The Impact of Non-Linear Electricity Pricing

The current [inverted block pricing] rate structure cuts the electricity bills of households in the lowest income bracket by about 12 percent, but a targeted low-income program may offer as much assistance while distorting prices less.

With rising energy costs and a growing awareness of the threat of climate change, some policymakers believe that retail energy prices will have to rise to reflect the true cost of energy consumption. At the same time there is concern that higher energy prices, particularly in the electric utility sector, will disproportionately affect the poor.

Increasing-block pricing (IBP) for electricity -- which is also called inverted-block pricing, increasing-tier pricing, or lifeline rates -- is seen as one way to ensure that nearly every household can afford a basic quantity of electricity while raising additional revenue from wealthier electricity consumers. One recent survey of 61 U.S. utilities found that about one-third of them use IBP for residential customers, and many more utilities and regulators are currently considering adopting IBP.

California's regulated utilities initially adopted IBP in the 1980s. After the California electricity crisis of 2000-2001, three investor-owned utilities needed to raise substantial revenues, but regulators and state legislators were concerned about the impact of rate increases on lower-income households. The regulators adopted a five-tier retail IBP structure where the prices on the first two tiers were virtually frozen at pre-crisis levels and incremental revenue needs were to be met by raising prices on tiers 3, 4, and 5. These changes led to much greater variation in the prices faced by different households within the IBP structure. By 2008, the price on the highest block -- that is, the marginal price for about 6-to-9 percent of all residential customers -- was between 80 and 300 percent higher than the price on the lowest block, depending on the utility.

In The Redistributional Impact of Non-linear Electricity Pricing (NBER Working Paper No. 15822), author Severin Borenstein studies the effect of California's IBP regime, combining household-level utility billing data with census data on income distribution by area. He finds that the current rate structure redistributes income to lower-income groups, cutting the electricity bills of households in the lowest income bracket by about 12 percent (about $5 per month). But Borenstein also finds that the redistribution from IBP comes at a significant cost linked to distorted prices, with many customers facing marginal prices that are much higher or lower than the marginal cost of providing electricity. As a result, some customers may consume much more electricity than would be optimal and others much less.

Borenstein compares the impact of IBP to the California Alternate Rates for Energy (CARE) program, which offers a different and lower electricity rate structure to qualified low-income households. He concludes that means-tested programs, such as CARE, can help low-income households as effectively as IBP while causing less inefficiency from price distortions. He also notes, however, that more of the revenues under IBP come from the very wealthiest households than under the CARE program, so IBP may be a more progressive means of redistribution.

Finally, Borenstein shows that a common approach to studying (or controlling for) income distribution effects by using median household income within a census block group may substantially understate the potential redistributional effects of programs like IBP or CARE.

-- Lester Picker