Electric Rates Can Help or Hinder Heat Pump Progress

An economic case for heat pump-friendly electricity rates.

Across the United States, clean electric heat pumps are gaining momentum in the market, and state and local governments are supporting their deployment to boost energy efficiency, cut climate pollution, improve health outcomes, and grow the clean energy economy.

This has come alongside an intensified focus on electricity rates as utility bills have increased for many Americans. Specifically, there is a present risk that converting home heating from gas to electricity will raise household bills in some parts of the country, deterring families from electrifying. This is especially critical for the growing share of families who struggle to afford high energy bills.

This policy brief attempts to answer these questions by focusing on how electricity bills are calculated, a process known as rate design. Reforming these rates is an important strategy for accelerating the decarbonization of homes and encouraging the adoption of heat pumps, an energy-efficient solution for heating and cooling.

Below we provide background information on rate design and evidence that due to these designs, heat pump customers are often being overcharged by their utilities. These customers are paying a disproportionate amount of money for energy compared to customers without heat pumps based on their utility’s actual costs to provide electricity. We offer some solutions to address this cost discrepancy and propose the next steps for both the near and long term.

Rate Design and the Heat Pump Misalignment

Utilities and their regulators have always had to balance multiple objectives when designing rates and calculating bills. Standard practice suggests, among other considerations, that rates should be easy to understand, predictable, and effective in covering utility costs, and that utilities charge customers fairly based on the costs they impose on the overall system. Historically, this fairness principle has often manifested simply as higher bills for customers who use more electricity. In recent years, regulators have moved utilities toward charging peak and off-peak rates to reflect the higher cost of serving customers during periods of high demand. These peak periods are the drivers of investments in expanding the capacity of the electricity system and, therefore, play a major role in shaping the cost of electricity.

Today, residential electric rates are in transition, as long-held models for consumer demand and electricity system costs are being upended by the rising role of large-scale renewables, consumer adoption of electric vehicles, and residential solar. These factors change system economics in many ways, from making mid-day electricity cheap in areas where solar energy is prevalent to driving new demand spikes where many customers plug in electric vehicles at home following their evening commutes. Below, we explore whether electricity prices appropriately reflect actual system costs across much of the country, a question surfaced by recent research by academics at the University of California.

Another study from the New York State Energy Research and Development Authority (NYSERDA) identified that the current rate design overcharges heat pump customers for their added electricity demand because that demand predominantly occurs in the winter, and the state’s grid demand peaks in the summer. The result is that customers using heat pumps may pay more than their fair share of the utility system costs. Because many electric utility system costs are fixed and driven by peak demand (e.g., during the hottest hours in the summer), utilities face high costs to meet increased demand during a peak period but relatively low costs to provide electricity when there is excess capacity on the system. Rate design is, in a sense, a way to fairly allocate these costs to customers in line with each customer class’s contribution to system costs.

To delve deeper into this issue, RMI partnered with 5 Lakes Energy to estimate a typical residential customer’s costs and bills across several Midwest utilities. This is a critical region to explore this issue, as high heating needs during cold winter months already drive significant energy costs, and the ratio of electricity to natural gas prices is higher than in other parts of the country. We first calculated costs and bills for space heating, water heating, and cooking for both a household that uses natural gas and a household that uses efficient electric equipment such as heat pumps.

This analysis relies on the current capability of utilities to estimate their costs to serve different customers. Utilities regularly study their cost of service and establish a variety of factors that reflect cost on their system — for instance, assigning a high-cost factor for meeting demand on the hottest summer afternoons. Using these factors from one utility — NIPSCO in Northern Indiana — showed that a typical customer would see bill increases if they replaced natural gas equipment with heat pump equipment in the home. However, as shown in the figure below, the utility’s rates raised the electrified customer’s bills above what it costs to serve them and unfairly overcharged them hundreds of dollars on their bill per year. If electricity bills matched the cost of service, the same customer would save hundreds of dollars per year when electrifying compared with using natural gas equipment.

Options to Establish More Electrification-Friendly Rates

Rate design has always required balancing multiple objectives, and cost causation (i.e., the goal that customer bills reflect the actual cost to serve them) is not the only important principle. However, in this case, rates may be actively working against policy priorities supporting electrification and the societal goals of reduced climate and health pollution that undergird them. Regulators have an opportunity to address this misalignment of electric rates with electrification. Rapid action on this is important to capture the tailwind of heat pump market growth and any local or federal funding for heat pump programs.

The first steps in rate reform for building electrification are to understand the local landscape and get clear on objectives for rate changes. Regulators and advocates should assess the local utility system dynamics and costs and review rates already available to electric heating customers.

Several approaches exist or have been proposed, and they could be used in isolation or combination. Each approach has tradeoffs that should be carefully considered in ratemaking proceedings to ensure that changes align with other important policy goals.

Seasonal Heating Rates

Utilities could shift more of their cost recovery from winter months to summer months, given most utility systems in the United States see peak demand and costs in summer. For example, two utilities in Maine (Central Maine Power and Versant Power) have introduced seasonal heating rates aimed at reducing electricity rates during winter and making heat pumps more affordable. Their rates combine increases in the fixed charge on customer bills with provisions to lower the volumetric energy rates during winter months. However, in some areas this strategy risks enabling low-efficiency heating systems where winter electricity is relatively cheap today, which could substantially increase system costs in the long run as more households adopt electric heating.

Increased Fixed Charges and Reduced Variable Rates

The strategy of increasing fixed charges and reducing the variable rate increases bills for customers with lower energy usage and reduces bills for customers with high energy usage. This has a negative impact on low-income customers, who tend to use less energy. These rate changes reduce the incentive for rooftop solar and energy efficiency but also reduce household costs for adding electricity use with a heat pump or electric vehicle, supporting beneficial electrification. Arguments in favor of these changes emphasize that they improve alignment between prices and costs and support beneficial uses of electricity that reduce fossil fuels though this is often contested. In an attempt to avoid the regressive nature of fixed charges, recent rate efforts in California have included reducing the marginal electricity price by shifting some costs into a monthly fixed charge while simultaneously providing a discount for households meeting either of the state’s existing thresholds for income-based bill reductions.

Time-Varying Rates

Other approaches emphasize time-varying rates that change throughout the day. While today many such rates are focused on summer months, these rates would have to be applied in winter months to have a substantial effect on heating energy use. Time-varying rates offer broader advantages by increasing the value of energy efficiency at specific times of high electricity usage when it’s most needed.

Separating the Customer Class

Alternatively, utilities may simply consider heat pump households as a separate class of customers and calculate rates independently for this group, just as they consider business and residential customers separately today. This approach could resolve the “overcharge” problem described above in the near-term, but as more and more households make the conversion to electric heat pumps and change the cost dynamics, it may require another revision in the medium term.

Customer Rebates

Rather than address the heat pump cost issue through rates, utilities could offer fixed rebates designed to compensate for the way heat pump customers are overcharged on their electricity bills. Such a rebate could be offered as an up-front lump sum, or as a monthly credit applied to such customers’ bills.

Additional Considerations

Any solution aimed at solving today’s rate design challenges will need to account for multiple factors. Additional considerations include the following:

• Energy affordability measures are needed for low- and moderate-income customers, who experience far greater hardship from current electricity price increases. By itself, electrification-friendly rate design will not address high energy costs, utility disconnection, or the heat-or-eat dilemma that 1 in 7 households face today. Additional solutions for affordable heating are needed everywhere.
• Efficiency and demand flexibility reduce costs long-term. Rate changes that make electrified heating more attractive should encourage efficient and flexible use of electricity that reduces strain on the grid, limits system buildout needs, and keeps costs in check for ratepayers. This is valuable today for managing summer peaks but could also play a role in the future for heating demand, given the prospect of more people using electricity for heating in the winter.
• Cost-aligned rate structures will evolve over time. There may be a disparity between near-term and long-term solutions. In colder climates, higher adoption of electrified heating may shift the electricity system from summer to winter peaking. In such a system, additional electricity use in the winter would not draw from excess capacity but instead impose a higher cost of service. Rates would need to evolve to reflect this reality as well.
• Rates must support a broad set of needs in the clean energy transition, not just building electrification. Households will change how they consume electricity due to a variety of factors over the coming years and may need different rate solutions for electric vehicle charging than for electric heating, for example. Rates need to send efficient signals to all customers, not just to those who opt in to optional rates.
• Rates should provide incentives for the most cost-effective pathways to integrate new demand while the electricity system itself transitions away from traditional fossil fuel power plants to greater shares of clean resources such as wind, solar and batteries.

Conclusion

Electric rate reform for beneficial electrification is a near- and long-term endeavor.

In the near term, policymakers continue to make progress addressing up-front costs for heat pumps. Regulators should urgently explore the economic and public interest rationale for electrification-friendly rate design to address mispriced operating costs. Reform will be critical to scale electrification’s impact as a decarbonization strategy.

In the long term, rates should evolve to align with both traditional regulatory principles and emerging ones. The next 20 years promise to look very different than the previous 20, especially with increased extreme weather events and the emergence of different sources of load growth from space heating electrification, data centers, electric transportation, and more. Improving rates now will help confront these emerging grid system challenges and allow utilities to provide clean, affordable, and reliable electricity in the years to come.

RMI would like to acknowledge 5 Lakes Energy for their supporting analysis regarding utility cost of service and bill impacts of electrification.