Demand Charges:
What Do They Really
Measure?
By John Kelly
Demand charges have been staples
in the electric utility industry for
decades. They are attempts to allocate
portions of capital expenditures, most
significantly those for generating facilities, to individual large customers or
groups of customers. The charges are
supposed to represent payments for
relative amounts of generating capacity for which customers are
responsible. But what do demand
charges really indicate? What do they
measure? How reliable are they as a
guide for understanding costs and designing rates?
The conventional justification for
demand charges may seem reasonable
when viewed casually, but a closer look
reveals serious problems. First, such
charges are the product of a futile exercise—an attempt to allocate common
costs in a meaningful, economic way
(See “The Problem with Cost Allocation: The Heart of the Matter,” Public
Power, March-April 2004). The general logic of demand charges does not
hold up under scrutiny, nor do the assumptions that underlie their
calculation.
Demand charges are typically assigned to individual customers or to
groups of customers (customer classes)
based on the proportion of kilowatt demand those customers or customer
classes contribute to a utility’s peak.
The capital costs of generating facilities
are allocated based on such proportions
and then assessed in terms of dollars
per kilowatt. There are several variations of this calculation (e.g., using
different peak periods or combination
of them) but the basic result is the
same: consumers are assigned particular, fixed kilowatt demand charge rate
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(e.g., $5/kW, $8.50/kW). Customers a utility’s peak demand: 20 percent; 30
usually pay this assigned charge for at percent; and 50 percent. The demandleast a year. More typically, though, the charge rate structure would use these
periods between adjustments are much proportions as major factors in assignlonger, often several years, before an- ing fixed costs, justifying the allocations
other cost study is done to estimate by contending that these customers
demand charges. The demand charge caused these relative amounts of genrate is multiplied by the amount of a erating capacity to be built. But what
customer’s maximum monthly kilowatt happens if a cost analysis is performed
demand(which usually varies) to arrive the following year and the relative proat the total demand-charge payments portions change to 25, 35, and 40
(e.g., $5/kW multiplied by 50 kW percent? Did the causal responsibility
equals $250 in total-demand charge change? And what happens in year
payments). The resulting pattern of three if the customer that contributed
rates can be characterized as a “de- 40 percent to the system peak leaves
and is replaced by a new customer
mand-charge rate structure.”
Calculating a significant portion of
the cost of electric Calculating a significant portion
service using de- of the cost of electric service
mand charges is
using demand charges is like
like using one
frame of an 8,760- using one frame of an 8,760frame film to tell a frame film to tell a story.
story. Included in
the frame, frozen in
a brief period of time, typically one whose proportion of peak load is also
hour, are a utility’s balance sheet and 40 percent? Is it reasonable to say that
selected operating costs, juxtaposed. A the new customer caused, or was in any
utility may have millions of dollars in- way responsible for, the construction of
vested in generating facilities and existing generating facilities, which
during its system peak there are hun- were likely built many years before? All
dreds of possible amounts individual that can be said is the descriptive fact
customers or customer classes could that at a particular time a customer or
have contributed to that peak. These customer class happened to use a ceramounts will then be used to determine tain proportion of the existing
a rate (dollars per kilowatt) at which megawatt capacity.
It is unrealistic to assume that what
customers will be billed for subsequent
happens in one hour during a particular
consumption.
The flawed assumptions underlying year, or some other period, is represenof demand charge calculations are il- tative of what happened in past years,
lustrated by a simple example. Assume what’s happening currently, and what
there are only three utility customers will occur in the future. Because parwho accounted for these proportions of ticular customers or customer classes
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MAY-JUNE 2004
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Demand Charges
happen to have certain kilowatt demands in one film frame does not mean
they were responsible for related proportions of capital investments in
generation facilities. It is unlikely that
the reasons for, and decisions to build
existing generation facilities are even
on the same film reel.
Customers come and go over the
productive life of generating facilities.
To say that a particular customer or
customer class was responsible for a
This example becomes more troublesome if the utility decides to offer a
discounted rate to attract the customer.
On one hand, some will argue that it
makes sense to give the potential customer a special discount because the
new load will help pay for existing capacity. Yet others will say the
conventional view that the potential
customer has in some way caused, and
is consequently responsible for, construction of existing peaking capacity.
If the logic and
practicality of deDemand charges often mand charges make
sense, then why
penalize customers with low aren’t they used in
load factors and reward those o t h e r c a p i t a l with high load factors. intensive industries
such as restaurants,
hotels, phone comparticular increment of generating ca- panies, and airlines? Hotels in major
pacity is virtually impossible, unless cities that cater primarily to business
facilities were dedicated under some travelers may let rooms at $200 or
contractual arrangement.
more a night during peak times, then
The difficulties with and contradic- drop the price to $100 during nontions encountered in the use of demand peak times. A person who books a
charges are obvious when a large in- room during peak season is not asdustrial customer is urged to locate in a signed a demand charge (based upon
community. If the company will con- some estimate of the portion of addisume a relatively large share of the tional facilities needed to meet peak
utility’s peak demand, can it be said to demands) that he or she carries during
have caused that peak? Clearly not. the rest of the year, and that will be
collected if the person returns during
non-peak times. Summer resort restaurants that remain open during the
winter do not assign demand charges
to customers for the extra space,
chairs, tables, dishes, silver and facilities required to meet peak summer
demand. If customers return in the
winter for a meal, they are not expected to pay the regular off-season
price of a meal plus a demand charge
that was allocated to them during the
summer.
In the airline industry, summer and
holiday travelers are not assigned demand charges for the extra planes
required to meet peak demands. They
are not allocated peak costs and then expected to pay them when they travel in
off-peak periods. Off-peak travelers pay
the cost of operating the plane they are
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traveling on plus any mark-up the airline
can impose to make the flight as profitable as possible. This usually means
low fares that are close to operating
costs (including maintenance costs and
economic depreciation of the plane).
F
rom a historical perspective, even
one of the early, leading proponents of
demand-charge rate structures conceded “that it could be easily shown”
that peak responsibility was “not the
theoretically correct measure for the
demand charge” (“Engineers and
Economists: Historical Perspectives on
the Pricing of Electricity,” Technology
and Culture, William J. Hausman and
John L. Neufeld, January 1989). Hausman and Neufeld are quoting engineer
Hugh Eisenmenger. They go on to
note that in 1921 one of the early critics
of demand charges, economist George
Watkins, argued that customers with
large individual peaks were not necessarily more expensive to serve than
other customers. Assuming that they
were was a serious theoretical and practical flaw in the demand charge.
Demand charges often penalize customers with low load factors and
reward those with high load factors.
The conventional thinking in Watkins’
time, as it is today, is that such an
arrangement is appropriate. It promotes efficiency because a high load
factor suggests a relatively smooth
pattern of consumption and thus
reduces the average demand costs per
kilowatt. Hausman and Neufeld noted
that Watkins took issue with this view
and with its suggestion that “what is
good for the utility should be rewarded in individual customers.”
Watkins contended:
It is easy, at this point, to let one’s
reasoning go astray by identifying the
interests of the company in building
up a good load for itself with a policy
of favoring consumers with good individual load factors. The acquisition of
a new consumer with an individual
load factor better than that of the
company must, it is true, tend to raise
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Demand Charges
So why are demand charges so 20th century at about the same time
prevalent? The answer is twofold, “utilities faced a serious competitive
partly historical accident and partly challenge in supplying electricity to
economic motivation (“The Curious industrial users in the self-generation of
Economics of the Electricity Demand electricity” by these users, Neufeld
Charge,” Public Power, John Neufeld, said. The demand-charge rate strucMay-June 1999). Rate structures rest- ture gave the electric utility industry a
ing on sounder conceptual
grounds were proposed in
the early days of the elec- The demand-charge rate
tric utility industry. structure served double duty
Neufeld found that “much
of the early debate on rate during the years 1907-1914,
structures was fueled by when most states began
the desire to sell meters.” regulating utility rates.
One of the particularly effective salesmen was an
Englishman, Arthur Wright, who had means to set prices based on the value
the backing of Samuel Insull, one of the of service to industrial customers rather
most prominent individuals in the U.S. than what it cost utilities to serve such
electric power industry. Wright held customers. If a customer’s maximum
patents on the first practical demand- demand was 10 kilowatts and the comcharge meter and advocated a variation pany could afford to purchase and
operate its own generating equipment,
of the demand charge rate structure.
All this happened during the early the utility would offer a demand charge
intended to approximate the cost of the
customer operating a 25-kilowatt generator of its own. If another customer
had a maximum demand of 50 kilowatts, the utility would structure a
demand charge based on that amount.
The intention was not to set rates based
on a utility’s actual cost of serving
various customers, but to pricediscriminate to retain and attract
customers and to maximize profits.
The demand-charge rate structure
served double duty during the years
1907-1914, when most states began
regulating utility rates. Manufacturing
companies worked to prevent utilities
from practicing the price discrimination that occurred in private
negotiations of rates. State regulation
required that rates could no longer be
determined by negotiation and had to
be published in publicly available
schedules. But utilities were successful
in holding on to demand-charge rate
structures and these structures provided “an exquisite device for
automatically supplying discounts,
where needed,” or, more simply, for
practicing price discrimination. ●
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