California's Green Gaffe

Deck: 

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

Fortnightly Magazine - November 2007

Imagine a regulatory commission orders a utility to charge some customers high electricity prices to finance rebates for the commissioners’ friends and family members.

As absurd as this scenario might seem, it could qualify as a conservation program under California’s cost-benefit analysis because overcharged customers presumably would reduce their energy usage.

Similarly, a blackout might also score well in California by reducing energy consumption and consumer utility bills.

The problem is California’s cost-benefit analysis overlooks how consumers benefit from energy use. Such consumer-surplus benefits are a staple of modern economics, which consider the value of goods and services—not just their cost1(see sidebar, “Econ 101: Surplus Value”). Some value is lost if higher prices force usage cutbacks, or if less attractive ways to use energy are mandated for the sake of conservation. A corresponding measure, producer surplus, recognizes the value sellers get from market transactions.

Measuring changes in consumer and producer surplus is a necessary step in proper cost-benefit analysis.2 But California’s approach omits this step.

Ironically, monopoly regulation is intended to prevent excessive prices—which not only hit consumers in the pocketbook, but also force them to give up the benefits of needed utility services. By ignoring such harm, California’s flawed analysis confounds basic principles of consumer protection.

This issue is more than technical, because economic losses not only hurt consumers, they also can undermine political support for beneficial and necessary green efforts.

Paying More for Less

To accomplish the state’s environmental and conservation goals, the California Public Utilities Commission and California Energy Commission rely on a cost-benefit analysis3 that focuses on several important factors, including:

• The costs of generating electricity and of alternatives to its use;
• Program administration costs;
• Added out-of-pocket expenses to consumers; and
• The time value of money.

Further, California’s approach may identify revenue transfers between customers, which is helpful but doesn’t solve the problem. The value of energy use to consumers is left out of California’s cost-benefit analysis.

Unfortunately, faulty analysis can lead to bad policy choices. Errors can occur any time energy prices are raised, customers are paid to forgo usage, efficiency devices are sold at subsidized prices, or standards force customers into choices they rather would have avoided.

When rising prices reflect increased costs, it makes economic sense for consumers to reduce usage. But if a price is increased when costs stay the same, then consumers suffer an economic loss that California’s analysis ignores.

While probably small in particular cases, this impact could be substantial if green program costs raise retail prices significantly. California’s analysis now ignores such price impacts on consumption. If it did include this effect, California would get the answer backward by counting energy-production cost savings while ignoring the greater harm to consumers of being denied usage they valued and wanted.

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 change this, regulators raise utility bills to fund rebates that make the bulbs free to customers.

As before, considering economic value changes the results of a cost-benefit analysis. The added consideration is that efficient appliances sometimes provide lower-quality services, as this example implies. A consumer who won’t spend $5 to save $10 evidently expects at least another $5 in lost value associated with the cost-saving purchase.

Suppose our consumer fears an $8 loss in value from placing the bulb in a lamp where it doesn’t look good. Then, a $5 rebate will get the customer to accept the bulb, because the free bulb plus the energy price savings (another $10) is enough to outweigh the $8 loss in value. A California analysis only would compare the bulb cost to the energy-generation savings, to find a benefit of $2. However, the overlooked $8 loss in consumer value actually would tip the cost-benefit balance over to a net loss financed again by increased utility bills to other customers.

As a final example, consumers might respond to more energy-efficient appliances by using them more, causing what is sometimes called “bounce back.” If bounce-back effects were considered, California’s calculations would record them as a loss because more energy is used without creating any offsetting gain the analysis can recognize. But when incremental costs actually fall (as when less energy is needed to produce the same service), then increased usage of the appliance by consumers is economically justified and creates added value. Properly understood, bounce back makes the case for efficient appliances stronger, not weaker.

Good Analysis Matters

Practically speaking, California has a large inventory of previous cost-benefit studies. A corrected approach might modify some, but leave others yielding the same answers. It’s also possible some analyses have acknowledged consumer value despite the standard practice document’s directions.

Many important policy choices in California—and in other jurisdictions—seem driven by factors other than economics. For example, California’s multi-billion dollar solar roofs initiative was adopted without any cost-benefit analysis.4 Similarly, the crisis-era legislation that continues to distort California residential electricity prices was a product of politics rather than any economic justification.5 And common sense may lead policy-makers to turn down harmful program proposals even if the results of a flawed analysis seem to endorse them.

Still, California spends extensively on cost-benefit analysis, and better calculations could matter for policy making.6

Consider how a flawed California-style cost-benefit analysis would affect some other industries. A ban on new housing would show large benefits due to reductions in land, materials, and labor the home building would have consumed. A ban on new clothing would “save” mountains of fabric.

As such examples illustrate, a genuine economic benefit is created when a consumer buys a product for a price that exceeds its cost of production, and any cost-benefit analysis approach that ignores this value will produce undesirable policy results.

Neither does correcting this problem preclude action on global warming. For example, a carbon tax effectively increases the marginal cost of fossil-fuel-based electricity. However, consumers and society still can benefit even when using services whose production causes pollution. A proper analysis will include these factors.

Acknowledging the economic well-being of consumers also has broader policy implications. For instance, California energy agencies assert that per-capita electricity use in the state has not increased in decades, unlike it has elsewhere.7 However, evaluating California’s experience requires understanding why usage has not increased. Efficiency savings are good, but suppressed consumption due to high retail prices is likely to reflect economic harm. Similarly, commercial or industrial cutbacks might reflect better technology, or a loss of output and jobs in energy-intensive businesses. The general point is that a single-minded focus on minimizing the use of one input (in this case energy) seldom leads to the greatest economic welfare for society.

There is also a more fundamental issue. Economists treat energy as a normal good that benefits consumers and society. Adverse side-effects also can be captured in an analysis that still presumes a gain when a consumer gets what he wants. But a California-style analysis starts with an opposite presumption, that energy use is a bad thing that should be minimized for its own sake.

Indeed, this might represent the greatest challenge for lawmakers in California and other states who are struggling to develop effective green-energy policies. It is one thing to become more efficient; it is another to deny consumers their preferred choices in the name of usage reductions that may ultimately harm society.8

To address this challenge, regulators and utilities can try to persuade consumers that going without some usage is not such a burden, or is tied to a greater purpose that justifies a minor annoyance. Perceptions matter, too, as the new light bulb that is “ugly” today may be seen as fashionable tomorrow. If such persuasion changes buying choices in the marketplace, then the economics of consumer and producer surplus will follow and bring the cost-benefit balance along with them.

But it also may be possible to erode public support for green-energy efforts, even in an environmentally conscious state like California, by focusing too much on mandates that frustrate consumer demands instead of allowing them to be fulfilled more efficiently. Recognizing real consumer value will help policy-makers steer toward the latter, and away from the former.

Getting the analysis right is not just good economics. It may help avoid a political reaction that threatens all green initiatives—beneficial or not.

 

Endnotes

1. For example: Boardman, Anthony E. Greenberg, David H. Vining, Aidan R. and David L. Weimer: Chapter 4, Cost-Benefit Analysis: Concepts and Practice, Pearson Prentice Hall, 3rd. ed., 2006.

2. E.g., United States Office of Management and Budget, “Circular No. A-94 (revised),” Oct. 29, 1992.

3. California Standard Practice Manual: Economic Analysis of Demand-Side Programs and Projects, California Energy Commission and California Public Utilities Commission, October 2001.

4. See CPUC Decision 06-01-024, mimeo p. 19.

5. California Assembly Bill 1X, enacted Feb. 1, 2001.

6. The CPUC’s 2006-08 “evaluation, measurement and verification” budget is $162 million. CPUC Decision 05-11-011. A database of California studies is at www.calmac.org.

7. For example, “Energy Efficiency: California’s Highest Priority Resource,” p. 3, California Public Utilities Commission and California Energy Commission, August 2006 (ftp://ftp.cpuc.ca.gov/Egy_Efficiency/CalCleanEng-English-Aug2006.pdf).

8. Some other authorities have highlighted this distinction: “The Private Cost Effectiveness of Improving Energy Efficiency,” Australian Government Productivity Commission, Inquiry Report No. 36, Aug. 31, 2005, Overview section.