17/03/2019 The future of electricity rate design | McKinsey

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Electric Power & Natural Gas

Solving the rate puzzle: The future

of electricity rate design
March 2019 | Article

By Blake Houghton, Jackson Salovaara, and Humayun Tai

Systemic trends are forcing utilities to confront the need for rate design
changes.

U
S electric utilities are seeing their industry transformed. Renewable portfolio
standards,[ 1 ] nonutility generators of renewable electricity,[ 2 ] net metering,[ 3 ]
behind-the-meter storage,[ 4 ] and other distributed energy solutions have drawn revenues
and customers away from traditional utilities and created a mismatch between electricity
rates and utilities’ costs.[ 5 ] In the long term, policy and technology trends, largely spurred
by decarbonization,[ 6 ] could continue to motivate customers to decrease their
dependence on—or even abandon—traditional utilities in favor of third-party suppliers.
There is no cure-all, but electricity rate designs must be reformed to ensure a stable
transition to less carbon-intensive sources and secure utilities’ role in the future system.

Historically, electricity rate structures have bundled all electric services into one volumetric
rate—charging customers by kilowatt-hour of use served all major stakeholders’
objectives. Customers within the same rate classes (commercial, industrial, residential)
received the same level of service and understood that their electric bills varied based on
the amount of electricity they used. Utilities recovered their costs and capital investments
without significant rate increases. Policy makers liked that volumetric rates encouraged
energy efficiency. And with few substitute options for customers, the system was stable.

Today, against the backdrop of decarbonization, increasing customer sophistication, and

new competition, utilities’ fixed costs are increasing. Grid modernization and investments
to meet sustainability goals come at significant capital expense. As a larger share of
electricity is sourced from renewables , utilities must ensure enough system flexibility to
maintain reliability when supply from renewables is intermittent or low. With volumetric

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rates, mounting fixed costs are passed on to customers who have not taken advantage of
decentralized, third-party arbitrage opportunities (such as net metering or behind-the-
meter storage). Customers find their bills confusing as a result, unable to understand why
their bills are increasing despite limited changes in their usage and level of service.

Unless utilities update their pricing and offerings, they will find themselves with a shrinking
base of customers among which to distribute rising costs. With regulatory processes that
can last years, rate-design reform must start today if utilities hope to address the
problems coming in the next decade.

Principles of rate-design reform

Progress toward a lower-carbon, customer-centric electric-power industry is underway;
previous McKinsey research has explored flexibility and resilience questions underlying
decarbonization .[ 7 ] A critical element needed to enable this transition is an overhaul of
rate design. An updated rate design must align rates with system-wide costs, encourage
flexibility, and address customers’ differing needs.

Ensure that rate structure reflects cost

structure
With the adoption of renewables growing, fixed costs make up an expanding share of the
cost of funding the grid. Unlike fossil-fuel generation, renewables have no fuel costs and
relatively minimal operation and maintenance costs.[ 8 ] Renewables are also intermittent
power sources, which necessitates increased grid flexibility. As a result, utilities have made
significant capital expenditures to upgrade grid assets to provide reliability, flexibility, and
security. As forward-thinking commercial, industrial, and residential customers take
advantage of opportunities in distributed energy such as rooftop solar and behind-the-
meter storage, the remaining volumetric users are left to shoulder an outsize amount of
the growing fixed costs associated with these system-wide changes.

Utilities could remedy the discrepancy by matching a fixed-charge component (a set

monthly fee) and a demand-charge component (a payment per kilowatt peak) to actual
grid costs. These rate components are already part of many commercial and industrial
rates and, to a lesser extent, residential rates. However, the rate components do not

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reflect their costs to the system. Accurately reflecting system-level cost breakdowns will
motivate distributed generation, behind-the-meter storage, and other distributed energy
resources (DERs) where they are economically efficient.

It is important to consider the regulatory response to any proposed changes to rate

structures. Recent experience has shown that utility commissions usually reject large
increases in fixed and demand charges. However, many utilities have seen success with
small increases in these charges, which can gradually align rates with costs.

Use rate structures to encourage

flexibility
Load shaping through rates is a first step toward addressing systemic flexibility needs by,
for instance, reducing the height of an afternoon peak and decreasing the need for fast-
ramping generation assets. The marginal cost to generate and distribute electricity varies
significantly from hour to hour, season to season, and from different locations on a power
grid. However, under most rate models today, customers pay the same rate throughout the
day, regardless of their location—failing to discourage inefficient use of electricity at peak
periods.

Utilities need to implement a time-of-use (TOU) pricing component for energy and
demand charges, under which prices are higher during peak periods. Consider if electric
vehicles were charged at peak times; they would create a substantial burden on the
electricity grid and necessitate capital investments. But a TOU-linked demand charge
would help stimulate optimal charging behavior (such as charging overnight when demand
is lowest) and smooth demand throughout the day. In this way, TOU pricing can reflect
actual cost variability and encourage customers to efficiently time their electricity use.

To mitigate the need for capital-intensive grid assets, customers can also participate more
actively in contributing flexibility to grid operations. Customers can help balance supply
and demand using their own home-automation devices to control electricity consumption
and battery storage, but only if grid operators give them the right incentives to do so. For
example, some utilities offer demand-response tariffs that pay customers who reduce
their demand during peak periods. These tariffs could be expanded to encourage load
reduction during steep ramping periods or in response to supply swings from renewable
resources. The rates could also include dynamic pricing, a step beyond TOU pricing, in
which customers see prices that change from period to period based on real-time

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wholesale prices. Similarly, utilities could incorporate location-based pricing to encourage

customers in capacity-constrained areas of the grid to adjust consumption. Such pricing
would help mitigate the need for costly transmission and distribution upgrades.

With the right prices as incentives, customers can contribute to grid operations in multiple
ways, including demand-response, flexibility, and distributed generation. Over time,
customers can be integrated into an on-grid market that prices energy, capacity, and
flexibility in real time based on system needs. In this future, the utility could function as a
platform that facilitates transactions—for a fee—between itself and customers, between
third parties and customers, and between customers. Rate-based compensation for these
services is a potential first step toward such a grid-based market.

Meet customer needs with differentiated

offerings
Current rate structures deliver standardized service, which means all customers receive
the same level of power quality, reliability, resilience, and renewables share—however,
different customers have different needs. For instance, backup power is essential for
hospitals and some manufacturers. High power quality is important to other manufacturers
and data centers.[ 9 ] Meanwhile, sustainability-minded customers value a higher share of
renewables.

Utilities’ undifferentiated service offerings have driven many customers to work with
nonutility third-party providers to meet their evolving needs. To remain competitive in the
future, utilities could offer services—such as heightened reliability, 100-percent-
renewable procurement, additional service levels, and DER equipment installation—on a
cost-plus basis. Customers who value these offerings could opt in to add-on tariffs and
receive corresponding services. Those tariffs would cover costs and avoid
nonparticipating customers’ subsidizing participating customers. For instance, hospitals
and manufacturers that value resilience could pay for backup power through extra
generators, microgrids, advanced distribution management systems, and other equipment
that the utility could install and maintain. And customers who value renewable energy
could pay to receive up to 100 percent of their energy from renewable resources without
scaling back or abandoning their relationships with utilities.

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Customers who want simple bills could opt in to a volumetric rate design—even a fixed bill
—at a premium to today’s rates. This design accounts for the flexibility needs these
customers would impose on the grid (they don’t respond to TOU pricing), allowing them to
find a rate structure that meets their needs while efficiently pricing grid services and
avoiding disintermediation.

Utilities can meet distinct customer needs with a menu of options instead of a single,
undifferentiated tariff as seen in the exhibit below, illustrating a hypothetical utility offering
based on a future rate structure. Updated rates accurately reflect the size and share of
costs and TOU pricing, and new services include high renewables share, higher reliability,
and DER installation and servicing. And again, customers could also participate in offering
additional flexibility to the electrical grid. For customers who prefer volumetric rates or a
flat bill, these options would still be available at a premium to new rates.

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Exhibit

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Both utility and nonutility industries have seen success with different billing models, from
flat fees to free periods. For more, see sidebar, “Innovative billing: Models from within and
outside the utility industry.”

Four keys to a successful rate-redesign

implementation
Utilities need to make significant progress to overhaul their rate designs in ways
consistent with the principles discussed above. Some have updated elements of their rate
design, such as adding green tariffs and TOU pricing. Comprehensive reform will continue
to grow in importance for utilities in the coming years. As more utilities begin discussions
about the best way forward, it is worth keeping in mind several elements of a successful
rate-design implementation.

Internal support and capabilities

Utilities must have the capabilities and resources necessary, such as advanced metering
infrastructure, to implement a new rate design. The organization will also need to expand
its talent pool to support tracking and categorizing costs of generation and distribution. A
marketing push focused on gaining customer support and segmenting customers based
on their specific needs will also be vital.

Customer acceptance
Customers must adopt updated rate designs as the result of their perceived value or
because they are easy to understand. Success requires staying close to key customer
groups, gathering feedback, and providing ongoing support to ensure adoption and
positive customer experiences.

Sensitivity to the regulatory process

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Rate design must be performed jointly with regulators. This approach entails working
groups, frequent communication, and a transition plan. For example, many regulators have
resisted increasing fixed charges or policies that appear to discourage energy efficiency
and are regressive to low-income customers. Utilities must start the rate-design process
by allaying those fears and set the stage for a transition from today’s rates. For example,
utilities could propose gradual increases to fixed costs for some customer segments while
balancing cost increases with other energy efficiency incentives. Because the regulatory
process can be iterative and incremental, utilities can work with policy makers to tweak
rate designs over a series of rate cases and regulatory proceedings.

Sustainability for business operations

A new rate or tariff structure must generate enough revenue to fund grid investment,
maintain its operation, and ensure its reliability. To achieve this objective, utilities have
experimented with using high fixed charges and high demand charges to compete with
DERs on pricing, but most attempts have been unsuccessful. Instead, rate components
(fixed, demand, and energy) should accurately reflect their costs. This transparency will
help make sure that grid power is cost-competitive when it is the optimal solution—with no
institutional intervention required. A sustainable rate design uses transparency to create
incentives for customers to contribute to the system’s financial and environmental
sustainability.

As the need for rate design grows, utilities would benefit from positioning rate-design
reform to gain regulatory approval, customer adoption, and revenue generation. Early
action, cooperation with regulators, and a customer-centric approach can help transform
utilities’ one-rate-for-all model into a rate structure that helps retain customers, create
revenue that contributes to the upkeep of the grid, and make customer behavior and
utilities’ operations more sustainable.

1. Renewable portfolio standards are regulations that require utilities to ensure that a specified share
of the electricity they sell comes from renewable sources.
2. Also known as independent power producers, nonutility generators are companies that generate
electric power for sale to utilities and end users.
3. Net metering allows consumers who generate their own electricity to connect their own
generators to a public power grid and transfer surplus power to the grid. Under the current system,
net metering helps consumers offset the cost of electricity they draw from the utility. In practice, this

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leads consumers who do not use net metering solutions to carry a disproportionate amount of the
system’s fixed costs.
4. Behind-the-meter storage refers to battery-energy storage systems that customers install on-site
to reduce their peak demand or otherwise arbitrage energy costs.
5. Distributed energy systems generate or store electricity (often from renewable sources) for a
single customer. These systems can also be used to reduce or shift customer loads.
6. Decarbonization is the process of reducing carbon dioxide emissions in electric-power generation
and other industries.
7. For more, see Evan Polymeneas, Humayun Tai, and Amy Wagner, “ Less carbon means more
flexibility: Recognizing the rise of new resources in the electricity mix ,” October 2018.
8. US Energy Information Agency, “Levelized cost and levelized avoided cost of new generation
resources in the annual energy outlook 2018,” March 2018, EIA.gov.
9. Power quality can be framed as the compatibility between the current that flows from an electric
outlet and the power required to operate the associated device.
10. For more on connected-car ecosystems, see Markus Löffler, Christopher Mokwa, Björn
Münstermann, and Johannes Wojciak, “Shifting gears: Insurers adjust for connected-car
ecosystems,” May 2016.

About the author(s)

Blake Houghton is an associate partner in McKinsey’s Dallas office, Jackson Salovaara

is a consultant in the San Francisco office, and Humayun Tai is a senior partner in the
New York office.

The authors wish to thank Amy Wagner for her contributions to this article.

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