Rising Price of Energy

• Rising wholesale prices for energy
• Effect on consumer prices for energy
• Effect on consumer budgets in California

Regional Report. The Regional Report appears on an occasional basis. It is prepared under the auspices of the Financial and Regional Analysis Section of the FRBSF’s Economic Research Department.

Wholesale prices of natural gas and electricity have risen dramatically in the West in recent months. These wholesale price increases are showing through to rates paid by households, particularly in the unregulated retail market for natural gas. Over the past year, the natural gas component of the Consumer Price Index (CPI) rose by 68% in western metropolitan areas, boosted in part by the nearly 135% increase in the index for the San Francisco Bay Area. The electricity component of the CPI has risen less dramatically because of price regulation, but it is expected to rise more in coming months with newly approved retail rate increases in California and other western states. In this Economic Letter, we examine the link between wholesale and retail price increases and estimate the impact of rising wholesale energy prices on energy expenditures for the average California household.

Rising wholesale prices for energy

The wholesale price of natural gas in the U.S. has risen substantially during the past year, with particularly large increases this winter. The increase in natural gas prices has been most dramatic in California. Boosted by supply constraints in Southern California, rapid growth in demand in Northern California, and financial problems at Pacific Gas and Electric (PG&E), the wholesale price of natural gas in California was four times the national average in December. The spread between prices in California and the rest of the nation has narrowed since then but remains substantial.

Unlike natural gas, the dramatic increase in wholesale electricity prices has been generally confined to the western U.S. The spread between prices in the West and the rest of the U.S. began to widen last summer, when structural problems in California’s electricity markets exacerbated underlying supply shortages associated with growing demand, poor conditions for hydroelectric generation, and rising prices for fossil fuels used to generate electricity. Because electricity markets in the West are linked by the Western Grid—a closed system of transmission and distribution networks covering 11 western states, British Columbia and Alberta, Canada, and a small part of Baja California, Mexico—problems in one area affect markets in the rest of the grid.

Effect on consumer prices for energy

Since the U.S. natural gas industry is largely deregulated, the wholesale price of gas fluctuates with supply and demand. Natural gas utilities, which transmit and distribute gas to consumers, pass price changes directly to consumers. On average, the cost of gas accounts for about one-third of consumers’ bills, with distribution costs and transmission costs accounting for the remaining portion. Thus, holding consumption constant, a 10% change in the wholesale price of natural gas results in about a 3.3% change in charges on consumers’ bills.

Figure 1 plots the change in wholesale natural gas prices at the PG&E City Gate pricing point (left scale) and the change in the natural gas component of the CPI for the San Francisco Bay Area (right scale). Between February 2000 and February 2001, the PG&E City Gate price for natural gas increased by about 375%, and the natural gas component of the CPI for San Francisco, which is in PG&E’s service area, increased by about 133%. This represents a complete pass-through to consumers of the increase in wholesale gas prices.

In other parts of the West, where natural gas prices have risen less rapidly, consumers have seen more modest price increases. In the Los Angeles and San Diego areas, consumer prices for natural gas increased by 48% (Feb. 2000–Feb. 2001) and 34% (Dec. 1999–Dec. 2000), respectively. In the Pacific Northwest, price increases were highest in the Seattle area, rising by 46% (Feb. 2000–Feb. 2001); in Portland, prices rose by 18% (Dec. 1999–Dec. 2000). Overall, in metropolitan areas in the West—other than the San Francisco Bay Area—the average increase in consumer natural gas prices over the past year was a bit lower than the average 54% increase in the U.S.

Unlike natural gas prices, retail prices for residential electricity consumers largely are subject to regulation. In most areas of the West this means that local utilities must apply for rate increases on the basis of increases in the average cost of providing electric power. For a given utility, the impact on average cost of a rise in the wholesale spot price of electricity depends on factors such as the utility’s generation capacity, its type of generation, and its long-term contracts with fuel and power suppliers. Due to the rate application process, retail price hikes frequently lag behind wholesale price increases. Finally, like natural gas, the commodity cost of electric power is only a fraction of a consumer’s electric bill.

Prior to the runup in wholesale electric prices in the summer of 2000, the commodity costs for electricity ranged from about 30% to 40% of consumers’ bills at the major investor-owned utilities in California. However, the more relevant figure for these customers and utilities is the electric power rate set under California’s deregulation legislation. Under deregulation, retail rates for electricity were frozen at a level intended to be high enough to allow the investor-owned utilities to recover certain costs on stranded assets. The “frozen” part of retail rates (that is, excluding charges for transmission, distribution, etc.) represented about 50% to 60% of the total charges on consumers’ bills. Since June 2000, the rate freeze has held retail rates well below average cost, acting as a rate cap. Figure 2 illustrates the effect of the rate cap by showing the percent difference between average cost of electricity and the capped portion of PG&E’s retail rate (in effect prior to January 2001) (left scale). (The average cost data are publicly available from PG&E and are used only to illustrate the behavior of underlying costs—they are not used to determine retail rates.) The figure also shows the percent change in the electricity component of the CPI for the San Francisco Bay Area (right scale).

Compared to natural gas prices, the rise in electricity prices for Bay Area consumers through February was modest. While the average cost of electricity for PG&E rose to about 280% of the capped portion of the retail rate in February, the electricity component of the CPI rose by only about 10% over the same period. A full pass-through of the increase in PG&E’s average cost would have entailed more than a doubling of the retail rates, or a rise of about 140% in the electricity component of the CPI in the Bay Area.

In other metropolitan areas of California the patterns have been similar, with wholesale electric costs rising much faster than retail rates. However, recent decisions by the California PUC to raise retail electricity prices for PG&E and Southern California Edison (SCE) customers means that the electricity CPI will rise in coming months. The PUC’s plan makes permanent the approximately 1 cent per kilowatt hour (kwh) surcharge put in place in January of this year. It also imposes a rate increase that would average about 3 cents per kwh, with most of the increase borne by heavy users of electricity. The combined effect of the PUC’s decision would be to raise PG&E’s and SCE’s rates an average of about 40%. (San Diego Gas and Electric (SDG&E) has petitioned separately to the PUC for a 2.3 cents per kwh increase in retail rates. Also, the governor of California’s proposal includes tiered electricity rate increases, which would apply to all three of the large investor-owned utilities in California.)

Elsewhere in the West, increases in electricity prices through February also were modest, although somewhat higher than the U.S. average. However, announced increases in future rates have been notable in many communities. For example, Seattle City Light has received approval for two rate increases in recent months in order to offset the rising cost of acquiring electricity. An examination of other electric utilities in the West shows that a number have applied for and received cost-based retail rate increases for the coming year. These rate hikes will be reflected in increases in the electricity component of the CPI over the next several months.

Effect on consumer budgets in California

Rising energy costs affect consumers directly through rising energy bills and indirectly through rising prices of other goods and services. Obtaining accurate estimates of these effects is complicated by uncertainty about factors such as future movements in wholesale prices, the extent to which utilities will pass along wholesale costs, how much households and businesses will reduce consumption given price increases, and the extent to which businesses can pass along increases in energy-related costs of production to consumers. With these uncertainties in mind, we make a first-cut approximation of the near-term effects of increased energy costs based on current wholesale and retail prices, assuming that households and businesses do not reduce consumption in response to rising prices and that businesses pass increases in energy costs on to consumers. We estimate the effects of rising energy prices using retail rate increases on natural gas through February 2001 and the March Cal PUC plan for increasing electricity rates. We assume that similar electricity price increases are allowed for SDG&E. Since it is possible that other utilities in California will seek rate increases to cover higher costs, we also assume that those utilities on average raise rates by about 2 cents per kwh.

For natural gas, we estimate that, given retail prices in February, annual expenditures for the average California household will rise by about $200 compared to a year ago, bringing total annual expenditures to $450 per year. This average surely hides significant regional variation associated with differences in consumption; for example, we would expect Northern California residents to pay more than Southern California residents simply due to differences in climate. Also, as indicated above, retail rates on natural gas have risen much more in Northern California than in other parts of the state.

Performing the same calculation for electricity, including the rate increases recently approved by the PUC, the average California household would see an annual increase in its electric bill of about $250, boosting annual electric expenditures to about $900. Again, this average suppresses significant regional variation in usage and in rate increases; for example, heavier users of electricity in general will see larger increases, while customers of utilities such as Los Angeles Department of Water and Power, with ample generation capacity, likely will face smaller increases in retail electricity rates.

Combining the increases in expenditures on natural gas ($200) and in upcoming electricity ($250) bills, we estimate that the average California household would spend about $450 more this year than last on energy, assuming the current levels of prices and typical seasonal usage. This represents about 1% of average household income in the state. But the increases in direct expenditures on natural gas and electricity are only part of the story. Consumers likely also will face increases in the prices of other goods and services associated with rising energy costs for businesses. Estimates suggest that these indirect costs may equal as much as two-thirds of the direct costs. In that event, the indirect costs of rising energy prices would absorb an additional $300 ($450 x 0.66) a year of the budget for the average California household. Adding the direct and indirect costs together ($450 + $300) implies a hit of $750 a year to the pocketbooks of the average California household due to higher energy prices. This represents a little more than 1.5% of average household income in the state.

Again, the estimates presented here take current and planned retail prices and consumption as given. Should consumers cut back on energy usage or should wholesale prices for natural gas or electric power change, the costs to California households also would change. Also, the estimates only refer to the energy costs passed through to the utilities’ customers. If the full rise in wholesale electricity prices—much of which currently is being covered by the state as a result of the procurement of power by the Department of Water Resources—were taken into account, our estimate of the increase in energy-related expenditures by the average California household would rise substantially.

Mary Daly
Senior Economist

Fred Furlong
Vice President, Financial and Regional Studies