Transcript Slide 1

Efficient Pricing of Energy
Conservation and Load
Management Programs.
August 9th,2006
Kansas Corporation Commission
Staff
Much of the discussion in this presentation comes from a
series of articles written by Larry E. Ruff. These articles
are documented at the end of the presentation.
Regarding the recovery of costs from DSM
programs, there are two alternative
schools of thought:
1)
2)
Free DSM (zero price for DSM)
Program costs are recovered through a
cross-subsidy
Subsidy-free DSM (non-zero price for
DSM)
Program costs are recovered through
price charged to DSM customers
In spite of the debate about how to evaluate DSM
proposals, there is much to be gained if the primary
objective for DSM is made clear, helping pave the way
to resolve any debate about evaluation of DSM
programs.
Here’s one possible objective:
Encourage each ratepayer to choose the
least-cost combination of energy and DSM
services from the utility based on prices that
reflect the costs of providing these services.
This objective will support an economically
efficient outcome: the lowest possible utility
cost and the lowest possible energy prices.
Let’s compare and contrast the two cost
recovery alternatives:
– Free DSM
– Subsidy-Free DSM
Free DSM
When programs are designed to
provide free DSM, then a benefit/cost
analysis (TRC, RIM, Utility Cost, etc.)
is used to determine which programs
to implement.
Free DSM
There are two problems with giving anything away for free:
1) Excess demand. In this case, many ratepayers will take
advantage of the DSM service whether it has any real value to
them or not. Excess demand may lead to shortages,
preventing customers who would greatly benefit from the
service from getting any.
2) Cross-subsidization. Since there are no free lunches,
energy prices must be increased to allow for recovery of
costs. Free DSM is likely to require a cross-subsidy from the
utility’s energy business.
Free DSM
The concern with these two problems is that they
set a foundation for inefficient use of both DSM and
energy resources. Any inefficient use of resources
results in costs being higher than necessary.
Because program participants do not have the
correct incentives, there is no certainty that actual
savings (i.e., avoided cost) will exceed the cost of
the DSM.
Free DSM
Another problem: Utilities/regulators do not know
how much benefit DSM services will provide to
individual consumers. Individual benefits and also
costs are unobserved.
This results in the use of estimates or “hypothetical
data” to evaluate DSM programs.
Subsidy Free DSM
Larry E. Ruff has shown that if DSM is priced
efficiently, implementation of DSM programs can
meet the stated objective (see Slide 4).
Ruff shows that DSM should be priced as follows:
PRICEDSM = Unit Cost DSM – Rebate, where
Rebate ≡ (MCEnergy – PEnergy).
Subsidy Free DSM
Ruff shows that when DSM is priced efficiently:
1) Price of electricity needn’t be increased to pay
for the DSM; meaning that the DSM Program can
be offered subsidy-free and,
2) Each ratepayer purchases DSM services if and
only if it is cost effective for them to have it.
When these two conditions hold, the stated DSM
objective (see Slide 4) is satisfied!
Subsidy Free DSM
What the Ruff pricing formula shows is that when it
is cheaper to conserve than to produce the next
kWh - that is, when the system lambda exceeds the
tariff price of electricity , the DSM rebate is positive
– indeed a large enough rebate could make the
DSM free. But this is a special case outcome.
Subsidy Free DSM

Pay-as-you-go DSM Programs are an example of
non-free DSM. Such programs generally require
participant payment for DSM out of the savings
created by DSM. The participant pays for the DSM
with energy savings, and other ratepayers are not
at risk for higher rates.

Is the outcome efficient?

Is the outcome equitable?
Subsidy Free DSM
But for the possible rebate identified by Ruff, the
Commission should allow utilities to price DSM by
applying the usual cost-of-service standard!
Other Objectives for DSM
Besides promoting economic efficiency,
there are other objectives that may be
pursued with DSM Programs:
– landlord/tenant ownership/usage incentive
problem: DSM can target assistance to tenants
– low income bill affordability: DSM can target
assistance to low income households
– non-internalized external costs: DSM can reduce
GHG emissions (implying a possibly larger
rebate)
A Modest Proposal



Make clear the intended policy objective.
If the objective is an efficiency improvement, then DSM
should be priced like any other regulated utility service
(possibly modified by the Ruff Rebate). By focusing on the
right DSM price, the need to focus on the right benefit/cost
test is largely eliminated.
However, if the objective is something else – assisting renters
and/or low income households and/or reduction of external
costs – then it may be reasonable to set the DSM price at
zero. By having objectives other than economic efficiency, the
need to focus on the right benefit/cost test is again largely
eliminated. In this case the policy makers need to determine
the level of assistance that should be provided (e.g., allow an
annual DSM budget of $5mil).
Economic Efficiency
For any DSM program to be economically efficient that is, support the least-cost outcome, it must be
efficient in both supply and demand.
– To be cost effective in supply, the avoided cost must
exceed the cost of the DSM plus any costs incurred by the
Program participant:

NBi = MCEnergy – CDSM – Ci > 0.
–
–
–
–
NBi= Net Benefit to supply customer i
MCEnergy = marginal cost of 1 unit of energy
CDSM =utility cost of 1 unit of DSM (constant marginal cost)
Ci=customer cost of using DSM to save 1 unit of energy
– Unfortunately, utilities/regulators do not know or have
access to Ci, meaning it is impossible to verify whether
NBi > 0.
Economic Efficiency

To be efficient in demand, the tariff price must exceed the
DSM price plus any costs incurred by the program
participant:
– NIi = PEnergy – PDSM – Ci > 0.
NIi=Net Incentive to customer i
 PEnergy=Price of 1 unit of energy
 PDSM=Price of 1 unit of DSM
 Ci=Customer cost of using DSM
Again, note that the optimal price that the utility must charge
for the DSM is:


– P*DSM= CDSM+(MCEnergy-PEnergy)
With this DSM price, energy prices will not be increased, there
will be no cross subsidization of the DSM program, and the
outcome will be economically efficient.
Economic Efficiency

It may be seen that free DSM distorts incentives and creates
excess demand. The ratepayer’s Net Incentive becomes:
NIi = PEnergy – Ci > 0;
rather than the efficient Net Incentive previously outlined.


If DSM is priced according to Ruff’s formula, the DSM program
will be efficient in both supply and demand, and a least-cost
outcome is achieved.
When DSM is priced efficiently, it will be applied if and only if
it is cost-effective for the individual participant. Efficient
pricing of DSM “will prevent non-cost-effective DSM from
being demanded”. Proper DSM pricing is necessary and
sufficient if policy makers want cost-effective DSM Programs.
The RIM Test


In some instances, it is said that the RIM Test is a
test of distributional equity and not of cost
effectiveness.
The RIM test is a test of cost effectiveness and
of economic efficiency.
The RIM Test
Consider:
The RIM Test measures program impacts to
ratepayers, and a program passes the test if there
are no losers under the program – that is, if no
ratepayers are worse off than before the program.
Cost effectiveness generally means that total
program benefits exceed total program costs. In
other words, the gains by program winners exceed
the losses by program losers
The RIM Test
If a program is truly cost effective, the winners would be
willing to pay the full costs of the program because they
would still be better off than before (Remember total
benefits exceed total costs).
In this instance there are no losers! The program is cost
effective, it passes the RIM Test, and it does not require
cross-subsidy (under the assumption of no external costs).
The RIM Test
There are no impediments to the utility charging
customers the correct price for DSM. The utility
knows who receives the service and how much it
costs.
There is no need for cross-subsidization if a
program is truly cost effective!
Impacts of Free DSM
(Cross Subsidy)



Free DSM can have real economic impacts.
Consider the economic impacts on current energy
conservation service providers.
What will happen if utilities begin giving away DSM
services for free?
For the interested Viewer
For a comprehensive discussion on these and other
related issues, we refer the interested viewer to
these articles by Larry E. Ruff:
– Equity vs. Efficiency: Getting DSM Pricing Right, Electricity
Journal, Nov. 1992
– Least-cost Planning and Demand-side Management: Six
Common Fallacies and One Simple Truth, Public Utilities
Fortnightly, April 28, 1988
– Planning and Pricing in the Energy Conservation Business,
Conference on The Economics of Energy Conservation,
Berkeley, CA, June 1992
– Economic Principles of Demand Response in Electricity,
EEI, October 2002