Conservation investments benefit participants and non-participants alike
Dr. Charles Cicchetti is co-founding partner with Pacific Economics Group and a professor of economics at the University of Southern California. He formerly was chairman of the Wisconsin Public Service Commission, and directed the Wisconsin Energy Office. Contact him at email@example.com. Duke Energy provided some information and monetary support for this analysis. Only publicly available data are used. The conclusions reached are solely the responsibility of the author.
Americans once again are debating how to redirect consumers toward energy efficiency in the form of conservation, demand-side management (DSM) and renewables. In the past, such efforts mostly failed once high energy prices abated or Americans lost interest in conservation. Americans also seem unwilling to spend time and money on energy efficiency, despite no loss in quality and rather significant cost reductions.
Until recently, California was a notable exception to this declining interest in utility-sponsored conservation. California consumers use about 50 percent less electricity per person than the rest of the nation. The two political factors that make energy efficiency work for California are: 1) a political/consumer willingness to pay utilities to achieve strong energy-efficiency goals and targets (e.g., 20 percent renewables in utility supply portfolios before 2015); and 2) acceptance of a “wires and pipes” public-goods charge to finance California’s green efforts and to provide opportunities for utility companies to earn additional income from energy efficiency as a utility service.
While California has been very successful, much of the nation has distanced itself from the state and its seeming refusal to consider more conventional supply-side alternatives. Regardless, California demonstrates that energy efficiency works and can be relied upon to satisfy consumer needs (see “Mandating Demand Response”). That said, other proposals like Duke’s “Save-a-Watt” plan that do not have the stigma of the California crisis are beginning to create momentum toward for-profit energy-efficiency programs. Duke’s proposal is contributing to the renewed national discourse on the need for utility-sponsored energy efficiency—and quantifying the external benefits of such a program demonstrates an attractive payoff for all utility customers.
Duke’s proposals could profoundly change the regulatory landscape for energy efficiency, environmental improvement, and power-station investment. The core concept underlying the Duke plan is to align shareholder and retail customer interests behind an expanded least-cost approach.
This contrasts significantly with historic approaches. In the past, when regulators attempted to expand conservation and DSM, their primary concern was preventing harm to non-participants. Additionally, regulators attempted to treat utility conservation as a new product that would replace traditional energy sales. This raised such questions as how the plan would be implemented, who would pay, and who would benefit. The answers are complex and often derailed regulatory support.
Moreover, utility investors often were given little or no consideration in terms of how they would earn a return on these programs. Two issues were problematic: How to price conservation products; and how to set a utility’s earnings.
The traditional regulatory approach based utility income entirely on the amount invested, not the value of the services provided. Customers were ratepayers and choices were virtually non-existent. Providing conservation and demand-side services was considered part of the utility’s franchise responsibility (i.e., the regulated duty to serve). Under this regulatory paradigm, utilities had no opportunity to earn a margin on the services that other retailers would capture.
This created a strong disincentive against investment by regulated utilities, because when energy efficiency reduces sales between rate cases, shareholders lose income and have no opportunity to recover it. The greater the success of a utility’s energy-efficiency program, the greater the potential shareholder losses.
Regulation sometimes attempted to address this matter using revenue-decoupling mechanisms, whereby lost revenues would be recovered in an adder to regulated bills. At best, such a plan would help shareholders achieve a degree of indifference or neutrality. This often simply was not enough of an incentive to sustain support for energy efficiency.
The Duke plan fixes these traditional regulatory problems because it recognizes reasonable incentives are the essence of market-based societies. Earning a return on capital investments is essential, but earning a margin income on developing, packaging, and marketing energy-efficiency programs for retail customers is at least as important.
Additionally, Duke would treat energy efficiency as a fifth fuel or utility input, rather than a new product. State regulators would consider this fifth fuel among the options available to meet resource requirements, using least-cost planning principles.
The basic idea of Duke’s Save-a-Watt proposal includes three primary steps:
1) Determine the need, considering both supply and demand-side alternatives;
2) Use least-cost planning, and place cost-effective energy-efficiency choices in the utility’s rate base—at a revenue requirement of 90 percent of the present value of the avoided costs associated with supply-side alternatives. Such costs also would incorporate the annual depreciation and revenue requirements for energy-efficiency investments over their expected life.
3) Recover annual revenue requirements from all customers through a rate rider. This charge would be trued-up to ensure customers do not pay unless energy efficiency programs succeed.
This approach addresses the regulated revenue-requirements aspects of energy-efficiency simply and transparently. Regulators would consider and address the costs of service and future revenue-requirements effects for a new utility input, not a new product. They would understand the cost-benefit tradeoffs of various proposals to make the future resource mix green, greener or greenest. This would allow regulators to focus on what they can do best: Determining the reasonable future mix of conservation, traditional supplies and renewables.
Only one major regulatory question remains: How will regulators protect non-participants?
Just and Reasonable?
Most utility-sponsored energy-efficiency programs offer certain well-understood benefits. For example, if utility prices increase to pay for energy efficiency and provide utility income, reduced use generally offsets those price increases. This means lower monthly utility bills for participants.
Also, energy-efficiency products cost less than traditional supply-side alternatives, at least when they are designed in a sound way as part of an integrated planning process. Revenue requirements for utility-sponsored efficiency programs are lower than requirements for supply-side alternatives. Thus, societal benefits exceed costs.
The one ambiguous category is the effect on non-participating customers. Many regulators falsely might conclude that asking non-participants to pay more to help others consume less would represent an unjust form of price discrimination.
In fact, non-participants sometimes can pay less under utility-sponsored energy efficiency. The most important determinants are: whether marginal costs exceed average historic costs, the relative size of the program, and whether participants pay at least a portion of the direct costs.
In the event that non-participants would pay more under a utility program in which energy efficiency replaces generation, then societal benefits can help justify the costs. A majority of customers generally will support at least modest cost increases for such societal benefits .1
Broadly speaking, society would benefit when energy efficiency reduces negative externalities in the forms of cleaner air [specifically, reductions in sulfur dioxide (SO2), nitrogen oxide (NOX), and other emissions] and climate-change prevention [through reductions in carbon dioxide (CO2) emissions]. Society also benefits from an improved national-security posture, through reductions in energy imports and improved macroeconomic conditions (see sidebar, “Quantifying Societal Benefits” p.58).
Comparing Benefit to Cost
Regulators can quantify these marginal benefits to determine if society, and in particular non-participating customers, would be better off under an expanded energy-efficiency program such as Duke’s Save-a-Watt proposal.
Estimates of societal value range between 5.3 cents and 15.7 cents per kilowatt-hour of energy efficiency, based on national-average emission values and half the quantifiable national-security benefits from saving a barrel of crude oil (see Table 1, “Save-a-Watt Costs and Benefits”). A base-case estimate of 7.15 cents/kWh reflects average annual emissions from Duke Energy Carolinas’(DEC) Cliffside Units 1-4, which likely would be targeted for retirement if Duke’s Save-a-Watt program succeeds. 2
Regulators can determine whether conservation costs are just and reasonable by multiplying the price increase all non-participants would pay by their annual consumption, and comparing that amount to the value of energy-efficiency benefits. These benefits equal the total kWh saved, multiplied by the per-unit value of marginal benefits of energy efficiency—7.15 cents in the Duke base case.
Each utility region must perform its own benefit/cost analysis, and facts and conceptual differences, such as how to define costs, likely would vary. Regardless, the benefits of energy efficiency, which have been mostly underutilized, likely will exceed the corresponding costs, no matter who pays for energy efficiency.
DEC has filed data that make it possible to demonstrate how to do such an analysis for its non-participating customers. For the sake of simplicity, all DEC’s industrial consumers might be treated as non-participants. Their annual consumption is about 50.6 billion kWh/year3. Duke estimates its proposed Save-a-Watt rate rider would be 0.094 cents/kWh for non-residential consumers—which overstates the amount industrial non-participating customers would pay, because it does not account for the amount per kWh these customers would be allocated for new generation. Nevertheless, applying 0.094 cents to 50.6 billion kWh/year yields $47.6 million as a high estimate of the annual cost of Save-a-Watt for DEC’s industrial consumers.
These same industrial users also would pay their share (about 50.6 billion kWh out of 76.6 billion kWh total retail sales) of DEC’s traditional supply-side costs if DEC does not expand energy efficiency and build more new generation. (Recall that the Save-a-Watt rate rider is based on 90 percent of the avoided cost of new generation.)
After excluding rather significant demand-response capacity reductions, DEC’s proposed conservation programs under Save-a-Watt would save about 5.4 billion kWh in their first four years (See Table 2, “Save-a-Watt Projected Savings”). Assuming a constant rate rider for industrial users, they would pay about $190.3 million over this same four-year period, representing a cost per kWh for industrial users of about 2.51 cents.
Notably, this per-unit cost estimate ignores the benefits associated with demand-side response reductions of capacity requirements, which would equal about 1,594 MW in year four, as well as the offsetting price increases industrial customers would avoid paying for traditional supply-side expansions.
Under base-case assumptions, DEC’s industrial customer non-participants would enjoy benefit-to-cost ratios of about 3-to-1 over the four-year period for the conservation portion of Save-a-Watt (see Table 3, “Benefit/Cost Comparisons for Non-Participating Customers”).
Fifth Fuel Appeal
In all regulatory jurisdictions, the retail distribution end of the network remains a regulated “natural” monopoly. This means legislators or regulators can look to these regulated assets and services as a direct means to finance energy efficiency when, as is likely, they determine that utility, consumer, and external benefits exceed costs.
Some states are contemplating assessing wires charges, as California does, to finance social programs such as energy efficiency. Other states are considering different means to make energy efficiency profitable to the utility, such as Duke’s proposed Save-a-Watt rate mechanism based on 90 percent of avoided supply costs.
Duke’s Save-a-Watt proposal provides regulatory appeal because total revenue requirements would increase no more than 90 percent of the avoided supply costs. Everything else, such as avoiding negative externalities, is simply regulatory “icing on the cake.”
An analysis of external benefits from energy efficiency demonstrates that all customers likely would gain greater benefits than their respective costs, regardless of whether they participate or not.
Now regulators need to decide if they really want to improve energy efficiency, reduce the threat of climate change, enhance national security and improve air quality. This is an easier choice for regulators given the impressive benefit-to-cost ratios of energy-conservation programs.
1. Aliff, Gregory E., and Terzic, Branko, “The Greening of Utility Customers,” Public Utilities Fortnightly, September 2007.
2. For each megawatt hour generated from January 1997 through March 2007, on average the Cliffside plants emitted about 1.37 tons of CO2; 5.5 pounds of NOX; and 0.01 tons of SO2. Source: U.S. EPA Clean Air Markets Program Unit Level Emissions.
3. DEC’s FERC Form 1 for 2006.