Report Says Cost Based Rates Are Needed To Make Heat Pumps Competitive

Switching to cost based or cost reflective utility rates would make heat pumps competitive with natural gas heating and speed electrification, according to a new report.

The report, Heat Pump-Friendly Cost-Based Rate Designs, was done by Brattle Group for the Energy Systems Integration Group, a nonprofit organization that marshals the expertise of the electric industry’s technical community to support grid transformation and energy systems integration and operation.

In the white paper, the Brattle analysts analyzed a proprietary dataset of natural gas and electricity usage for 80 single-family residential customers of a large investor-owned utility with relatively high electricity rates and cold winters.

The analysis showed that the operating cost gap was positive, that is, the cost of operating heat pumps was higher for all 80 customers under default electricity rates than the cost of using natural gas-fired heating systems.

Heat pumps are more efficient than natural gas-based heating systems and their costs are expected to decline over time, but right now heat pumps are often more expensive to install and operate, the report noted.

However, the analysis also showed that cost based rate designs can improve the economics of heat pumps by making electric heating bills lower than natural gas heating bills.

“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,” the authors wrote.

Under rate II, the first alternative rate studied – rate I was the default rate – the fixed charge component of a customer’s bill was increased and the volumetric charge was lowered. The result was a reduction in customer heating bills sufficient to turn the operating cost gap negative for all customers.

Switching to a time of use day/night structure (rate III) or a demand-based structure (rate IV) resulted in even larger negative operating cost gaps with rate IV showing the largest reductions in electric heating bills for the sample of 80 single-family residential customers, the report found.

“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,” the authors said. “In many jurisdictions across the country, retail electricity prices are largely disconnected from the marginal costs.”

The authors also noted that there was a 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 customer sited technologies,” they said.

One of the unintended consequences of such default electric rates, the report found, is the slower adoption of heat pumps because the use of heat pumps increases total electricity consumption and, therefore, electricity bills, making the use of heat pumps uneconomic under typical volumetric default rate structures.

The authors noted, however, that as electric system conditions evolve, and summer-peaking systems become winter peaking systems with increasing levels of building electrification, rate structures may need to be refreshed if they are to continue to reflect actual costs.

While alternative rates can make adoption of heat pumps more economic for many customers, the report’s authors said it is important to note the implications of those rates for customers’ other electric loads.

For some of the customers in the sample, switching to time-of-use rates (rate III) would increase their electricity bills by about $200 per year even before any electrification, the report found. For some other customers, switching to one of the demand-based rates would reduce their bills by about $100 per year before electrification.

The report recommended that utilities develop screening tools to determine which customers might benefit from alternative rates and market those rates accordingly. The report also recommended that utilities develop data analytics tools to identify customers who may be getting close to replacing their heating systems and contact them before they make an investment decision.