Efficient Pricing of Energy Conservation and Load Management Programs.

1. Efficient Pricing of Energy Conservation and Load Management Programs. August 9th,2006 Kansas Corporation Commission Staff

2. 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.

3. Regarding the recovery of costs from DSM programs, there are two alternative schools of thought: 1)Free DSM (zero price for DSM) Program costs are recovered through a cross-subsidy 2) Subsidy-free DSM (non-zero price for DSM) Program costs are recovered through price charged to DSM customers

4. 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.

5. 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.

6. Let’s compare and contrast the two cost recovery alternatives: Free DSM Subsidy-Free DSM

7. 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.

8. 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.

9. 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.

10. 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.

11. 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).

12. 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!

13. 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.

14. 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?

15. 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!

16. 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)

17. 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).

18. 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.

19. 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.

20. 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.

21. 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.

22. 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

23. 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).

24. 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!

25. 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?

26. 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