How are electricity rates determined?Rising costs lead to shutoffs, evictions, and other terrible outcomes for low income and working class Rhode Islanders. To counter this, we need to aggressively move towards renewable energy sources like wind and solar – but can we do more?
Published on October 11, 2022
By Steve Ahlquist
Our utility costs rise and fall based on seemingly random events a world away. In Rhode Island, we are facing gigantic increases in electric and gas rates, increases that are sure to compound the existing problems of affordable housing, inflation, and serious poverty. When Rhode Island Energy announced in July that electric customers will see in over $50 per month increase in the utility bills starting in October, many wondered how that works. The war in Ukraine is raising the cost of natural gas worldwide, and 51% of the electricity generated in New England comes from fossil fuel power plants run on natural gas.
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Rising costs lead to shutoffs, evictions, and other terrible outcomes for low income and working class Rhode Islanders. To counter this, we need to aggressively move towards renewable energy sources like wind and solar – but can we do more? Uprise RI invited Jerry Elmer, a former senior attorney at CLF, who literally wrote the book, or at least a short monograph, on how what we pay for our electricity is determined. Jerry Elmer was instrumental in preventing Invenergy, a large power plant developer based in Chicago, from building a $1 billion fracked gas and diesel oil burning power plant aimed at the pristine forest of Burrillville, Rhode Island. He’s the person I call on when I need complex energy issues explained in a way I can understand them. We spoke via Zoom before the PUC approved the record rate increases…
Uprise RI: Rhode Island Energy maintains the grid in our state and profits from being the provider of electricity to pretty much everyone in the state. The Public Utilities Commission regulates Rhode Island Energy and tells them exactly how much they can profit. Why is it that a government agency has so much power over a for-profit company?
Jerry Elmer: That’s a very interesting question. In the United States in general, we have a free market capitalist economic system. If you want to open a car dealership and I have one next door, you’re allowed to do it. If you want to charge high prices for the cars you sell, you’re allowed to do it. If you want to set set low prices, you can do it. Some businesses like to make a lot of profit and they say, “Oh, I’ll set a high price.” Other businesses may choose to make up on volume what they lose in margin on individual sales. “I’ll set a low price and sell a lot more units than you will.” A utility is what is called a natural monopoly. Normally, in a free enterprise capitalist system, we have laws against monopolies. The antitrust laws, the Sherman Antitrust Act, the Clayton Antitrust Act.
Utilities are natural monopolies. The gas company is a utility. We do not want five different companies tearing up our streets to put in gas lines. It just doesn’t make sense. We don’t want five different companies all putting up separate telephone poles for electricity wires to bring [electricity] to your house. Things like the water company, the sewer company, the electric company, the gas company, these are natural monopolies. We as a society allow them to have a monopoly. But because a monopoly can rip people off, can overcharge, can take advantage of people, we regulate them. And that’s what the Public Utilities Commission is. They regulate these utilities and in effect, society is making a two part bargain. We’re saying, on the one hand, we will give you a monopoly over gas or water or sewer. On the other hand, we are going to regulate how much profit you are allowed to make, unlike somebody who sells ice cream cones on the corner or has a car dealership.
That’s what a utility is. That’s where the utilities commission comes from. Every state has a utilities commission though they call it different things. Here in Rhode Island, it’s the Public Utilities Commission, and the names vary from state to state. What we’ve done is we’ve set up by state law, these are run by state law, these commissions to regulate what the utilities are allowed to do, how much they can charge for their services, and how much profit they’re allowed to make.
Uprise RI: On our electric bill, there are many separate charges, the two biggest charges are the commodity costs and the distribution costs. My understanding is that the commodity side of the bill is decided three years in advance through a complex bidding process known as forward capacity auctions. Why is it that a war started six months ago can affect prices set three years ago? I know I’m missing something here.
Jerry Elmer: Okay, let’s separate out these different parts of the bill and I think then you’ll be able to see this. There are, although there are some additional smaller items, there are basically two major parts of an electricity bill, right? The first part, which represents about two thirds of it, is the commodity charge. That’s the actual price for the electricity that you’re using, the electrons that run through your lamps or through your laptop computer, right? The second part of the charge is called the distribution charge. That’s the charge that the utility company, it used to be National Grid here in Rhode Island, now it’s Rhode Island Energy, that they charge for bringing the electricity to you. They own the wires, the telephone poles, and the gas utility. They own the pipes going through the street. So there’s two thirds of the bill is the commodity charge.
That’s what you’re charged for the actual electrons. One third of the bill is the distribution charge. That’s the charge for what it costs to bring the electricity to your door, to your house. The commodity charge is a simple pass through in the part of the utility every year. The Rhode Island utility used to be National Grid. Now it’s Rhode Island Energy. They make a profit of $0 and 0 cents on the commodity side of the bill, and they lose $0 and 0 cents on the commodity side of the bill. Whatever they pay for those electrons, they pass along the cost to you and you reimburse them. It’s a total wash for them. So where does the utility make their money? They’re a money making business. They have shareholders. They make their money on the distribution side of the bill and the, and that’s where the Public Utilities Commission can set how much profit the utility is allowed to make.
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The way a utility commission sets that profit level the acronym is ROE, Return On Equity. What they do is the electric utility adds up the total value of all of the stations and wires and substations that the utility owns comes up to a certain value. And then the PUC says, Okay, you can get a certain return on equity of 10% per year profit, or 8% or eight and three quarter percent, or 11 and a half percent. That’s where the utility’s profit comes in. The commodity price for electricity, or for natural gas is a very volatile market. It can fluctuate a great deal, so you can have the utility commission raising or lowering the commodity side of the bill multiple times a year, and they really don’t have discretion. The law says that the utility passes that through.
So when natural gas prices go up, the commodity side of the bill goes up. When natural gas prices go down, the commodity side of the bill goes down. Same on with electricity, but the distribution part of the bill only gets set once every two or three or five or eight years when the utilities commission does an actual, full blown, rate case. Any public utilities commission in the country, really, has no control over setting what the commodity price is. That’s the market. That’s not your utility gouging customers.
It is the distribution side of the bill that sets the profit level of the utility. And that can be adjusted up or down. Now coming back to your question about those volatile fluctuations. On the commodity side, we need to sort of separate, tease out from each other, the two major components of the commodity side of the bill.
One is energy – electricity, the other is capacity. And that market that you were alluding to earlier that gets set three years ahead is the forward capacity market. That’s the capacity side of the bill. However, keep in mind that the capacity component of the commodity side of the bill is only about 8-12% of the overall commodity charge. 88-92% of the commodity charge is the current price of electricity. It’s not the capacity part. So if you say to yourself that the capacity market three years ago set a very high price for capacity, that’ll be passed on to the consumer three years later, in part, you’re correct. The capacity market price set three years ago will be passed along to consumers three years later. But it’s a relatively small part of the bill.
The reason that you see electricity prices now being so volatile is only in very small part because of the capacity market and what happened three years ago, because that’s a small part of the commodity charge. Rhode Island Energy, when you look on their website as I did this morning, they say, “Well, you know, this past summer commodity prices were at a historic low and now they’re at a historic high. So we lowered our prices over the summer because that’s a pure pass through and we’re raising them now.” That’s true. That’s how, by law, the utility National Grid or Rhode Island Energy passes through the commodity prices and those are volatile. They are mostly the current cost of electric energy. Capacity does come in at a three year time lag. You’re absolutely correct about that. But the capacity part of the commodity charge is a relatively small part. It’s only about one 10th of the commodity charge.
Uprise RI: But if capacity is such a small part of the final bill, why do we pay so much attention to it when we discuss the building of new power plants?
Jerry Elmer: Well, that’s a great question. The reason we pay great attention to it was really shown in the Invenergy proceeding before the Energy Facility Citing Board. What happens in the capacity market – are prices going up or are they going down – shows whether or not there’s a need to build a new power plant. Invenergy said, “We need a new power plant in Burrillville. Look how capacity prices spiked.” And Invenergy had a very good argument. When capacity prices spike, that is a signal that new power plants may be needed. The reason Invenergy lost the case is that after there was a very short term spike in capacity clearing prices, there was a plummeting of prices that showed that power plants weren’t needed.
So when you say, “Why do we pay attention to capacity markets? It’s such a small part of the overall electricity bill” you are right about that. Remember the capacity price is only about 10% of the commodity part of the bill. And the commodity price is only 2/3 of the bill. So the capacity value in the bills that rate payers pay is really a small part. Capacity prices can go up or down quite a bit and they won’t have a huge impact on ratepayer bills. But capacity prices are important for other reasons. Capacity prices are important because they tell the market, they tell the world, and they tell utility regulators, whether or not new power plants are needed.
Uprise RI: That really clears up a lot for me, I have to say. Our present situation is that there’s a big war in Ukraine. It’s constraining our gas internationally and prices on gas are going up. And since many of the power plants through Rhode Island are powered by natural gas, electricity rates are going up…
Jerry Elmer: Well, close. Natural gas prices are going up. You shouldn’t look only at the electricity generating plants in Rhode Island. Although those are all natural gas, we have a unified New England market. Really, the largest fuel used here in New England, including Rhode Island, is natural gas. About 51% of the electricity that we generate is from natural gas, more than all the other sources put together. More than nuclear oil, coal, solar, wind – natural gas is more. Also, natural gas sets the clearing price for energy most of the hours of the year. So when you say the price of electricity here in Rhode Island is very closely linked to the price of natural gas, you are right, but it’s not because most of the electricity generation in the state is natural gas. It’s because most of the electricity generation in the six New England states is natural gas. We have one unified system for all the six states, including here in Rhode Island.
Uprise RI: Got it. Because natural gas prices are up, electricity has gone up as well. And to my understanding, and please correct me if I’m wrong, when we pay for electricity, we pay for the highest priced part of what that energy might be. So if we’re getting electricity from solar or wind and that comes into our house during the winter months, we are going to still be paying gas level prices for the same energy. Correct?
Jerry Elmer: Well, it is a little bit more complicated than that. I’m happy to explain it to you, but it is complicated and it may not be necessary for what you’re doing.
Uprise RI: Let’s go for it and see what happens.
Jerry Elmer: Our electricity grid in New England is operated by this federally regulated entity called ISO, Independent Service Operator. What they do is see how much electricity we need here in New England for every hour of the year. And then they go out and buy electricity from producers. If we need 16,000 megawatts of electricity per hour, they’ll use that. They buy as much as we need for every hour of the year. And they try to keep prices low. Every generator sells electricity to the ISO at a different cost, depending on how much it costs them to produce it. What the ISO does, for every hour of the year, is ask people to sell it electricity up to the amount that they want so that for this hour we have enough electricity to sell to the 13.5 million end users in New England.
They start at the lowest price and they get, let’s say electricity for a penny per kilowatt hour. Kilowatt hours are what are on your bill and a typical home may use 5, 6, 700 kilowatt hours a month. Let’s say for this hour that we’re talking right now, the ISO needs 15,000 megawatts of electricity. They’ll start by saying, “Okay, who wants to sell electricity for a penny a kilowatt hour” and right up they got 3000 megawatts at a penny. So they take them, now they go to the next price increment, “Who wants to sell electricity to us for two pennies a kilowatt hour?” We got another 3000. Now we have 6,000.
Are we up to 15 yet? No, we’re not up to 15. We need more. Okay. “Who wants to sell it for 5 cents an hour up?” We got another 2000 megawatts. So now we’re up to eight. At a certain point the prices go up, they get closer and closer to the 15,000 they need for this hour. Somebody’s going to sell them electricity for 8 cents, 9 cents, 10 cents, 12 cents. And they’re going to get up to 15,000. Let’s say it was a 12 cents. 12. 12 cents is now said to be the clearing price for that hour. And everybody who bid in at a lower price gets paid the clearing price for that hour, 12 cents. So if you bid in at a penny, but the clearing price is 12 cents, you’re going to get 12 cents. You cannot turn nuclear power on and off like you can a gas plant. So nuclear plants, like the Seabrook plant, bid in at 0 cents an hour because they’ve got to clear every hour.
They know that they’re not going to get 0 cents, they’re going to get eight or 12 cents, which was the clearing price. The reason that solar farms and wind farms lower costs for all consumer is that they bid in every hour at zero. And what happens if you bid in at zero is the ultimate clearing price will be lower, because you won’t have gone up that high to get as much as you want. So when solar producers and wind producers say, “We lower the price for all consumers,” they’re absolutely correct about that.
Now here’s another odd artifact of this system. Every producer gets paid the clearing price, not what they bid in. And the clearing price tends to go very, very high. Basically, on August 9th, the dog days of summer, it’s really hot. Everybody turns on their air conditioner, electricity demand sores, and the clearing price for those hours gets very, very high.
It’s usually 6 cents, 8 cents, 9 cents per kilowatt hour. But on those hours it goes up to $2-$3. Think about the gas fired power plant. They break even at 6 cents for those hours. They’re getting $2. Gas fired power plants often make 96-98% of their annual income on 50 hours a year on hot summer afternoons in August because they can run for 6 cents an hour, and they’re selling for $2 an hour. So these big gas generators that run a lot of hours a year will make 98% of their profits during just a few hours a year, the way that system works.
Uprise RI: That’s amazing. It looks like to me that that would be a place where savings for consumers could maybe be built in with some sort of legislation or some sort of retooling of the economy. I’m not sure if that makes sense, but you know what I’m saying?
Jerry Elmer: That would require a thoroughgoing restructuring of the energy markets. It’s probably not worth it. In contrast, when you look at the requests or demands of the George Wiley Center before the PUC, now you notice that everything they’re asking for, at least everything they’re asking for that appeared on Uprise RI, everything they’re asking for does not appear on the commodity side of the bill. It all appears on the distribution side of the bill. What they’re saying is, “Take it out of the utilities profit.”
Five and 10 years ago, the George Wiley Center would protest to the PUC and say, “Don’t let them charge so much for the commodity on the commodity side of the bill” but the PUC had no power over that. They couldn’t do anything about that. The utility was not making any money on it. They weren’t making any loss on it. It was a straight pass through. Where the PUC can control things is on the distribution side of the bill. The PUC can say we only want the utility Rhode Island energy to get an ROE return on equity of 7% instead of 10%. Yeah. Or 6% instead of 11%. And give that difference back to rate payers. Everything that the Wiley Center is talking about this time is within the power of the PUC to do because it’s on the distribution side of the bill. Yeah. The Wiley Center is not wasting their time and wasting their breath arguing about the commodity side of the bill. They’re talking the distribution side of the bill that the PUC does have control over and can adjust.
Uprise RI: So what am I missing and what questions should I be asking?
Jerry Elmer: The fact is that commodity prices, the commodity side of the bill, are volatile. They go up and down and everybody notices when the electricity utility comes in and says, “You know, the commodity prices have been up recently.” Sometimes the Providence Journal will have a headline that says, “Fourth rate increase in a year.” That’s the commodity side. And it also goes down, it’s volatile and the PUC doesn’t have control over it.
Uprise RI: Would it require a rate case for the PUC to say, “Hey, take less profit this time?”
Jerry Elmer: That’s a very interesting question and I don’t know the extent to which they can tinker around the edges. Rate cases are very complicated. I remember doing a program once with utility regulator who basically showed me the algebraic formula for what goes into a rate case. It’s basically 20 or 21 different variables that you have to figure. And even with very good faith, some of those variables are really not known with certainty. For example, one of the 20 variables is what the cost of capital will be during the life of the rate, which could be 2, 4, or 6 years. Nobody really knows what interest rates will be like four years from now. Even even if you speak in good faith, there is a lot of fudge factors as to what in what goes into that.
Uprise RI: So to summarize all of this…
Jerry Elmer: The commodity price goes up and down. It’s up now. That’s what everybody is up in arms about. And on the commodity side, only 10% is capacity. What that means is that even a sharp change in capacity up or down affects end user bills relatively little.
Uprise RI: So it makes sense to think about how to alter the profit margin of Rhode Island Energy, but the commodity prices, there’s not much we can do. The volatility is there and aside from building more windmills and more solar farms and getting rid of gas, we’re stuck in this cycle until we really figure that out.
Jerry Elmer: If you want to look longer term, what you just said is very true. That is, renewable energy, in the short and medium and long term, will lower commodity prices because renewable energy sources almost always bid into that hourly bid stack at zero. They’re called price takers. They bid in at zero. They’ll take whatever the clearing price is. And the reason they are price takers, the reason they bid in at zero is because they get these renewable energy credits under state law, but hey only get that money when the ISO is taking their electricity. Remember the nuclear power plant, Seabrook, they have to bid in at zero because you can’t turn a nuclear power plant on and off. They’ve got to be operating. So they bid in at zero.
And sometimes, this is another complicated topic, but the ISO has for five years now allowed companies to bid in at negative amounts and that really lowers the clearing price. Think about a gas fired producer who needs 6 cents an hour to produce electricity. Now you’ve got wind farms bidding in it. Negative money. What does that mean? That means instead of the ISO paying you, you’re paying the ISO because you’re bidding in a negative price that lowers the clearing price for everybody.
Let’s make an analogy here of a guy who sells ice cream cones on the street corner. Normally I pay a dollar to the ice cream man and he gives me a cone. If I pay $2, I get a double scoop. If I pay $3 I get a triple scoop. But it’s always the same. I pay him, he gives me the ice cream. What does a negative price mean? It means I get the ice cream and he pays me to take the ice cream. Yeah. So with negative prices at the ISO, which they’ve had now for five years or more, the ISO gets money to take some of this electricity instead of paying for it. Renewable producers who get renewable energy credits can afford to bid in at negative pricing increments. They can afford to tell the ISO, “You take my electricity, I’ll pay you.” What is that going to do to conventional producers who produce electricity from gas, oil, or coal? It’ll totally screw them out of the market because they need to be paid for their electricity.
Uprise RI: Don’t [non-renewable energy providers] also have to buy some of those renewable energy credits?
Jerry Elmer: In some cases yes, but that’s the utility that needs to do that, not the producers. So in the short, medium, and long term, one of the best ways to reduce the price of electricity and to reduce the volatility of the prices is to get more from renewable energy because renewable energy producers bid in as price takers at zero or at negative increments and that lowers the price for everybody. Especially lowers the price at those few hours of the year in August when everybody turns on their air conditioners and prices spike. That’s where it has the biggest impact. Instead of reducing prices from 8 cents to 7 cents, it reduces prices from $2 to a $1.40. Yeah. It’s a much bigger increment.
Uprise RI: I noticed that the PUC is considering phasing out gas entirely in response to the recently passed Act on Climate legislation.
Jerry Elmer: You know it’s interesting. The current chair of the PUC, Ronald Gerwatowski, used to work, for many years, for National Grid. And one of the things that he said back when he worked for National Grid is that Rhode Island may have a unique opportunity to get off of natural gas because when any community doesn’t have natural gas, they need to shift to something else. Generally it would be electricity. A lot of natural gas is used for heating homes and you can use electricity for that. Rhode Island has a unique opportunity because here we have the same utility for electricity and natural gas, which means that the same company could be making money on the electricity side that it’s losing on the natural gas side. Other states that have separate utilities for electricity and natural gas, the gas company doesn’t want to go out of business. Here, we’re just shifting the business from one side of the company to the other side of the company and shareholders may not lose money on the deal.
Uprise RI: Interesting. So we’re not picking winners and losers on that.
Jerry Elmer: We’re not hurting the shareholders of a company by insisting that we go off natural gas. We’re saying we want the same company to heat our house, but we want to do it in a more environmentally sound manner and Rhode Island may be situated much better than some other states that have a separate utility for gas and electricity.
Uprise RI: Well, this has been fascinating. You really bring it down to the level I need it to be at to understand. I really appreciate that.
Jerry Elmer: Glad to help. Let me know if I can help further. Thank you, sir.
Thanks to Jerry Elmer, former senior attorney at the Conservation Law Foundation, for helping me and maybe you understand a little more about how utility rates work and where our future lies and establishing affordable clean energy for everyone.
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