The importance of natural gas rate design during the energy transition

The importance of natural gas rate design during the energy transition
By Niki Mi
Oct 21, 2022

With the impacts of climate change becoming more apparent every day, emission reduction goals and policies are gaining momentum. Twenty-four states plus the District of Columbia have adopted aggressive greenhouse gas reduction goals to address climate change, and more than 80% utilities have set carbon reduction goals. The scale of the U.S. economy’s dependence on natural gas, which supplies 35% of U.S. total energy consumption, means that any pathway to achieve established emission reduction goals needs to address emissions associated with the consumption of natural gas. Many studies of decarbonization pathways have shown that the electrification of some portion of natural gas demand is required to meet GHG reduction goals. Some parties even propose the approach of electrifying all natural gas demands. At first glance, full electrification paired with low-carbon electricity seems to be an attractive solution to decarbonization.

However, there are a number of potential catches to this solution, such as the lack of fuel diversity, the technical difficulties associated with electrification, and the uncertainty surrounding the reliability of the electric grid as the load increases. Another concern, which this article focuses on, is the consumer costs and equity issues. As demand for natural gas falls, the fixed costs of gas system operation and maintenance—including utilities’ return on investment—will be spread over a smaller amount of gas sales. The higher gas rate may drive away customers, which will intensify the cost acceleration for the remaining gas customers, exacerbating the issue. The result: a costly “death spiral” that heavily burdens customers who can’t transition, strands assets, and leaves public service regulators in an impossible bind. 

Figure 1 Retail gas rate forecasts

To compound the problem that the financial impact of raising retail gas rates is likely to fall disproportionately on low-income individuals. As electrification necessitates upfront expenditure for the conversion of appliances or building renovation, low-income consumers may not be able to afford the switch and may instead continue using the gas system, even with financial incentives. 

Is the gas utility death spiral real? It doesn’t have to be. While each has its advantages and drawbacks, there are several options to stabilize customers’ gas rates and bills. 

Avert the hockey stick curve: the role of low carbon fuels 

Electrification paired with low-carbon electricity is one of many potential decarbonization approaches. An alternative approach to achieve emission reduction goals is to utilize existing natural gas infrastructure, high-efficiency natural gas applications, and low carbon gases, such as renewable natural gas and hydrogen. For more information on these kinds of strategies and the potential benefits they may offer for decarbonization planning, read our recent paper Defining the role of gas utilities in a decarbonized energy future from the proceedings of the 2022 ACEEE Summer Study on Energy Efficiency in Buildings. 

Utilizing low carbon fuels—especially in large commercial and institutional building types that are typically difficult and expensive to electrify (some building designs may not be conducive to electric heat pump installations)—could make reaching emission reduction goals more feasible and affordable. Combined with energy efficiency improvements, this approach reduces the demand for conventional natural gas and allows the continued use of existing natural gas delivery infrastructure. 

For remaining gas customers, this pathway shows an advantage in minimizing the growth in gas rate. Contrary to the hockey stick shape in the Aggressive Electrification Scenario, the Low Carbon Fuels Scenario avoids the exponential growth in gas rate while achieving the same emission reduction goal. The more gradual increase in the gas rate in the Low Carbon Fuels Scenario is driven by the reduction in gas throughputs (caused by increased energy efficiency and partial electrification) and the use of RNG and hydrogen, which are more expensive than conventional natural gas. Furthermore, the Low Carbon Fuels Scenario continues to utilize the existing natural gas infrastructure, which has the ability to store and transport large amounts of energy to meet seasonal and peak day energy demand. It is a valuable resource for ensuring energy system resilience.  

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Figure 2 Retail gas rate forecasts

The major uncertainties and risks associated with this pathway are the availability and pricing of low carbon fuels. This approach requires low carbon fuels being available in large quantities, and the price of low carbon fuels has a direct bearing on how affordable the gas system is for consumers. If a limited supply of low carbon fuels (which leads to deep reduction in gas throughput) or high price of low carbon fuels results in retail gas rates rising above electricity rates, an uncontrolled exit from the gas system could occur—leading to a further escalation in gas rates.  

Cost reallocation: Sharing the burden 

As early adopting natural gas customers transition to electricity, the remaining gas customers will be burdened with incremental costs directly related to this transition. Incremental transition costs occurring on the electric side will occur  with growth in electricity demand (i.e., higher costs can be spread across more volume of usage), which has the potential to moderates the increase in electric rates. On the gas side, the opportunity does not exist as gas customers decrease, and remaining gas customers will bear the larger cost burden and subsidize the transition process. To help stabilize those remaining gas customers’ bills, one solution is cost reallocation. The table below lists a few ways to reallocate the costs. 

Gas customer exit fees - Fees charged to customers leaving the gas system for the full recovery of the costs incurred to serve these customers.
  • Pro: Allows the utility to recover the system investment costs from the customers that the system was built to serve.
  • Con: If the exit fees are charged directly to the consumers, it would likely discourage electrification. 

Electricity rate riders - Allocating a share of the long-term natural gas system costs to electricity consumers in the form of electricity rate riders.

  • Pro: Helps mitigate the long-term costs associated with the decarbonization of the natural gas system while not increasing electricity rates substantially.
  • Con: Electric customers who have never used natural gas will be involved in funding the transition, which is likely to lead to concerns about cross-subsidization. 

Electric utility transition payments - Payments by the electric utility to the natural gas utility based on the number of customers transitioning away from natural gas to electricity.

  • Pro: As the payment is directly linked to the number of customers transitioned from the gas system, there won't be cross-subsidization from existing electric customers.
  • Con: Growth-driven incremental investments in the electric grid can reduce the extra revenues earned by electric utilities to fund the transition payments.

Government transition payments - Government can provide support to gas utilities and remaining gas customers in many forms, such as providing transition payments to gas utilities.

  • Pro: This approach ensures the return of capital to the natural gas utilities without burdening electric ratepayers.
  • Con: The government funding is based on taxation, the balance of which will be shared by all taxpayers. 

Lower the rate base: Curb the investments in gas system expansions and upgrades of gas infrastructure

Investments in the natural gas distribution system are typically depreciated over a 50–60 year projected service life. Once the investments are made, they become sunk costs to the system. Every year, gas utilities invest billions of dollars in system maintenance and new customer connections. Recently, large investments in pipeline and gas storage field safety have created upward pressures on gas rates. In a decarbonized future, such pressures will only intensify, driven by the combination of cumulative investments in the gas system over the years and fewer gas sales.  

That’s why it’s critical that gas utilities make their investments efficiently. For example, utilities can target electrification geographically, invest in non-pipeline alternatives (NPA), and limit new customer connections.  

Targeted electrification: Utilities can target electrification at areas served by a specific section of the gas distribution system that need extensive, expensive modifications. By doing this, utilities can avoid investing much more money in the gas system with declining demands. It also enables the retirement of a portion of the distribution network, eliminating the requirement for ongoing O&M expenditures there. 

NPA: Analogous to the non-wire alternatives in the power sector, NPA aim to invest in lower-cost measures such as energy efficiency to substitute for expansion of distribution and transmission assets, which tend to be more expensive and have long service lifetime.  

Limit new customer connections: Compared to electrifying existing gas customers, new construction electrification—reducing the connection of new customers to gas distribution systems—is more affordable and encouraging since it avoids the complication of the exits from the gas system. Many cities, including Brookline, Massachusetts, San Francisco, and New York City have set restrictions on fossil fuel usage in new buildings, which prevents gas system expansion investments.  

There are a range of barriers and challenges to overcome implement these strategies at a national scale. The boxes below show a few examples. 

Figure 3

Shake up the recipe: Reexamine and reform current gas ratemaking practices

According to Bonbright’s principles of public utility rates, rates should be designed to recover costs that are incurred by the utilities, ensure fair apportionment of costs among customers, and incentivize optimal efficiency. To comply with these principles, current ratemaking practices need to evolve and reform with the decarbonization future. 

For example, traditionally the value of an asset is depreciated over its expected useful life. However, given climate goals, the physical capability of a gas system asset will no longer be the only limitation on its value. As the demand for gas reduces, the gas system may need to shrink significantly, and many assets will be retired early. The result? Assets will become stranded or remaining gas customers will pay for the assets that are no longer useful. 

Here lies the opportunity for alternative ratemaking practices. For instance, accelerated depreciation can mitigate the risks associated with the gas system's early retirement. Accelerated depreciation, by reducing assets’ depreciation timeline, allows faster recoveries of utilities’ investments. The annual depreciation expenses will increase in the short term; however, the increase in depreciation expenses will be shared by a large base of customers and usage today, resulting in a modest rate increase. In exchange, the remaining balance of existing infrastructure will decline significantly faster in the coming decades, which helps moderate the rate increase in the future and avoiding handing the biggest bills to those least able to pay. It is an equitable approach as it allows all customers for whom utilities invest in assets pay for the investment rather than passing the expense along to the few remaining customers over the long run. 

Securitization is another financial approach to addressing the risks of gas rate spikes and stranded assets. Instead of recovering utilities’ investments with the return on capital for both debt and equity through customer rates, securitization allows utilities to recover investments through bond financings, which usually have low interest rate. Gas customers can receive significant savings due to the difference between the utilities' cost of capital (the weighted average cost of debt and equity) and the cost of bonds. 

Decarbonization is a must-do, and all options need to be on the table

The demand for natural gas is anticipated to decline as we head toward a decarbonized future. While reducing emissions, the reduction in gas sales could bring up a number of issues, including the financial viability of the gas system, the affordability of retail gas, and the energy equity among energy consumers. In an effort to illustrate how actions taken today could have an impact on the future, this paper introduces a few ideas for moderating the financial impacts of decarbonization for gas utilities and gas users. Further study and investigation to carefully examine all of the available options are required to find the most prudent course of actions moving forward. Thoughtful and comprehensive analysis that lead to diverse and innovative strategies will ensure that decarbonization optimizes the use of existing energy systems while minimizing burden to customers, particularly those who are least able to pay.

Meet the author
  1. Niki Mi, Gas Energy Markets Consultant
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