Editor's Note: The following is a guest post written by Jon Wellinghoff and James Tong. Wellinghoff is the former chairman of the Federal Energy Regulatory Commission and is currently a partner at law firm Stoel Rives LLP. Tong is the vice president of strategy and government affairs for Clean Power Finance, a financial services and software firm in the residential solar market. This article is the second in a series from Tong and Wellinghoff looking at issues surrounding utilities, distributed energy resources, and the grid. You can read the first piece on the common confusion over "cost-shifting" and "not paying your fair share" here.

“Failure is not an option!”

The line, popularized by Apollo 13, re-creates mission control’s scramble to rescue a damaged spacecraft. Though fictional, this could easily be the real-life creed of utilities and regulators.

Consumers expect reasonably priced electric services 24-7. Utilities provide those services through billions of dollars in continual grid investments. The smallest error in maintenance or operation may result in catastrophic grid failure with severe financial and legal repercussions.

Naturally, local distribution utilities feel under-appreciated, if not indignant, when green advocates, tea party activists, and upstart businesses push hard for policies they believe may jeopardize the grid. This utility angst is compounded by declining revenues from waning demand growth and the emergence of disruptive innovations, such as smart thermostats and rooftop solar. Utilities want to slow down change, or at least ensure full recovery of their investments.

Cue the fixed charges

To this end, utilities have been pushing for more fixed charges. Some fixed charge increases simply augment existing “customer charges.” Others are targeted primarily at consumers who choose to install rooftop solar PV systems.

Arguments for these charges tout basic economics and fairness. The basic economics argument contends that since most costs of electric services are fixed, customer fees should also be fixed. Utilities assert that using volumetric pricing, or charging per kilowatt-hour (kWh) consumed, to recover fixed infrastructure and operations costs creates utility risk. Risk raises utilities’ cost of capital and ultimately prices for all customers.

The fairness argument takes aim at solar customers, contending that by significantly reducing the kWhs they consume, they avoid their fair share of the fixed cost. Fixed charges imposed on solar customers, it is assumed, would prevent an unfair shift of cost burdens to non-solar customers.

The reasoning for this shift to fixed charges may seem logical. Utilities are legally entitled to fair compensation for the service they provide. And customers connected to the grid should indeed pay to use it. Both assertions are indisputable. Yet neither proves the need for fixed charges – especially for solar customers.

As we argued in our previous piece, the assertion that solar customers do not pay their fair share is based on a flawed assumption that cost shifters are necessarily freeloaders.

The “economics” argument is equally wrong. As Severin Borenstein, a respected economist and a sharp critic of current solar policies, writes: “…the statement that I have heard a number of times recently that ‘the utility should cover fixed costs with fixed charges’ has no basis in economics when it comes to system fixed costs.” [1] Borenstein accurately notes that fixed-cost recovery can be addressed through smarter, more efficient kWh volumetric pricing that accounts for all cost variations due to timing and location, as well as externalities such as carbon emissions.

[1] Economic principles do justify fixed charges for customer-specific fixed costs like metering and billing. But these are much smaller than system-wide fixed costs (generators, poles and wires) and not the focus of current fixed-fee discussions.

The promise of smarter pricing and distributed energy resources

What we must understand is that fixed charges actually steer us away from smarter pricing. They invite more inefficiency, not less, because they encourage customers to consume more and utilities to build more, not smarter.

Utilities have traditionally built enough capacity to ensure peak demand is always met, even during relatively rare moments when every single air conditioner is running at full throttle. But across the nation, peak usage is diverging from average usage (see the graph below). This means that increasingly, much of grid infrastructure is going unused at any given time. In other words, much of what is called “fixed costs” actually represents overcapacity, or waste. And that waste is growing.

A ratio of 1.78 means that peak demand is 78% higher than average demand. A higher ratio indicates a lower asset-utilization rate. EIA

Expanding fixed fees does nothing to reduce such waste. In fact, it encourages the opposite. Instead of increasing fixed fees, we need to consider instituting dynamic or time-varying rates that align prices with how and when utilities incur costs. This would both strengthen historical fixed cost recovery mechanisms and reduce investment waste.

Public policy has long resisted time-varying rates for consumers, in large part because they are deemed too confusing for consumers. The expansion of rooftop solar, however, questions conventional wisdom. As Borenstein notes (albeit cynically), the rapid growth of rooftop solar in California is largely attributed to solar installers’ success in explaining the state’s incomprehensible rate structures to consumers. The California experience suggests that, given strong market incentives, third-party providers can effectively assist consumers in understanding sophisticated pricing structures and provide them appropriate options. The goal of policies then should be to develop market incentives consistent with a strong, reliable grid.

Myriad distributed energy resources (DER) offer consumers countless tools to better manage their consumption and reduce grid costs: intelligent communicating devices can enable greater demand response at peak times or automatically start or stop dishwashers and washing machines depending on the high and lows of daily energy prices (see below). Electric vehicles can interact with grid market signals to charge batteries when prices are low and supply grid services when the market allows. And distributed photovoltaic systems can sync with all of the above, deciding when to use generation internally, when to sell it to the market and when to store it locally.

Many of these DER technologies are available today. Even more are on the way. All need better market structures to harness their full value. This does not mean we should create more subsidies or mandates, or levy fixed fees. It means we need a fair market structure and pricing mechanisms that more accurately capture the benefits and costs of the grid and all resources – including DER.

Destroying the promise of a more efficient grid

In the utilities’ frenzy to realign their business model with a dynamically shifting consumer relationship to the grid, the push for more fixed charges charts a damagingly retroactive course. By minimizing volumetric pricing in favor of fixed charges, regulators eviscerate pricing signals, which encourage both efficient consumption behavior and cost-effective grid investments by distribution utilities, customers and entrepreneurs. Customers would lack clear signals to act more efficiently, adopt appropriate technologies or utilize DER to improve the grid for others. DER providers would, in turn, see little reward for innovating and delivering solutions to customers. More wasteful consumer consumption would lead to more wasteful investments by utilities.

We are not suggesting that fixed charges are inherently wrong. But they are wrong when they distort markets and create larger problems than the ones they were intended to cure. If the concern is ratepayer fairness, then consider a minimum bill. If the concern is protecting the underserved, consider programs that leverage DER to help them better manage their energy consumption and thus their bills. If the concern is efficient cost-recovery, consider time-varying rates or broader reforms, which we have suggested.

Current calls for more fixed charges completely ignore appropriate market structures as an option. In fact, they seek to undermine such structures. Uncritical approval by regulators of fixed-charge proposals without considering market options would imply a lack of appreciation of the power of markets and DER technologies. It suggests one of two things: either the promise of DER to empower consumers is secondary to a utility’s financial happiness, or the traditional regulated monopoly can best match diverse disruptive technologies with increasingly diverse customer needs. The latter is highly unlikely: consider utilities’ inability thus far to capture the promise of the 50 million smart meters already deployed. All of us – especially those who champion market principles – should be skeptical.

A call for regulatory courage

The traditional regulated electric utility model is on an unsustainable trajectory – some say a death spiral. Regulators at mission control will need to take creative and likely unconventional measures to guide it back to a safe landing. We commend commissions in New York, Hawaii, Massachusetts, California, and Minnesota for acknowledging the challenge and exploring ways to modernize the grid with DER. We applaud commissions in Idaho, Louisiana, Utah, and others for rejecting proposals for fixed charges on solar customers because of insufficient data. Failure is indeed not an option. A rash push for fixed charges dangerously flirts with failure, threatening not just the public, but the utilities’ shareholders as well. We’ll explain more on that point in our next post.