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Utility Margins Are Key to Electrification

09/18/2020

Is it time for utilities to ditch “revenue requirements” and start talking about “margin requirements?” Yes, and it should have been done decades ago! The utility industry and its customers would be much better off today if that change had been made because it would have delivered lower electric rates and lower emissions. But, it is still not too late to make the change.

While the above statement applies to both electric and gas utilities, we will focus on electric utilities in this article. Increased contribution margins (as defined in the sidebar) are the biggest benefit of massive electric vehicle and cold climate heat pump adoption, and electrification more generally. You might be thinking, “Utility margins? What about CO2 reductions, or base load growth or anything but utilities making money!” 

contribution margin, defined

We know--very few people have strong positive feelings about their electric company (though public power and cooperatives do get good marks!), but the real power of utility margins isn’t lining the pockets of investorsit is ensuring the growth of electrification is financially sustainable and doesn’t just benefit early adopters of electrification technologies. In fact, most of the electrification benefits will flow directly into the pockets of utility customers in the form of lower electric rates! By focusing on increasing the utility contribution margins, we can deliver the trifecta of lower electric rates, lower emissions and financially more stable utilities that can invest billions of dollars into infrastructure without increasing rates.

This summer, Sagewell joined a panel at SEPA’s virtual Grid Evolution Summit (this session, and all the others, are still available to watch at https://sepapower.org/grid-evolution-summit/!). In that session, we mentioned that utility margins are the biggest benefit of massive electric vehicle adoption, and electrification more generally.

But first, a quick reminder about what margins are. In this context, think of margins as the economic benefit of a program or service minus the costs of providing that service. Let’s go through a few quick hypotheticals to make sure we’re on the same page. A customer in the midwest installs a new heat pump, replacing their old propane-fired furnace. They’ll use an additional 5,000 kWh per year to heat their home, at a cost of 10 cents per kWh, resulting in $500 in revenue for their utility. This hypothetical utility pays 3 cents per kWh to supply electricity, or $150. This means the utility earns $350 in margins on that heat pump installation. Things get more complex when we include peak costs, or incentives. Imagine this heat pump also increases winter peak costs by $100 so the annual contribution margin is $250. If the utility provides a $500 rebate for the installation, it takes two years to get the money back. Starting in year three, the heat pump is providing $250 a year towards the other costs of running the utility.  This may not sound like much, but considered this - a typical home in this territory is only generating about $100 per year in net income so the heat pump increases the income from $100 to $350 a year, or 350% increase. And, that cashflow will typically last for 15 years. There are very few investments that a utility can make that can have that kind of a return on investment. However, to get a more full picture, one has to deduct other upfront costs of customer acquisition from the margins (e.g. heat pump marketing costs, customer and contractor management program cost, etc.). We typically find that utilities can achieve a four or five year payback on their investment and then earn another 10 years of positive cash flow from a heat pump marketing program.

However, the following point is crucial for anyone considering launching an electrification program. When electrification programs don’t have positive margins, the entire customer base is subsidizing participating customers, and due to the large upfront costs of fuel switching, those customers tend to be wealthier. However, electrification programs with positive margins can provide system-wide benefits!

A few of the benefits of increased margins from electrification are:

Enabling infrastructure improvements without rate increases

Utilities could use the added margins from electrification to improve grid infrastructure. Potential investments could be used to increase smart meter penetration, increase transmission and distribution capacity to handle the increased load, or countless other projects that are currently being under funded, or paid for by all customers.

Expand carbon-free generation

The long-term goal of electrification is a carbon-free future across the entire energy economy. The increased margins from electrification programs can accelerate that transition to a carbon-free future faster by providing funds to pay for solar, wind and storage investments to meet the needs of the system.

Lower rates for all customer

The potentially biggest impact of successful positive margin-generating electrification programs is downward rate pressure. As more customers electrify and therefore increase the margins for the utility, the utility will be able to lower the electric rates for all customers. EVs are the cheapest form of transportation nationwide (often less than $1/ gallon of gas), and in many parts of the country heat pumps already have price parity with natural gas. Using the margins from electrification to lower rates will be a virtuous cycle, that increases the cost competitiveness of electricity and further increases electrification.

Rather than improving the grid and shifting toward carbon-free generation, and hoping electrification will follow, utilities should design their electrification programs to create positive margins - and aggressively promote electrified technologies. Many utilities have had appliance stores (some until the 1980’s) so the old concepts are new again. With the increased margins, the grid benefits, and electrification programs will pay for themselves and benefit everyone by lowering emissions. 

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