the first 50 to 60 percent of the typical household usage. 10 In 1988, the California legislature enacted Senate Bill 987 to limit the differences between baseline and non-baseline rate levels and to