Rate Shock: A Matter of If, or When?

Fortnightly Magazine - January 2006

Better communication will be required in an environment of volatile and rapidly increasing commodity prices.

The utility industry is transitioning from its focus on “back to basics” to an emphasis on investment and consolidation—a shift some might describe as “déjà vu all over again.” In the near future, the majority of investor-owned electric utilities (IOUs) will request, and ultimately win, rate increases. For many, these will be the first significant increases in more than a decade. And in some areas, the completion of regulatory transition periods will enable utilities to claim increases they consider long overdue. Despite the length of time most utilities have taken between cases, it is unlikely that the rate-based component of increases will match the percentages of the 1970s and early 1980s.

Although these rate increases may be seen as reasonable and justified, rates are only part of the story. Consumers will see higher electric bills, which will result from a number of factors outside of traditional rate base and cost control. The confluence of these factors may catch some companies unprepared—pursuing the traditional argument of electric rate adequacy in what will be a public debate about total energy costs.

Higher electric rates will follow sharply higher costs of gasoline and natural gas that are beginning to have significant, and perhaps lasting, effects on businesses and consumer markets. For many businesses, evaluation of fuel switching and efficiency options is well underway. Residential customers have been reintroduced to volatility, with the price of gasoline fluctuating between $2 and $3 per gallon. This winter, a bigger surprise for consumers in colder climates will come through higher natural gas prices for home heating—resulting in individual bills that are hundreds of dollars more per month. EIA expects that the total amount spent for gas consumed by a representative residential customer this winter will be about 48 percent more than last winter. 1

For an average family using gas heat, the impact of higher gasoline, electric and gas bills could be approximately $1,300 per year—3 percent of after-tax income. (see sidebar). When combined with a low and declining national savings rate, this will force some difficult choices. On a per-capita basis, average personal savings in 2004 was $530—only 1.8 percent of disposable income.

How will customers respond to higher electric rates following a rise in gasoline and heating costs that will absorb all discretionary savings for many consumers? Will “rate shock”—a term not heard in the industry for many years—return?

Responses May Vary

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One response for electric utilities would be to continue to lower costs and further delay rate cases. However, they are facing a rising-cost environment driven by factors that are both powerful and long-term. Six structural factors are driving fundamental increases in electric prices:

1. Capital investment . Many utilities are beginning a new wave of capital projects to meet increasing demand, improve environmental performance, and maintain the reliability of generation and transmission and distribution (T&D) infrastructure. Although there are