Monday Study – Price Signals In Rates To Grow Heat Pump Use

Heat Pump–Friendly Cost-Based Rate Designs

Sanem Sergici, Akhilesh Ramakrishnan, Goksin Kavlak, Adam Bigelow, and Megan Diehl, January 2023 (The Brattle Group and Energy Systems Integration Group)

The economics of heat pumps relative to natural gas heating will be an important driver of customer adoption of these technologies and will determine the extent to which ambitious building electrification goals can be met in a timely manner. If the operating costs for heat pumps turn out to be favorable compared to the operating costs for natural gas equipment, it is possible to see a significant uptake of the heat pumps even before the technology cost declines. In this white paper, we examine the role of alternative “cost-based” and “cost-reflective” electricity rate designs in improving the economics of heat pumps by reducing their operating costs. We use a proprietary dataset of gas and electricity usage for 80 single-family residential customers of a large investor-owned utility for modeling customers’ electric and gas heating bills before and after electrification. We find that the operating cost gap is positive for all 80 customers under the default electricity rate (energy costs for operating the heating equipment are higher post-electrification). However, moving to one of the three alternative rates flips all 80 customers from a positive cost gap to a negative cost gap, in which energy costs for operating the heating equipment are lower post-electrification.

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Introduction

Residential and commercial buildings consume large amounts of energy for cooling, heating, and lighting needs. In the U.S., the building sector has been contributing roughly 30 percent of total greenhouse gas emissions. According to a recent United Nations report, the building sector was responsible for 38 percent of CO2 emissions globally in 2019 (UNEP/GABC, 2020). Given the magnitude of building sector emissions, the decarbonization of this sector, mainly through heating electrification using heat pumps, constitutes a key component of state and city climate action plans.

The economics of heat pumps relative to natural gas heating will be an important driver of customer adoption of these technologies, and thereby determine the extent to which ambitious building electrification goals can be met in a timely manner. While heat pumps are much more efficient in converting energy into heating output than efficient natural gas boilers and furnaces, they also have higher initial capital costs.1 Heat pumps’ operating costs can also be higher than natural gas equipment depending on climate, equipment type and efficiency, electricity rates, and rate structures. Even in regions where heat pump operating costs are lower than operating costs for natural gas equipment, the operating cost gap will need to be significant to offset the upfront cost premium and return a reasonable payback for customers who are in the market to purchase a new heating system.

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Technology costs are expected to come down over time, and heat pumps will likely reach cost-parity with natural gas equipment eventually. However, if the operating costs for heat pumps turn out to be favorable compared to the operating costs for natural gas equipment, it is possible to see a significant uptake of the heat pumps even before the technology cost declines. In this white paper, we examine the role of alternative “cost-based” and “costreflective” rate designs in improving the economics of heat pumps by reducing their operating costs. We define cost-based rates as rates that recover a utility’s entire cost of providing service to a class of customers, and define cost-reflective rates as rates that send efficient price signals reflective of the extent to which a change in a customer’s timing or magnitude of usage would change overall utility costs. Default utility rates for the residential class typically consist of a small fixed monthly charge and a volumetric charge on kWh consumption. This type of rate is typically cost-based because it recovers the utility’s revenue requirement for the class, but not very cost-reflective because transmission and distribution costs are not driven by kWh consumption.

This analysis considers alternative rates that are costbased in the sense that they would collect the same amount of revenue from the average customer (who has not yet electrified) as the default rate. Therefore, the rates need not be limited to electric heating customers but could be designed for the residential class and made available to all residential customers (not just the electric heating customers) on a voluntary basis. In addition, all three alternative rates put forth in this analysis incorporate more cost-reflective components than the default rate. This includes components such as higher fixed charges, time-varying volumetric charges, and time-varying demand charges, all of which are more reflective of utility cost causation than flat volumetric charges. In other words, we are not advancing differing, subsidized rates for different end uses here. Rather, we are assessing the broader appeal of these structures, finding that there are alternative cost-based rates that could be made available to all customers, with customers with different appliances and use cases opting into these rates if the structure of the rates is better aligned with their usage profiles.

This white paper is structured in four sections. The second section describes our analytical approach to modeling customers’ gas and electric usage for heating. The third section describes our modeling results from calculating heat pump and natural gas boiler heating bills under various rate structures. The fourth section concludes with the key takeaways from the white paper…

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Key Takeaways

This analysis shows that there are alternative costbased rate designs that can improve the economics of heat pumps by resulting in electric heating bills being lower than natural gas heating bills (i.e., a negative operating cost gap). Specifically, we show that while the operating cost gap is positive for all 80 customers under the default electricity rate (Rate I) (energy costs for operating the heating equipment are higher postelectrification), moving to one of the three alternative rates flips all 80 customers from a positive cost gap to a negative cost gap, in which energy costs for operating the heating equipment are lower post-electrification.

Increasing the fixed charge and lowering the volumetric charge (Rate II) reduces the electric heating bill to a sufficient extent that the operating cost gap turns negative for all customers. Further, switching to a TOU day/night structure (Rate III) or a demand-based structure (Rate IV) results in even larger negative operating cost gaps. Rate IV is the most effective rate for reducing electric heating bills, for our sample of 80 single-family residential customers, with Rate III closely following it.

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More Cost-Reflective Rate Designs Improve the Economics of Electrification

These results reflect the fact that all of the alternative rate designs are better aligned with the marginal cost of generating and delivering power, compared to the default residential rate design, which typically is not. In many jurisdictions across the country, retail electricity prices are largely disconnected from the marginal costs. As Borenstein and Bushnell (2022) argued, “residential electricity rates exceed average social marginal cost in most of the U.S.” and “there is large variation both geographically and temporally.” To the extent that retail prices are above the short-run marginal costs because a large portion of the fixed costs of delivering power are also collected through volumetric rates, this creates a distortion in price signals and leads to suboptimal levels of electricity consumption and adoption of new customersited technologies. One of the unintended consequences of this phenomenon is the slower adoption of heat pumps, because heat pump usage increases total electricity consumption and therefore electricity bills, turning out to be uneconomic under typically volumetric default residential electricity rate structures.

All of the alternative rates modeled in this study are cost-based and revenue-neutral in that they recover the same costs as the default rate. They also improve upon the cost-reflectivity of the default rate by better aligning one or more components of the rate design with the underlying cost structure. These alternative rates also favor the operating characteristics of heat pumps:

• Rate II has a higher fixed charge and lower volumetric charge, which is favorable for heat pumps since this equipment substantially increases a household’s electricity usage.

• Rate III is a seasonal day/night TOU rate, with lower rates for off-peak (night) hours and also lower day and night rates for the non-summer season. A significant portion of the heat pump load tends to fall into the off-peak periods because those tend to be the coldest, which implies that various cost-based TOU rates might favor heat pump usage, all else equal. Moreover, most of the heat pump load materializes in the nonsummer months; therefore, seasonally differentiated rates in summer-peaking systems (with lower nonsummer rates) might favor heat pump usage, all else equal.

• Rate IV is a seasonal TOU-based demand rate. Heat pumps tend to have high load factors, which implies that demand-based rates might favor heat pump usage, all else equal. In our rate design, we defined the billing demand to be the average of the top four demand hours, with the averaging intended to avoid the unpleasant customer experience of getting a high bill due to one high hour.

It is important to note that as the system conditions evolve, and summer-peaking systems become winter peaking with increasing levels of building electrification, rate structures may need to be refreshed to maintain their cost-reflectivity. Some of the attractive features of the rates modeled in this study (i.e., lower non-summer rates due to seasonality) may need to be eliminated at that time since the system cost drivers would no longer support these design choices. These revisions and adjustments are all part of the rate design process, since it is not possible to “future-proof ” rate designs.

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These Alternative Rate Structures Have Implications for Customers’ Other Electric Loads

While our analysis showed that these alternative rates were effective in creating a negative operating cost gap for heating (a lower cost of heating after electrification), it is important to understand the implications of these rates for customers’ other electric loads. Rate migration can create costs or savings independent of heating electrification, depending on the nature of customers’ nonheating loads. This is an important consideration when marketing alternative rates to customers. For some of the customers in the sample, even before any electrification, switching to the TOU rate (Rate III) would increase their electricity bill by ~$200/year. (This increase could be reduced or eliminated through load response to TOU rates, although we did not model this impact in our study.) On the other hand, there are some customers for whom switching to one of the demand-based rates would reduce the bill by ~$100/year even before any electrification. Utilities may choose to develop screening tools to determine which customers may benefit from these alternative rates and market these rates accordingly to the customer base.

For the purposes of this study, we assumed that customers maintain their gas service for non-heating-related use cases such as cooking. This implies that these customers continue to pay the fixed customer charges for the gas service, along with the cost of volumetric gas usage. Fully electrifying a household would create additional savings by allowing it to avoid all gas charges (an additional $350/year in fixed gas charges for a single-family home). It is very likely that gas rates will increase faster than electricity rates in the next decade; therefore, the cost advantage of heat pumps will only increase over time. It is important to note that as the system conditions evolve, and summer-peaking systems become winter peaking with increasing levels of building electrification, rate structures may need to be refreshed to maintain their cost-reflectivity.

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Information Barriers Need to Be Addressed

Lastly, the availability of alternative rates that favor the economics of heat pumps does not necessarily mean that customers will start taking advantage of these rates in droves. Information barriers need to be addressed through utility programs targeting customers and pairing them with the rate design most favorable to them. Utilities can develop data analytics tools to identify customers who may be getting close to replacing their heating systems and “catch” them before they make their investment decision. Contractor training programs could be developed in which contractors increase awareness for new rates for customers who are in the market for a new heating system. With the availability of alternative rates, contractors could take into account the rate characteristics to make system recommendations. For example, if the demand charges are very high in an alternative rate, it could mean that purchasing a highly efficient cold climate heat pump is a better choice than a less efficient heat pump with resistance backup even if there is an upfront cost premium for the cold climate heat pump.

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The Use of Cost-Reflective Rate Designs Is Increasing

More and more utilities are starting to move toward more cost-reflective rate designs. Some are increasing their fixed customer charges to move them closer to the values implied by their cost-of-service studies. Others are moving toward time-varying rates, mostly in the form of voluntary/opt-in rates, but in a few cases offered as default, opt-out rates. When utilities offer opt-in cost-reflective rates, customers are able to opt in to the rates that are most convenient for their “energy lifestyle.” To the extent that all of these alternative voluntary rates are cost-reflective, it will be possible to achieve a win-win: customer satisfaction will increase and utility cost recovery will become more equitable…

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