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California's Green Gaffe

Some green-energy policies disregard the value of energy use, risking market distortion and consumer backlash.

Fortnightly Magazine - November 2007

Some advocates support energy-price increases simply to depress usage—which would harm consumers in the same fashion.

Demand-response programs sometimes pay consumers not to use electricity, particularly during peak times. Other customers may be charged to fund this. If the net costs are lower than the generation costs saved, a benefit may be declared. However, that comparison is the wrong test.

Instead, the right test would compare value and cost. Specifically, where a retail energy price exceeds its incremental cost, usage creates a net benefit measured as the difference between consumer value and cost. A demand-response payment under these conditions may cause an economic loss.

For example, consider a consumer who pays $10 to use electricity that costs the utility $7 to deliver. That consumer willingly might curtail usage for a $5 demand-response payment. In this scenario, the fact that $7 exceeds $5 proves nothing. All we learned was that the customer was netting less than $5 in surplus value from consumption in the first place—since the added $5 was enough to make him stop.

To find out whether society actually gains, the analysis must consider consumer value. In total, this consumer evidently considered such usage to be worth between $10 and $15, since he was willing to pay the former amount but not the latter (as reflected in the $10 energy bill plus the added $5 rebate). If the value was $13—which the program took away by inducing him to stop his usage—then, the program’s cost equals the lost consumer value, or $13. The benefit is $7 in generation costs avoided, leaving a net loss to society of $6.

Although the corresponding monetary transfers between customers are not technically costs, they are interesting. Specifically, the participant is $2 better off because he has $15 in cash (the bill savings plus the rebate) in exchange for losing $13 in value. The other customers lose twice by being forced to provide the $5 payment, and by having to make up the lost $3 markup the participating customer would have paid if he had used the energy. In fact, the total burden on other customers ($8 here) will always reflect the societal economic loss ($6) plus the net benefit to the participant ($2).

By contrast, a social gain can occur if the program participant’s energy is priced below its full incremental cost, including externalities. Then the remaining customers are subsidizing the participant, and can make everyone better off if they can get him to accept a small enough payment (less than the subsidy) to stop. Of course, raising the participant’s price to cost would be an even better solution.

California’s analysis also can err on subsidies for energy-efficient appliances—which are akin to demand-response payments. Just as before, the likely result is economic loss if retail prices exceed incremental costs. The wrinkle is that the use of the device itself may cause an added economic impact.

Suppose a $5 energy-saving light bulb would save $7 in electricity for which the customer would be charged $10. But customers don’t buy these bulbs, despite the out-of-pocket savings. To