FRBSF Economic Letter
2001-11; April 20, 2001
Rising Price of Energy
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
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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