demand-side management (DSM).1
With broad-based support from utilities, consumer representatives, environmentalists, the California Public Utilities Commission (CPUC), and the California Energy Commission (CEC), some $1.8 billion has been spent since 1990 (and $3 billion since 1980) on ratepayer-subsidized electric conservation programs.2 The CPUC blessed this effort in 1993 as not only prudent but highly cost-effective:
"DSM programs initiated since the  Collaborative have produced an
estimated $1.9 billion in life-cycle net resource benefits (in nominal dollars). ... Even allowing for considerable uncertainty in savings forecasts, there is no doubt that ratepayers have received substantial benefits from utility DSM activities during the post-incentive period."3
With DSM expenditures in California exceeding $500 million in 1994, a record high, the future not only seemed bright but impregnable for ratepayer-funded energy efficiency in the state.
But three events have reversed the momentum. First, a rate crisis forced the CPUC to change course and issue the "Blue Book" proposal (April 1994) to restructure the California electric industry. Among the reforms was to
streamline DSM along consumer-driven lines. Second, during the Blue Book hearings, certain consumer groups that previously supported DSM started lobbying against forced ratepayer funding of utility conservation. No longer would they buy the "higher rates, lower bills" promise of DSM. Third, CEC hearings connected with the 1994 Energy Efficiency Report and the 1994 Electricity Report revealed that a flawed cost/benefit test was overstating the case for California's DSM programs.
Suddenly, the state's two largest utilities announced over $200 million in DSM cutbacks for 1995. The DSM community began openly to question the continued viability of ratepayer-subsidized energy conservation in a competitive market. Three questions arise:
s Has DSM led California to underconsume electricity, stranding electric (and gas) assets and distorting rates?
s Should DSM play a role in cutting power plant emissions?
s Should the state allow market forces to promote growth in electric consumption?
Carried to Excess
It is difficult to conclude that consumers in California are as ignorant about energy efficiency as some might believe. A more plausible explanation, suggested by the CEC's own inquiry into the Customer Value Test (CVT), is that important costs "in customer comfort, convenience, aesthetics, and productivity" have been ignored.4 This is not a "market failure" so much as an "analyst failure."
From the perspective of customer choice, California consumers have overconserved rather than underconserved electricity. California's economy is often cited as "a model of energy efficiency." But in that model lies a Pyrrhic victory, to the extent that ratepayer-subsidized DSM has contributed to the state's rate problem. Four reasons support the argument that California has overconserved electricity during the last decade.
Inflated electric rates. California's high, noncompetitive electric rates have fostered uneconomic conservation. With rates "approaching 150 percent of the national average," electric consumption in California has been pared below what more competitive rates would have incited.5 In this regard, "above-market" contracts for qualifying facilities (QFs) and nuclear investments have unintentionally promoted energy conservation. These artificially high rates have not now suddenly occurred; they have existed for years, particularly during the DSM Collaborative era. Between 1990 and 1994, Californians paid $28.2 billion more for electricity than if they had bought the same quantity at the average U.S. rate, a $912 per-capita surcharge.6 Given California's relative abundance of low-cost hydropower (including hydro-by-wire imports from the Pacific Northwest), and natural gas, as the swing fuel for electric generation), the hypothetical competitive rate would have been at or below the national average. In any case, a huge overpayment has occurred, with real wealth effects and negative usage impacts.
Uneconomic programs. California has systematically implemented uneconomic DSM programs. Its $3-billion ratepayer-subsidized DSM investment has been predicated on a Total Resource Cost test (TRC) that has understated costs and overstated benefits. Measurement and evaluation costs, which sum to as much as 10 percent of total DSM costs, have not been allocated among specific programs. "Market barrier costs" (also called "hidden participant costs") such as imperfect information, financial constraints, uncertainty, and inconvenience have been assumed away in the TRC as well. The negative rate effect on consumers from lost demand from DSM-related rate increases ("long-run rate impacts") is ignored, as are any "takeback effects" (consumers responding to DSM bill savings with higher energy use). Quality losses from DSM substitutions are also not considered.7 The raft of DSM programs that met the TRC (em but that would not have passed a corrected Customer Value Test (CVT) (em represent uneconomic overconservation.
Another cost escapes even the CVT (em the higher rates for natural gas that flow from a chronically underutilized gas infrastructure. California's electric DSM
programs have cut demand for gas for electric generation, bunching fixed gas costs over fewer units. The lost revenue for gas ratepayers of the displaced load is over 40›/MMBtu, judging from the transportation rate and
incremental cost of Southern California Gas Co. (SoCalGas).8 This fuel displacement clearly represents a substantial cost that should figure into any DSM cost/benefit analysis.
Appliance and building codes. Two decades of state and federal appliance standards and building codes have forced energy conservation. The energy crises prompted these rules. Today, as surplus replaces energy shortages, these standards have tightened. Prospective standards from the Department of Energy would be stricter still.
Advocacy groups. Multimillion-dollar, private-sector philanthropic efforts have promoted energy efficiency for its own sake. These efforts, ranging from private foundation grants for energy conservation to public service advertise-ments to "use energy wisely," have reduced energy usage. This not-for-profit effort for the "public good" assumes that public and other private efforts have fallen short of internalizing the externalities of fossil-fuel usage.
Exposed to Markets
If the California market has "overachieved" with energy conservation, and the large and growing discrepancy between marginal costs and rates suggest that it has, a move to market-driven competition can be expected to sharply curtail energy efficiency activities, at least in the short run. This move will uncover excess capacity throughout the DSM infrastructure, as prior deregulation revealed in the airline, trucking, railroad, petroleum, and natural gas industries. This truth is what the proponents of ratepayer-subsidized DSM fear. And, judging from the DSM cutbacks with just the prospect of restructuring, their fears are well-founded.9
Do electricity customers fear the end of subsidized DSM? After all, their dollars are at stake. Large and small consumers, some of whom five years ago were signatories to the DSM Collaborative that accelerated ratepayer-funded DSM, clearly do not. Toward Utility Rate Normalization (TURN), a lobby group for captive electric and gas ratepayers in California, stated in the CPUC Blue Book hearings:
"The time has come to test the need for continuing ratepayer subsidies in the DSM market. . . . First ... the vast majority of the benefits accrue to participants, while the vast majority of the costs fall upon nonparticipating ratepayers. And second, even after the injection of hundreds of millions of dollars of ratepayer-funded subsidies . .. the proponents of DSM still contend that significant market barriers endure. ... [T]he flow of subsidies must be stemmed."10
The California Manufacturers Association, representing larger users, also testified that utility-funded DSM is "fundamentally inconsistent with customer choice and cannot comfortably exist within a structure which seeks to promote a 'vibrant market ... for efficiency energy services.'"11
On the natural gas side, SoCalGas revamped its Total Energy
Efficiency Management (TEEM) program to remove ratepayer funding on the determination that their customers are best served by market DSM, not coercive DSM.
The CPUC's 1994 Blue Book order (R.94-04-031, I.94-04-032, 151 PUR4th 73) also revealed second thoughts about subsidized DSM by focusing almost exclusively on rates. The 1994 proposed order would have ended the electric revenue adjustment mechanism (ERAM) for DSM, a balancing account allowing utilities to increase rates to recover revenue lost by reduced sales from energy efficiency. A second proposal would have terminated ratepayer cross-subsidies for direct-access customers. These two proposals could mark the beginning of the end of force-funded DSM, and led an "astonished" Natural Resources Defense Council (NRDC) to warn that market-based DSM would be "automatic money-losers for utilities" and "all but hopeless" for independent energy-service firms.12
There is good reason to be excited about a more competitive electric industry (em rates will fall substantially. Adjusted for
inflation, U.S. natural gas prices have fallen by one-third for end users during the 1985-94 period of open-access transmission, and electricity rates today on the competitive wholesale market are one-third below retail rates offered by the utilities. These lower rates will make fewer DSM programs economic under the TRC, CVT, or any other cost/benefit test.
Why Natural Gas
Economics tells us to expand production if marginal costs fall below selling prices. Expanded production in that case lowers rates.
California's electric (and gas) market exhibits retail rates substantially above short-run marginal costs. The marginal cost of surplus gas-fired electric generation in the state is under 3 cents per kilowatt-hour (›/Kwh); average generation costs and total delivered marginal costs are under 5›/Kwh; and retail electric rates are around 10›/Kwh. Whether these incremental units are generated for offsystem sales or for expanded consumption within the state, each kilowatt-hour produces a ratepayer benefit over 5 cents. For this reason, Southern California Edison (Edison) has asked the CPUC for incentive rates for offsystem sales so that "additional value captured from [its] gas-fired generation units will decrease
customers' rates in the long term."13
By analogy, every unit of generation left unused by DSM has a negative impact on ratepayers. In fact, the cost/rate discrepancy makes the economics of electric conservation worse in California than in virtually any other state in the country. It is true as well for natural gas, since California leads the country in peak-month excess capacity.
An expanding electric market begs the question: Will more generation pose environmental problems? The good news is "no."
Natural gas serves as the swing fuel for electric generation in California.14 Oil burning in the state's power plants has been minimal; no coal plants are located in California; coal-by-wire from neighboring states tends to serve base loads. Available nuclear power is also baseload.
Yet the NRDC portrays coal (really coal-by-wire from the Southwest) as the marginal resource. Its analysis begins by using general terms such as "fossil fuels" and "power plants," and ends by specifically citing the negative environmental effects of mine-mouth coal plants. Natural gas, curiously, is not even mentioned in its three-page environmental impact section.15
The NRDC is right (em there will be more "fossil fuel burning" in a competitive electric industry. But it is wrong to portray that increase as an environmental problem since natural gas serves as the marginal fuel. Natural gas represents the cleanest burning fossil fuel for the California generation market. As compared to scrubbed coal, combined-cycle natural gas plants reduce air and water emissions:
s 50 percent less use of process water
s 58 percent less carbon dioxide
s 81 percent less nitrogen oxide
s 95 percent fewer particulates
s 100 percent less sulfur dioxide
s 100 percent less ash and sludge16
Moreover, any increased reliance on California's heretofore chronically underutilized gas-fired plants must still meet stringent clean-air rules that "internalize" many environmental externalities. As Pacific Gas & Electric testified before the CEC:
"In the late 1980s ¬ utility powerplants accounted for 3-5 percent of statewide NOx emissions. Many plants did not have advanced NOx control equipment, such as Selective Catalytic Reduction. Since then, air-quality regulators have imposed 'Best Available Retrofit Control Technology' requirements and other regulations that will drastically reduce NOx emissions. In effect, NOx emissions from utility powerplants are being internalized."17
Edison also addressed environmental concerns in light of the prospect of increased gas burning in the Los Angeles Basin:
"Edison's offsystem sales from existing units will not increase system generating capacity, but only better utilize existing generating capacity. If Edison needs to bring standby reserve units back to dependable service, Edison will retrofit these units with additional emission controls such as Selective Catalytic Reduction equipment. If Edison requires additional capacity . . . [emission trading] offsets will be required. . . . Edison's current air quality plans will not be affected by increased offsystem sales."18
Technological advances have allowed NOx emissions to be reduced by over 90 percent from uncontrolled levels (which were commonplace for many powerplants in the 1970s). Significantly increased efficiencies (more electricity output per input of gas) have also reduced effective emissions.19 Ratepayer-subsidized DSM for ad hoc emissions control thus represents an environmental overreach.
A False Apocalypse
The NRDC has harsh words for DSM critics who favor long overdue market reforms in the electric industry:
"Some parties have argued that a market system composed of a proliferation of private actors each acting in their own narrow self-interest will provide for protection of the public welfare. NRDC believes that this contention is either naive or insincere. There is ample evidence that market forces will not necessarily optimize social welfare, even when there are no market failures. The well-documented, persistent market failures in the energy-efficiency market, and the limited level of development of the energy services industry, virtually assures that abandonment of the public interest to the free market would result
in a tragedy of the commons of enormous proportions."20
These apocalyptic forecasts are specious from an economic and environmental viewpoint.
Consumers have tried increasing doses of subsidized DSM and now trust themselves to make informed, stand-alone choices. The major California electric utilities have moved away from oil burning, have significantly reduced power-plant emissions, and prospectively operate under increasingly stringent NOx caps.
Policy reform to replace involuntary DSM with voluntary energy efficiency, however, might not occur in the initial rules governing California's restructured electric industry. Under intense pressure from the DSM lobby, the CPUC's majority proposed decision of May 1995 retreated from its market-based proposals of 13 months earlier to endorse ratepayer or taxpayer funding of DSM at "current or historical" levels as well as retention of a modified ERAM for DSM by utilities.21 The minority opinion of Commissioner Knight, while differing on other crucial aspects of the restructuring, seconds the majority decision to continue DSM with involuntary funding.22
Trends can again change. A consumer-oriented CPUC would end ratepayer subsidies and taxpayer funding for energy-efficiency programs. Utilities and independents, while free to offer energy-efficiency services on a "user pays" basis, could also advertise to boost electric use (em as purveyors of almost all other goods and services now do. Indeed, a "leave the lights on" campaign could stress the positive benefits of increased safety and comfort, while noting the negligable environmental effects of controlled burn, gas-fired electric generation.
A restructured electric industry would not artificially incite consumption by cost-capped rates. Nor would it promote conservation excessively through involuntary DSM. t
Robert L. Bradley, Jr. is president of the Institute for
Energy Research in Houston, TX, and an adjunct scholar of the Cato Institute, Washington, DC. He is
author of The Mirage of Oil Protection (Lanham, MD: University Press of America, 1989) and the two-volume Oil, Gas, and Government: The U.S. Experience (Lanham, MD: Rowman & Littlefield, 1995).
Go FigureBoth rates and total bills have increased faster in California than across the country in the post-1990 era of accelerated DSM funding. While the average national rate fell 16 percent between 1986 and 1992, California's rate was flat. And although California's average electric bill is lower than the national average because of its temperate climate, the expenditure trend is also negative. In 1983 California's bill was 60 percent of the U.S. average; by 1992 that fraction had climbed steadily to 90 percent.* *CEC, 1994 Electricity Report: Draft Final, June 1995, p. 4.
1 While there are some difference between energy-efficiency and DSM programs, the terms are used synonymously here, since load building and fuel substitution are relatively minor.
2 DSM expenditure information from 1980 through 1993 was provided by Mike Messinger, California Energy Commission.
3 CPUC Decision 93-09-078, Sept. 17, 1993, p. 24, 51 CPUC 2d 371, 381.
4 Seymour Goldstone, "California Utility DSM at the Crossroads," (California Energy Commission, January 1995), p. 2.
5 CPUC, Status Report on Restructuring California's Electric Services Industry and Reforming Regulation, 2 vols. (San Francisco: CPUC, January 24, 1995), vol. 1, p. 11.
6 This estimate is computed from rate and usage statistics reported in various issues of the Energy Information Administration, Electric Power Annual.
7 See Patricia Herman, "The Value Test: Its Context, Description, Calculation, and Implications," Paper Prepared for the California Energy Commission, May 3, 1994, pp. 3-1 to 3-7, 7-8. See also, summary of the CVT by CEC, Energy Forecasting and Planning Division, "In Response to the ER 94 Committee Order Relating to DSM Uncertainty and Competitive Effects, April 15, 1994," Docket 93-ER-94, August 11, 1994, pp. 3-4.
8 The rate charged by SoCalGas to transport gas for utility electric generation (UEG) is approximately 49 cents/MMBtu. With a short-run marginal cost (fuel, essentially) of below 5 cents/MMBtu, the foregone revenue is the difference, or a figure somewhat over 44 cents/MMBtu. (Conservation with Earl Takemura, SoCalGas, August 23, 1995.) If, for example, utility DSM has produced a UEG transportation loss of 75 MMcf/d, then the yearly loss to ratepayers of SoCalGas ratepayers of SoCalGas ratepayers is $12 million, PG&E and SDG&E could perform similar calculations to cover the entire state.
9 California's two largest electric utilities, Pacific Gas and Electric (PG&E) and Southern California Edison (Edison), announced electric DSM cutbacks from planned 1995 levels of $100 million (46%) and $106 million (68%) respectively. PG&E Letter to All Interested Parties on the Demand-Side Management Service List, Sept. 2, 1994; Arthur O'Donnell, "1995 DSM Spending Will Fall Below 1991 Levels," California Energy Markets, Dec. 16, 1994, pp. 5-6.
10 Comments of Toward Utility Rate Normalization on Equity/Social and Environmental Policies," CPUC Blue Book Hearings, June 24, 1994, pp. 15-17.
11 "Second Round Opening Comments of the California Manufacturers Association," CPUC Blue Book Hearings, June 23, 1994, p. 9.
12 Ralph Cavanagh, "Opening Comments of the Natural Resource Defense Council and Comments on Balancing Public Policy Objectives in a Competitive Environment," CPUC Blue Book Hearings, June 7, 1994, pp. 8, 10.
13 Southern California Edison Co., "Application for Off-System Power Sales Incentive Mechanism (OPSIM)," Aug. 2, 1993, p. 1. This application was later withdrawn due to regulatory barriers.
14 One estimate is that gas is the marginal fuel over 80% of the time. See "Comments of California Utility Employees on Balancing Public Policy Objectives," CPUC Blue Book Hearings, June 24, 1994, p. 11.
15 Ralph Cavanagh, op cit, pp. 12-14.
16 Enron Corp., The 1995 Enron Outlook, p. 22.
17 Pacific Gas and Electric Co., Testimony of Mark Meldgim and Curtis Hatton Before the CEC on Internalizing Externalities, Preparation of the 1994 Electricity Report, Dkt. 93-ER-94, Oct. 20, 1994, p. 1.
18 Southern California Edison, Testimony in Support of Off-System Power Sales Incentive Mechanism (OPSIM), Applica. 93-08-006, Aug. 1993, p. 28. Edison estimates NOx abatement expenditures to meet existing regulation to be $330 million. SECcorp, Form 10-K, Fiscal Year Ending December 31, 1993, p. 2.
19 "Comments of the American Gas Association," CPUC Blue Book Hearings, July 21, 1994, pp. 12-13.
20 Peter Miller, "Comments of the Natural Resources Defense Council for the 1994 Energy Efficiency Report and 1994 Electricity Report," Workshop on the Future Of DSM, California Energy Commission, Feb. 27, 1995, p. 2.
21 The only major proposed change from the status quo was to require that DSM costs be unbundled in utility bills. CPUC Decision 95-05-045, May 24, 1995, "Proposed Policy Decision Adopting a Preferred Industry Structure," pp. 73-75, 161 PUR4th at 258.
22 CPUC Decision 95-05-045, May 24, 1995, "Customer Choice Through Direct Access: Charting a Sustainable Course to a Competitive Electric Services Industry" (Knight commissioner), pp. 112-13, 161 PUR4th at 394-95.
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