Viewpoint ITMi Mr, Bank FPD Note No. 3 April 1994 When Energy Conservation Doesn't Work Critique of a DSM program Ranjit Lamech This Note is a contributiony to anl on- into a higher resource cost than merely going debate about the subsidies and the avoided cost of generation. Because rebates provided by power utilities to these programs don't minimize costs, encourage consumers to adopt efficient they are not a financially viable alterna- end-use appliances. The argument tive to expanding supply. presented here does not deny the need for demand-side energy conservation The utility managed subsidies fail on an strategies (commonly known as de- equity test too. Typically, the utility mand side management or DSM). bears some or all the investment costs. DSM programs can and do have a The subsidy programs are targeted at useful role in raising energy efficiency. only some consumers, while the bur- T'his Note examines one particular den of cost recovery is shared by all. "bra7ld" of DSM which some in the Some consumers get a conservation energy industry believe is seriously service and an electricity service while flawved. This iVote should not be con- others get only the electricity service strued as final FPD position on this though they pay the same price for debate, but it does represent a direc- each unit of electricity. The program tion that this Vice-Presidency is in- penalizes conservation-minded con- creasingly comfortable with. The views sumers who have already made the expressed are those of the author. switch. They are out of pocket twice because they pay full-price for their When governments urge consumers investment and then they pay higher to save power by giving them special rates to subsidize subsequent users. subsidies or rebates for more efficient appliances-special light bulbs, for A fuller case against the utility managed example-the results can be quite subsidy programs is outlined below: perverse. This is the case with utility- managed appliance programs. For ex- Cost-effective conservation may not ample, in the US, programs allow the be achieved at all utility to recover the cost of the rebate, as well as the revenue displaced by Energy conservation must be least cost energy conservation. This translates to be viable. A simple example shows Industry and Energy Department Vice Presidency for Finance and Private Sector Development why the subsidies may not meet this test. Suppose The programs can undermine competition electricity costs 7 cents (marginal cost) per kWh to generate. Assume a high efficiency light bulb costs Economic efficiency at the national level is $30 but saves 500 kWh over its lifetime compared achieved through reducing the cost of production to a normal light bulb. Every kWh saved is worth and delivery. It is competition that provides the 6 cents (30/500 = .06). Program advocates argue that necessary incentives for utilities to pursue this low the utility should be willing to pay the 6 cents per cost generation and supply. kWh saved, as a rebate on the consumers bill or as a direct transfer to the consumer. This actually provides The utility programs can undermine competition in the consumer with an incentive equal to 13 cents the following ways: per kWh to install high efficiency light bulbs-the 6 cents payment by the utility and the 7 cents elec- * Energy conservation services get bundled with tricity tariff saved. The total incentive is almost twice electricity supply services. Yet the characteristics the avoided cost. Depending on whether the con- of these two markets are very distinct. While there sumer chooses to install the light bulb with the re- are natural monopoly characteristics in electricity bate or not, the total resource cost could exceed supply services, energy conservation services can avoided cost. be delivered competitively. In other sectors, such as telephone services, anti-trust authorities have The best conservation signal is delivered when pow- prevented the cross-subsidization of a competitive er is priced at marginal cost. By the same logic, if sector (such as long distance services) by the "nat- the actual price is below marginal cost, customers ural" monopoly sector (local exchange services). don't have the right incentive to save and it may be When conservation services and electricity supply necessary to provide a subsidy payment to get them are provided by the same utility, there is clear to do so. The rate increase through this subsidy will potential for cross-subsidization. This can act as result in rates no higher than the marginal cost-the a barrier to competitive entry both for alternative level that customers should be charged to achieve low cost suppliers of electricity and for efficient economic efficiency. But this is a poor ("second providers of energy conservation services. best") way of improving efficiency. The best way is for the utility to align the electricity tariff with the * The mere existence of subsidy programs can cre- marginal cost, rather than subsidize consumer pur- ate powerful interest groups who may block evo- chases of efficient appliances. lution to a more competitive power industry. The most obvious interest groups include: incumbent The programs may entrench cross-subsidies utility owners and operators for whom subsidy between consumers programs represent protection from competition, and stakeholders providing conservation services Energy conservation should not produce or perpetu- for the utility. ate cross-subsidies between consumers. The utility managed subsidies typically benefit some consumers The utilities business is selling a commodity called while the costs are spread over them all. These are "electricity" not the "end-use" value of electricity. unfair and the longer they go on the more damaging Energy conservation services are different in kind they are to the economy and the harder they are to from these supply services. Conservation services unwind politically. The right approach is for all utili- require special skills. For example, knowledge of: ty transactions with all customers to be based on HVAC systems, building insulation and design stan- actual cost-of-service. This will lead to a financially dards; interior lighting and the interplay of ambient sustainable and competitive environment for power light and surface textures; and energy use in indus- utilities. trial processes such as cement making, chemicals, 2 paper and pulp. All involve a skill and knowledge can regulate or provide incentives to correct this base different from operating electricity generating distortion. When they do, they must apply two plants and associated high voltage transmission and principles: the proposed measures need to be as distribution systems. In these qualities, power utili- broad-based as possible to have a beneficial rather ties have no competitive advantage. The assumption than cosmetic effect, and the corrective action that the electricity utility is the appropriate provider should not induce fresh distortions. of energy conservation services is misleading. Ener- gy conservation service requires market research, On both counts, the utility programs fail: they are marketing, and managing a customer-oriented agenda. neither broad-based nor neutral: Here again, the power utilities have no inherent edge. Most utilities in developing countries are not yet * They make no allowances for the differing envi- able to restructure their operations along these lines. ronmental impacts of hydro, gas, coal, oil, wind or solar electricity. They affect all sources of gen- Intrusive regulatory behavior may occur eration and do not necessarily result in environ- mentally benign decisions. The public interest obligation of the electricity regu- lator is to ensure equitable and economic electricity * They may encourage self-generation by large service to all consumers. However, these programs consumers who might opt for coal or oil-fired may confuse the regulators role so that the regulator generation technologies to circumvent higher starts making decisions about investment strategies utility tariffs. and consumer choices. To avoid this, regulators can operate by the following principles: The energy conserved may not justify the costs * Utilily regulation is economically and conceptual- Utilities in the U.S. have frequently relied on theo- ly different from the sector planning function. retical engineering estimates of energy savings to Regulators should ensure that utilities make low- justify their first outlays. This practice was reason- cost decisions from a consumer's perspective, but able in the initial stages. However, as the programs not prescribe an investment strategy such as a mature and related expenditures increase, regulators specific conservation program. and utilities alike have to justify expenses related to verifiable program results. * Regulation should allow consumers to choose between a subsidized program and lower rates. A Attempts to do so have shown poor results. regulator can ask for greater cost transparency, The higher-than-estimated costs and lower-than- but cannot make inequitable and uneconomic expected load effects seen in some recent electric choices on behalf of the consumer. utility program evaluations indicate that some programs may not be as attractive in fact as they * Regulation should protect consumers from the looked on paper. monopoly power of public utilities. Regulation that allows the utility to make decisions on behalf However, evaluation is very difficult. Impact evalua- of consumers offers no protection from monopoly tion might seem to be a routine statistical sampling abuse. and data collection exercise. In reality, impact evalu- ation encompasses complex statistical problems, The pirograms distort internalized environmental with a great number of interacting factors: it requires costs establishing customer consumption characteristics, and estimating what would have happened in the Where environmental costs are not accounted for, absence of the subsidy. It is difficult to estimate there is a market failure or distortion. Govemments the low magnitude of individual customer load 3 impact, particularly for residential programs that must restrict its role to areas of clear comparative advan- sometimes be measured in fractions of a kilowatt hour. tage, such as supporting the development of these The impact on long-term consumer behavior (i.e. the service ancl intermediation entities, improving infor- persistence of such programs) makes even reasonably mation dissemination and public awareness and accurate estimates extremely difficult or expensive. setting appliance efficiency standards. In this vein, electric utilities should not be instruments of gov- Future Direction emment policy but operate as competitive firms that optimize their asset values and exploit their compar- None of the above arguments detract from the cen- ative advantage. If such an environment can be nur- tral need to pursue demand-side energy conserva- tured, conservation efforts will be self-sustaining tion strategies. Conservation services and efficient and have the maximum real impact. appliances can be provided by energy services com- panies (consultancy and audit firms) and manufac- turers, assisted by intermediaries such as leasing Ranjit Lamech, Restructuring Specialist, Finance and Private Sector companies, banks etc. But government ought to Development This series is published to share ideas and invite discussion. It covers financial and private sector development as well as industry and energy. The views expressed are those of the author(s) and are not intended to represent an official statement of Bank policy or strategy. Comments are welcome. Please call FPD Note line to leave a message: 202-458-1111. Suzanne Smith is the editor and production manager. Her address is Room G8105, The World Bank, 1818 H Street, NW, Washington, DC 20433. 4