The Economics of Conservation Programs

209 Pages·1997·14.409 MB·English

by  Franz Wirl (auth.)

THE ECONOMICS OF CONSERVATION PROGRAMS
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To Franzi and Charlotte, the youth and our foture.
Preface and acknowledgements
This book is the outcome of more than two years research on the economics of
demand side management programs undertaken by electric utilities around the
world. This research had been originally initiated and fmancially supported by the
Austrian Ministry for Science and Research. I had relied in this investigation for the
Ministry on my own research rather than copying or reviewing the arguments of the
so far existing literature, only to discover later that the Ministry wanted exactly that -
a definitely positive assessment in line with the literature they knew - in order to
criticize the Economics Ministry neglect of demand side management in utility
regulation. Nevertheless, I thank the Ministry for the fmancial support and some
interesting discussions. These difficulties continued when trying to publish some of
my research papers that argue differently (both, in terms of economic substance and
analytical means) than the overwhelming majority of researchers active in this area.
Therefore, I am grateful for Kluwer Academic Publishers of providing herewith a
platform to outline with the help of economic analysis my arguments to this heated,
controversial public debate. Along the way, Marie Stratta, Zachary Rolnik and
Allard Winterink have been helping me on behalf of the publishers.
This book is largely based on my own research (in particular, it does not pretend
to provide a complete review of the literature) such that a consistent framework can
be applied throughout this book. Despite the reliance on my own work, the write-up
took more time and efforts than expected. Fortunately, some people provided helpful
support. At the Otto-von-Guericke University of Magdeburg, at my Chair for Utility
Economics: Martina Stimming was critically reviewing the manuscript, in particular
the mathematics; Rainer Kleber with the assistance of Simone Siebrecht and Axel
Kambach was very helpful in editing and revising the manuscript. Mrs. Sylvia Plaza
(from Vienna) was carefully reading the book and correcting my English. At this
opportunity, I also thank Reinhard Haas and some other former colleagues (Georg
Baier, Wolfgang Orasch and Claus Huber to name a few) at the Technical University
of Vienna for many stimulating discussions on this topic.
Last but not least, my thanks go to my wife and my wonderful children who had
to pay for this endeavor with their patience.
Otto-von-Guericke University of Magdeburg, September 1996.
Contents
1 Introduction 9
2 Economic analysis of energy conservation 13
2.1 Consumers 13
2.2 Firms 42
2.3 Estimation of price elasticities and assessment of the rebound effect: an
application to transportation 44
2.4 The energy efficiency of supplied technologies 47
2.5 Derivation of an intertemporal R&D strategy 51
2.6 Energy demand, technology and taxes 56
3 The normative case for demand-side conservation 61
3.1 Market failures 61
3.2 The first best social optimum 63
3.3 Second best efficiency standards for electricity price regulation 64
3.4 Imperfect capital markets 70
3.5 Subsidies when the electricity price is regulated and capital markets are
imperfect 75
3.6 Assessment of the social gain from conservation 78
4 Least cost planning 81
5 Incentives to the utility 89
5.1 Shared savings 90
5.2 Mark-ups 92
5.3 Bonus 93
5.4 Optimal conservation incentives to utilities 93
6 Incentives for consumers 107
6 Contents
6.1 A constant investment bonus 108
6.2 Linear bonuses for financial outlays 110
6.3 Conservation bonus according to Lovins 114
6.4 Energy service and third party conservation companies 115
6.5 Bidding for negawatts and price differentiation 116
7 Asymmetric information and strategic consumer reactions 119
7.1 Adverse selection among program participants 120
7.2 Negawatt auctions induce moral hazard 126
7.3 Moral hazard induced by conservation programs 128
7.4 Moral hazard under least cost planning DSM 132
7.5 Standards 136
7.6 United States experience 137
8 Optimal conservation incentives under asymmetric information 143
8.1 Socially optimal incentives 144
8.2 Optimal least cost planning conservation incentives when efficiency is
observable 150
8.3 Optimal conservation incentives when efficiency is not observable 162
9 Rate-of-return regulation and incentives 173
9.1 Rate-of-return regulation, no incentives 173
9.2 Rate-of-return regulation plus incentives (shared savings) 175
9.3 Review of literature 183
10 Efficiency of DSM and positive explanations 185
10.1 Impact of United States DSM on electricity demand 186
10.2 Problems on the demand side 188
10.3 Regulation 189
Contents 7
11 Summary and concluding remarks 193
12 References 207
Index 213
1 Introduction
Demand side management (DSM) is one of the most topical issues in regulating
electric utilities, both in the United States and internationally. What is DSM? It
consists of various measures at the level of demand (households, commerce,
industry, others), which are at least partially financed by electric utilities and which
should either conserve energy or reduce the peak load.
The practice of DSM originates from The Public Utility Regulatory Policy Act of
1978 (PURPA) that provided the political and legal framework to set energy
conservation as a national goal, which encouraged regulatory commissions to initiate
utility conservation programs; see e.g., Nowell-Tschirhart (1990) and Fox-Penner
(1990). Moreover, integrated resource planning, which must account for DSM on a
level playing field with supply, is written into the 1992 Energy Policy Act as the U.S.
Government's preferred method of electric power planning. Although PURPA set
energy conservation as a national priority, its implementation was left to the states
with the consequence of considerable differences concerning efforts and rules. By
1993 16 states had already implemented integrated resource planning, 9 were in the
process of doing so and further 9 considered implementation, (EPRI 1993b). Due to
the Clean Air Act of 1990, 24 states are considering to include external costs in
integrated resource planning.
The above historical account highlights that DSM rests on two pillars, efficient
regulation and environmental concern. While regulatory aspects dominated the past
debate, environmental issues are now becoming more and more important. This shift
is largely due to the recently substantiated evidence on the greenhouse effect.
Therefore, lowering greenhouse gas emissions, in particular of carbon dioxide,
which is an inevitable by-product of burning fossil fuels, seems an important
environmental objective. In fact, corresponding protocols have been signed, e.g., the
climate convention in Rio de Janeiro 1992. Given the contribution of carbon dioxide
emissions, energy conservation through whatever that means in detail, becomes
highly important. Indeed, DSM and related conservation programs are considered as
a low cost option, or as a no regret strategy, independent of whether or not DSM
improves the power industry's economic efficiency. Therefore, conservation
programs have to be considered among the first instruments to be implemented in
any efficient carbon dioxide emission reduction plan. Just how cheap such programs
will tum out to be is the subject of this study.
Although DSM covers load management as well as conservation, this book, like
the public debate, too, focuses on conservation. The corresponding literature on this
topic is almost exclusively positive, sometimes even enthusiastic: Lovins (1985),
"making gigabucks with negawatts"; Hirst (1992), "energy markets do not operate
properly... utilities can help to overcome these barriers and do so at low cost".
Another example is Richard Clarke (1994), chairman and executive officer of the
Pacific Gas and Electric company, who uses a PG&E sponsored energy
conservation program to prove the possibility of win-win strategies. This positive
F. Wirl, The Economics of Conservation Programs
© Kluwer Academic Publishers 1997
10 Introduction
outcome of environmental regulation is strongly advocated by Michael Porter,
recently in Porter-van der Linde (1995). Walley and Whitehead (1994) and Jaffe
Peterson-Portnoy (1995) question this 'free lunch' for environmental regulation. The
voluminous, optimistic academic discussion had a strong impact on the public debate
and on the following political decisions: thousands of programs were launched (see
EPRI, 1993a) and the utilities spent billions of dollars, just during 1992
approximately US$ 2 billion. In particular the press was eager to report and to
support these claims. For example, Time, January 2nd, 1989, reports that " ... Osage's
(a town ... in Iowa) model conservation program saved the town an estimated US$
1.2 million in energy costs ... The utility (of Osage) recently decided to give
customers US$ 15 fluorescent light bulbs which use far less energy than
incandescent models ... ", Newsweek, June 18th, 1990, writes " ... Electric Utilities have
led the charge toward energy efficiency partly from environmental concern but
largely because of the bottom line: it costs 30 to 50 percent less to cut demand for
power than to build new generating capacity ... " and even The Economist, March
16th, 1991, known for its support of free markets and its scepsis concerning public
interventions, appraises DSM: "In recent months California's four big utilities have
leapt into energy-saving .... they are increasingly subsidizing their customers to switch
to more efficient appliances, windows, heating systems and air conditioners ... This
avoids the need to build several new power plants." Recently this wave has reached
the shores of Western Europe, while intended deregulation of the United States
electricity markets will presumably reduce, if not eliminate, utility conservation
programs. Particularly in Germany, politically supported by the Greens, conservation
programs were launched (e.g., in SaarbrUcken, Bremen and Frankfurt; in Austria in
one of the federal states, Salzburg) and were well, sometimes enthusiastically,
received.
The documentation on DSM undertaken by U.S.' electric utilities is huge:
companies report on their programs (e.g., Pacific Gas and Electric (1989), Central
Maine Power Company (1990); Moskovitz (1989) summarizes the intentions, Nadel
(1990a) compares different utility programs; Gilbert-Stoft (1992) reviews and
classifies incentives to the utilities; Joskow-Marron (1992) question the reported
costs of conservation. Due to this extensive literature, the review of DSM can be
brief. It was (to my knowledge) Amory Lovins who first advocated the fundamental
idea of DSM already in the seventies that
"a kilowatt-hour saved is just like a kilowatt-hour generated ... so that they should
be treated alike. ..
Although Lovins does not mention this, his insight seems very similar to that of
Coase (1960), namely that in principle all parties involved could be made liable to
correct an externality. Here, the utility should correct market failures imposed by
others (e.g., consumers take 'wrong' decisions which have negative spillover effects
on the utility and on the environment), if it can do this at the lowest cost. All
programs, in practice as well as in theoretical proposals, have in common that the
utility incurs expenses - subsidizing or complete financing" of conservation