How Does the Electric Utility Set its Price?

Throughout the world electric utilities have enjoyed monopoly power over the distribution of electricity.   Monopoly power was deemed necessary, even in Western capitalist economies, to avoid the chaos that would occur from competing utilities building redundant infrastructure such as power lines and transformer stations.  Similar monopolies have been granted to utilities that distribute natural gas, operate radio frequencies, and provide phone service or cable television programming.

In the United States, Canada, Australia, New Zealand, and parts of Western Europe, a number of utilities have opened their systems up to competitive electricity supply from third party vendors.  Even where competitive marketers can offer electricity to consumers the utility retains control over the infrastructure and in many cases continues to provide electric service.

In both competitive and monopoly markets, utilities set a price for electricity which is shipped over their system to consumers within their designated territory.  In the United States, the price of electricity is set by the utility in accordance with rules established by state regulators who are charged with overseeing utilities and preventing them from abusing their monopoly authority.

Utility prices (sometimes called tariffs) are based on three basic components plus a fourth category of miscellaneous charges:

1. Electricity or Commodity Price

Since the days of Edison utilities in the United States have not profited from the commodity component of their price.  The cost of electricity – which is based on the wholesale market prices where utilities buy their power or the cost of generation (the cost of fuel plus the operation and maintenance of the utility power plant where the electricity is produced) – is passed through to consumers without a markup.

The actual cost of electricity is generally fixed for periods of 3, 6 or 12 months.  Most utilities, subject to approval by their regulators, purchase their power forward and then set a price per kWh based on the total cost of its purchases divided by the anticipated amount of demand from consumers behind its system.

Of course, the forward purchases will never exactly equal the amount of actual demand.  To account for this discrepancy, the utility will calculate its additional purchases (or excess purchases which it sold back into the marketplace) at the end of each period and add (or subtract) from the estimated price for the next period a “price adjustment.”  As a result, the price of electricity in any given period may not be exactly equal to market prices – or to the prices offered by competitive third party suppliers – because the utility is constantly seeking to charge its customers with the actual cost of service.

2. Distribution Cost

Whether or not consumers purchase their electricity from the utility or from third party suppliers they will be charged a distribution cost by their local utility.  This cost helps the utility defray the cost of its physical plant and infrastructure and includes a markup which is permitted by regulatory authorities.

The utility’s physical assets are referred to as the “rate base.”  The rate based includes the utility’s wires, transformer stations, trucks and inventory, as well as the cost of labor (e.g., management, repair crews, and emergency technicians) associated with its operations.  The markup is a guaranteed rate of return permitted by regulatory authorities.    This approach has led to the ironic result that many utilities have an incentive to add to their assets in strange ways.  For example, if the utility buys expensive art to furnish its President’s office it will include the art in its rate base and increase its returns.  If the utility builds its new headquarters from expensive granite instead of pouring concrete its returns will increase proportionately.

3. Demand Charges

Demand charges are generally assessed against commercial accounts only.  They represent the cost of maintaining a system that is sized according to a consumer’s highest usage in any month.  An office building may use electricity for lighting and air-conditioning.  Its average consumption may be no more than, say, 300 kW per hour.  However, in April it turns on its air conditioners for the first time; a maintenance technician flips on a switch in a control room.  The instant the air conditioning units turn on they draw in an instantaneous surge of 500 kW from the grid.  As the cooling units run their usage declines.  But the utility sees the 500 kW and charges the building to keep this amount of electricity generation capacity available at all times.

4. Miscellaneous Charges

In addition to the three major cost factors described above, a number of minor but in the aggregate consequential items are also passed through to consumers each month:

  • Monthly billing charges. The significance of this charge is inversely proportional to the total amount of usage.
  • Transition charges. In the 1990s many utilities were forced by regulators to sell their assets at prices which at the time led to a loss below their fully depreciated costs.  Regulators permitted the utilities to recover those losses in a surcharge over time.
  • Low-income customer charges. Some state legislatures have required utilities to charge consumers amounts which are then used to help subsidize the energy costs of low-income consumers.
  • Environmental charges. Some state legislatures have likewise required utilities to pass on to their customers a fee – really an indirect cost – designed to build up a fund for use in environmental remediation, clean energy programs, etc.