Why Demand Charges Aren't The Solution To The Solar Net Metering Debate

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Includes: RUN, SPWR, TSLA, VSLR
by: Oliver Davies

Summary

Utilities are proposing demand charges as a way to compensate distributed solar for the value it provides the grid.

Utilities claim that these charges incentivize customers to deploy systems for the benefit of all ratepayers.

They also also claim that these charges fairly compensate solar customers for this benefit.

The utilities are wrong. Demand charges vastly undervalue distributed energy resources. They can also incentivize value-destructive operation.

Introduction

The market net metering conversation appears to be entirely focused on the fact that electric utility rates need to be set in a way that ensures solar customers pay their fair share of fixed grid costs. As Axiom Capital's Gordon Johnson said recently when commenting on SolarCity (NASDAQ:SCTY), rooftop solar customers aren't paying for the cost of the wires.

But what about the value of solar, which is the other side of the coin? This issue is too often ignored.

When the issue is tackled, a demand charge is usually proposed as a way to correctly incentivize and compensate distributed energy resources. The idea is that, if a price is set based on maximum grid usage - which is a demand charge - customers will be encouraged to reduce their peak load (peak demand). Quite simply, if they use less fixed infrastructure, they will be charged for less fixed infrastructure. As a result, they will be fairly compensated for the value they provide the grid through the reduction in peak load. Utilities in Arizona and Nevada are among those peddling the charges in this manner.

In this article, I show why this way of tackling the value of solar issue is wrong. A demand charge fails in both goals: it neither incentivizes customers to use their distributed resources in a way that maximizes benefits for ratepayers nor does it fairly compensate customers for the value they provide the grid.

A background on the net metering debate

The net metering debate is really about two issues. The first is what price a solar customer should pay for the electricity they consume from the grid. The second is what price the utility should pay for the solar systems' excess energy.

In the first case, utilities quite rightly argue that solar customers do not pay their fair share of the fixed costs of operating the grid. A customer who consumes half as much electricity shouldn't pay half as much to the utility, as there is a fixed cost of providing the transmission, distribution, and generation infrastructure necessary to serve that customer's maximum load. For instance, a customer who required 10kw of peak power before solar - but now requires 9kw - still needs 90% of the grid infrastructure as before. So even if the net kwh it consumes from the grid falls 50%, the cost of servicing that customer falls by much less than 50%. It is for this reason that utilities want to introduce fixed charges in order to capture the expense net metering customers are avoiding. The goal is to ensure that every solar customer pays what it truly costs to deliver them the electricity they consume from the grid.

Surprisingly enough, this logic alone does not cause contention. The only reason solar advocates disagree with it is because it is often pursued in absence of the second net metering issue, which is the value of the solar. Many solar advocates will counter attempts by utilities to impose fixed charges with the argument that the generated solar energy is worth more than the retail rate. And because of this fact, any costs customers are avoiding are offset (or more than offset) by this extra value provided to the grid.

Why does distributed solar add value to the grid?

The key benefit that sets rooftop solar apart from other technologies is that it can shave peak load. In most states it just so happens that (thanks to air conditioners) peak electricity demand occurs on the cloudless, hottest days. And so rooftop solar, which is located at the same site as the load, generates significant power at peak times. Put another way, distributed solar can reliably shave the peak load.

Peak shaving is valuable because of the same fixed costs discussed in the section above. If the peak load in a given year is 1,000 MW, then 1,000 MW of generation and transmission & distribution capacity must be built. It doesn't matter if the final 1 MW of demand only occurs for one hour a year, the infrastructure to supply that 1 MW must be there. The result is that a large portion of the generation and T&D capacity is heavily underutilized. So little energy passes through it each year that on a per kwh basis its cost is enormous.

It is for this reason that distributed solar can be so valuable. If a given penetration of rooftop solar shaves the peak by 1%, then the utility needs to build 1% less infrastructure. Depending on when the peak occurs and the marginal cost of generation and T&D capacity, distributed solar is often simply a cheaper way of supplying that peak demand (In Nevada, for instance, the peak occurs at 4pm, which means rooftop solar can provide significant value).

So solar is not only worth the value of the energy it produces, but also the value of the infrastructure it avoids. It has other intangible benefits too, but for the purposes of this article - which focuses on demand charges - it is peak shaving that matters.

Why do utilities think demand charges will correctly incentivize the deployment of valuable distributed energy assets?

Utilities have often proposed demand charges as a solution to solar net metering woes. A demand charge is similar to a fixed charge, except that it is based on the maximum kw in any given month. If your peak power demand is 10kw, you pay a demand charge based on 10kw; if your peak is 5kw, you pay a demand charge based on 5kw. The customer with a 5kw peak would pay half as much on their demand charge as the customer with a 10kw peak. Compare this to a regular bill, which charges customers only on a per kwh basis.

Utilities have taken a shine to this approach because it appears to solve two problems in one. First, it ensures that customers pay their fair share of fixed costs. Second, customers who actually shave their peak are rewarded for their valuable services. If your solar panels or storage system shave your peak by 20%, then you will receive a just reward. If you don't shave peak, then you won't benefit at all. If resources like solar and storage are truly profitable for ratepayers, then a demand charge will incentivize their deployment.

Right?

Wrong.

Why demand charge advocates are wrong

Demand charge proponents have made the classic mistake of assuming what's true in a part of a system is also true in the system as a whole. This error is what is known as the fallacy of composition. Just because a solar customer shaves their own peak by 1kw, doesn't mean they shave the grid's peak by 1kw.

For example, while the circuit-wide peak might occur at 4pm, the individual customer's peak might occur at 7pm. At 4pm, their 6kw solar system is generating 3kw power. At 7pm, it is generating 0.1kw. As a result, demand charges would only credit them for 0.1kw of peak shaving, when in fact they actually shaved the peak by 3kw.

The magnitude of the analytical failure grows when storage is added to the mix. In the case of solar in the paragraph above, ratepayers profited handsomely by paying for 0.1kw of peak shaving when they in fact received 3kw. Solar customers lost out to non-solar customers. In the case of storage, on the other hand, everyone loses. By incentivizing customers to only focus on their personal peak, you risk that the battery discharges at times that provide zero benefit to the grid. Through the mechanism of the lower demand charge, non-net metering customers end up paying net metering customers for phantom services. In other words, such a system not only fails to shave the circuit-wide peak, but it also causes an unfair wealth transfer from non-solar customers to solar customers.

For those wondering whether this problem applies in reality, it does. Residential customers' peaks often occur after the sun has stopped shining. Commercial customers' peaks, on the other hand, often occur in the middle of the day. For this reason, circuit-wide peaks often occur around 3-5pm, as the load curves are an aggregation of different customer classes. As a result, any residential customer who shaves their 7pm peak to reduce their demand charge is creating no value for the grid. The same applies to commercial customers who are incentivized to focus only on their 12pm peak (Note that some circuits might be mostly residential or mostly commercial, in which case the time of the peak would shift more to the evening or to midday. If a circuit was entirely made up of residential customers or commercial customers, then this problem would be much less severe).

Even if the individual customer's peak did coincide with the circuit-wide peak, the demand charge approach still fails to capture the full value of distributed energy systems. Rooftop solar and storage would receive inadequate compensation for the value they bring to the grid. As a result, technology that would save ratepayers money would not be deployed. To understand why, we need to look at a hypothetical daily solar generation and load profile of an individual customer (or group of solar customers) in a grid where rooftop solar is 2% penetrated:

In this case, the solar production pushes the peak out to 7pm. The peak is shaved by 16 MW (13.5%). The customers' demand charge would be only 13.5% lower. This level of savings clearly wouldn't be sufficient to incentivize deployment.

The reality, however, is that this method vastly underestimates the ratepayer benefit of rooftop solar. To understand why, we need to look at how this level of solar deployment affects the load profile of the entire grid. Take a look at the following table (the grid load is the same shape as the solar customers' load):

While the percentage drop in the circuit-wide peak load is far smaller than it was for the individual customer - 3.8% compared to 13.5% - what matters is that the ratio of peak shaving to solar capacity has jumped considerably. When the grid as a whole is considered, the amount of peak shaved by the same capacity of solar systems is 219 MW. Compare this result with the amount of shaving implied by the demand charge method, which is 16MW. What that means is that an individual solar system shaves significantly more MW of peak on a circuit-wide basis than it does on an individual basis. The solar systems cost the same in both scenarios - just on a circuit-wide basis, they are significantly more valuable.

For this reason, the demand charge, which focuses only on the reduction in an individual customer's peak, would massively undercompensate solar customers. The same issue would occur if storage was added to the mix: the amount of peak shaving it could achieve would be significantly higher than the amount implicit in the demand charge.

It is worth noting that the gap between the two methods reduces as penetration increases: at a 20% penetration, the solar systems shave 587 MW vs. the 162 MW assumed by the demand charge method. Despite the fact the gap closes as penetration rises, it is clear that until penetration hits 100%, the method would fail to capture the true value distributed energy resources add to the grid. As a result, the deployment of these valuable technologies simply wouldn't occur.

Conclusion

The distributed solar industry is in flux. Utilities are trying their hardest to avoid a future where their profits fall. The chief anti-net metering argument: that solar customers don't pay their fair share of fixed grid costs is seductive in its simplicity. It is far easier to understand than the other side of the solar net metering debate, which is the value of solar. Aided by this complexity, utilities are trying to implement demand charges under the false justification that they will capture the value these systems provide ratepayers. Fortunately, their efforts have been mostly resisted thanks to the difficulty residential customers would have understanding them. The implication, however, is that many regulators don't yet understand that, by focusing only on the individual, that they wouldn't fully capture the value of solar. They also don't seem to understand that such charges wouldn't incentivize operation in a way that provides the grid a benefit.

To fairly compensate distributed energy resources, regulators must calculate the value they create on a circuit-wide level. That's the only way to ensure valuable technology is deployed to the benefit of ratepayers. It's time utilities and regulators (and investors) understood that. Perhaps companies like Vivint (NYSE:VSLR), Sunrun (NASDAQ:RUN), SunPower (NASDAQ:SPWR), and SolarCity provide more value to the grid than the market currently thinks.

Disclosure: I am/we are long SCTY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.