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

Efficient Pricing of Efficient Pricing of Energy Conservation Energy Conservation and Load Management and Load Management Programs.Programs.

August 9August 9thth,2006,2006

Kansas Corporation Kansas Corporation Commission StaffCommission Staff

Much of the discussion in this presentation comes Much of the discussion in this presentation comes from a series of articles written by Larry E. Ruff. from a series of articles written by Larry E. Ruff. These articles are documented at the end of the These articles are documented at the end of the presentation. presentation.

Regarding the recovery of costs from Regarding the recovery of costs from DSM programs, there are two DSM programs, there are two alternative schools of thought:alternative schools of thought:

1)1) Free DSMFree DSM (zero price for DSM) (zero price for DSM)

Program costs are recovered Program costs are recovered through a through a cross-subsidycross-subsidy

2)2) Subsidy-free DSMSubsidy-free DSM (non-zero price for (non-zero price for DSM)DSM)

Program costs are recovered Program costs are recovered through through price charged to DSM price charged to DSM customerscustomers

In spite of the debate about how to evaluate DSM In spite of the debate about how to evaluate DSM proposals, there is much to be gained if the proposals, there is much to be gained if the primary objective primary objective for DSM is made clear, for DSM is made clear, helping pave the way to resolve any debate about helping pave the way to resolve any debate about evaluation of DSM programs.evaluation of DSM programs.

Here’s one possible objective:Here’s one possible objective:Encourage each ratepayer to choose the Encourage each ratepayer to choose the least-costleast-cost combination of energy and DSM combination of energy and DSM services from the utility based on prices services from the utility based on prices that reflect the costs of providing these that reflect the costs of providing these services. services.

This objective will support an economically This objective will support an economically efficient outcome: the lowest possible utility efficient outcome: the lowest possible utility cost and the lowest possible energy prices. cost and the lowest possible energy prices.

Let’s compare and contrast the two Let’s compare and contrast the two cost recovery alternatives:cost recovery alternatives:

– Free DSMFree DSM– Subsidy-Free DSMSubsidy-Free DSM

Free DSMFree DSM

When programs are designed to When programs are designed to provide free DSM, then a provide free DSM, then a benefit/cost analysis (TRC, RIM, benefit/cost analysis (TRC, RIM, Utility Cost, etc.) is used to Utility Cost, etc.) is used to determine which programs to determine which programs to implement. implement.

Free DSMFree DSM

There are two problems with giving anything away for There are two problems with giving anything away for free:free:

1) Excess demand. In this case, many ratepayers will 1) Excess demand. In this case, many ratepayers will take advantage of the DSM service whether it has any take advantage of the DSM service whether it has any real value to them or not. Excess demand may lead real value to them or not. Excess demand may lead to shortages, preventing customers who would greatly to shortages, preventing customers who would greatly benefit from the service from getting any. benefit from the service from getting any.

2) Cross-subsidization. Since there are no free 2) Cross-subsidization. Since there are no free lunches, energy prices must be increased to allow for lunches, energy prices must be increased to allow for recovery of costs. Free DSM is likely to require a recovery of costs. Free DSM is likely to require a cross-subsidy from the utility’s energy business. cross-subsidy from the utility’s energy business.

Free DSMFree DSM

The concern with these two problems is that The concern with these two problems is that they set a foundation for inefficient use of they set a foundation for inefficient use of both DSM and energy resources. Any both DSM and energy resources. Any inefficient use of resources results in costs inefficient use of resources results in costs being higher than necessary. Because being higher than necessary. Because program participants do not have the correct program participants do not have the correct incentives, there is no certainty that actual incentives, there is no certainty that actual savings (i.e., avoided cost) will exceed the savings (i.e., avoided cost) will exceed the cost of the DSM.cost of the DSM.

Free DSMFree DSM

Another problem: Utilities/regulators do not Another problem: Utilities/regulators do not know how much benefit DSM services will know how much benefit DSM services will provide to individual consumers. Individual provide to individual consumers. Individual benefits and also costs are unobserved.benefits and also costs are unobserved.

This results in the use of estimates or This results in the use of estimates or “hypothetical data” to evaluate DSM “hypothetical data” to evaluate DSM programs. programs.

Subsidy Free DSMSubsidy Free DSM

Larry E. Ruff has shown that if DSM is priced Larry E. Ruff has shown that if DSM is priced efficiently, implementation of DSM programs efficiently, implementation of DSM programs can meet the stated objective (see Slide 4).can meet the stated objective (see Slide 4).

Ruff shows that DSM should be priced as Ruff shows that DSM should be priced as follows:follows:

PRICEPRICEDSMDSM = Unit Cost DSM – Rebate, = Unit Cost DSM – Rebate, wherewhere

Rebate ≡ (MCRebate ≡ (MCEnergyEnergy – P – PEnergyEnergy).).


Ruff shows that when DSM is priced efficiently:Ruff shows that when DSM is priced efficiently:

1) Price of electricity needn’t be increased to 1) Price of electricity needn’t be increased to pay for the DSM; meaning that the DSM pay for the DSM; meaning that the DSM Program can be offered subsidy-free and,Program can be offered subsidy-free and,

2) Each ratepayer purchases DSM services if 2) Each ratepayer purchases DSM services if and only if it is cost effective for them to and only if it is cost effective for them to have it.have it.

When these two conditions hold, the stated When these two conditions hold, the stated DSM objective (see Slide 4) is satisfied!DSM objective (see Slide 4) is satisfied!


What the Ruff pricing formula shows is that What the Ruff pricing formula shows is that when it is cheaper to conserve than to when it is cheaper to conserve than to produce the next kWh - that is, when the produce the next kWh - that is, when the system lambda exceeds the tariff price of system lambda exceeds the tariff price of electricity , the DSM rebate is positive – electricity , the DSM rebate is positive – indeed a large enough rebate could make the indeed a large enough rebate could make the DSM free. But this is a special case outcome.DSM free. But this is a special case outcome.


Pay-as-you-goPay-as-you-go DSM Programs are an DSM Programs are an example of non-free DSM. Such programs example of non-free DSM. Such programs generally require participant payment for generally require participant payment for DSM out of the savings created by DSM. The DSM out of the savings created by DSM. The participant pays for the DSM with energy participant pays for the DSM with energy savings, and other ratepayers are not at risk savings, and other ratepayers are not at risk for higher rates.for higher rates.

Is the outcome efficient?Is the outcome efficient?

Is the outcome equitable?Is the outcome equitable?


But for the possible rebate identified by Ruff, But for the possible rebate identified by Ruff, the Commission should allow utilities to price the Commission should allow utilities to price DSM by applying the usual cost-of-service DSM by applying the usual cost-of-service standard! standard!

Other Objectives for Other Objectives for DSMDSM

Besides promoting economic efficiency, Besides promoting economic efficiency, there are other objectives that may be there are other objectives that may be pursued with DSM Programs:pursued with DSM Programs:– landlord/tenant ownership/usage incentive landlord/tenant ownership/usage incentive

problem: DSM can target assistance to tenantsproblem: DSM can target assistance to tenants– low income bill affordability: DSM can target low income bill affordability: DSM can target

assistance to low income householdsassistance to low income households– non-internalized external costs: DSM can non-internalized external costs: DSM can

reduce GHG emissions (implying a possibly reduce GHG emissions (implying a possibly larger rebate) larger rebate)

A Modest ProposalA Modest Proposal

Make clear the intended policy objective. Make clear the intended policy objective. If the objective is an efficiency improvement, then DSM If the objective is an efficiency improvement, then DSM

should be priced like any other regulated utility service should be priced like any other regulated utility service (possibly modified by the Ruff Rebate). By focusing on (possibly modified by the Ruff Rebate). By focusing on the right DSM price, the need to focus on the right the right DSM price, the need to focus on the right benefit/cost test is largely eliminated. benefit/cost test is largely eliminated.

However, if the objective is something else – assisting However, if the objective is something else – assisting renters and/or low income households and/or reduction renters and/or low income households and/or reduction of external costs – then it may be reasonable to set the of external costs – then it may be reasonable to set the DSM price at zero. By having objectives other than DSM price at zero. By having objectives other than economic efficiency, the need to focus on the right economic efficiency, the need to focus on the right benefit/cost test is again largely eliminated. In this case benefit/cost test is again largely eliminated. In this case the policy makers need to determine the level of the policy makers need to determine the level of assistance that should be provided (e.g., allow an annual assistance that should be provided (e.g., allow an annual DSM budget of $5mil).DSM budget of $5mil).

Economic EfficiencyEconomic Efficiency

For any DSM program to be economically efficient For any DSM program to be economically efficient - that is, support the least-cost outcome, it must - that is, support the least-cost outcome, it must be efficient in be efficient in bothboth supply and demand. supply and demand.

– To be cost effective in To be cost effective in supplysupply, the avoided cost must , the avoided cost must exceed the cost of the DSM plus any costs incurred by exceed the cost of the DSM plus any costs incurred by the Program participant:the Program participant:

NBNBii = MC = MCEnergyEnergy – C – CDSMDSM – C – Cii > 0. > 0. – NBNBii= Net Benefit to supply customer i= Net Benefit to supply customer i– MCMCEnergyEnergy = marginal cost of 1 unit of energy = marginal cost of 1 unit of energy– CCDSMDSM =utility cost of 1 unit of DSM (constant marginal cost) =utility cost of 1 unit of DSM (constant marginal cost)– CCii=customer cost of using DSM to save 1 unit of energy=customer cost of using DSM to save 1 unit of energy

– Unfortunately, utilities/regulators do not know or have Unfortunately, utilities/regulators do not know or have access to Caccess to Cii, meaning it is impossible to verify whether, meaning it is impossible to verify whether NBNBii > 0. > 0.


To be efficient in To be efficient in demanddemand, the tariff price must exceed , the tariff price must exceed the DSM price plus any costs incurred by the program the DSM price plus any costs incurred by the program participant:participant:– NINIii = P = PEnergyEnergy – P – PDSMDSM – C – Cii > 0. > 0.

NINIii=Net Incentive to customer i=Net Incentive to customer i PPEnergyEnergy=Price of 1 unit of energy=Price of 1 unit of energy PPDSMDSM=Price of 1 unit of DSM=Price of 1 unit of DSM CCii=Customer cost of using DSM=Customer cost of using DSM

Again, note that the optimal price that the utility must Again, note that the optimal price that the utility must charge for the DSM is:charge for the DSM is:– PP**

DSMDSM= C= CDSMDSM+(MC+(MCEnergyEnergy-P-PEnergyEnergy))With this DSM price, energy prices will not be increased, With this DSM price, energy prices will not be increased, there will be no cross subsidization of the DSM program, there will be no cross subsidization of the DSM program, and the outcome will be economically efficient.and the outcome will be economically efficient.


It may be seen that free DSM distorts incentives and It may be seen that free DSM distorts incentives and creates excess demand. The ratepayer’s Net Incentive creates excess demand. The ratepayer’s Net Incentive becomes:becomes:

NINIii = P = PEnergyEnergy – C – Cii > 0; > 0; rather than the efficient Net Incentive previously rather than the efficient Net Incentive previously

outlined.outlined. If DSM is priced according to Ruff’s formula, the DSM If DSM is priced according to Ruff’s formula, the DSM

program will be efficient in both supply and demand, program will be efficient in both supply and demand, and a least-cost outcome is achieved.and a least-cost outcome is achieved.

When DSM is priced efficiently, it will be applied if and When DSM is priced efficiently, it will be applied if and only if it is cost-effective for the individual participant. only if it is cost-effective for the individual participant. Efficient pricing of DSM “will prevent non-cost-effective Efficient pricing of DSM “will prevent non-cost-effective DSM from being demanded”. Proper DSM pricing is DSM from being demanded”. Proper DSM pricing is necessary and sufficient if policy makers want cost-necessary and sufficient if policy makers want cost-effective DSM Programs. effective DSM Programs.

The RIM TestThe RIM Test

In some instances, it is said that the RIM Test In some instances, it is said that the RIM Test is a test of distributional equity and not of is a test of distributional equity and not of cost effectiveness.cost effectiveness.

The RIM test The RIM test isis a test of a test of cost effectivenesscost effectiveness and of and of economic efficiencyeconomic efficiency..


Consider:Consider:The RIM TestThe RIM Test measures program impacts to measures program impacts to ratepayers, and a program passes the test if ratepayers, and a program passes the test if there are there are no losersno losers under the program – under the program – that is, if no ratepayers are worse off than that is, if no ratepayers are worse off than before the program.before the program.

Cost effectivenessCost effectiveness generally means that total generally means that total program benefits exceed total program program benefits exceed total program costs. In other words, the gains by program costs. In other words, the gains by program winners exceed the losses by program loserswinners exceed the losses by program losers


If a program is truly cost effective, the winners If a program is truly cost effective, the winners would be willing to pay the would be willing to pay the full costsfull costs of the of the program because they would still be better off than program because they would still be better off than before (Remember total benefits exceed total before (Remember total benefits exceed total costs). costs).

In this instance there areIn this instance there are no losers! no losers! The program The program is cost effective, it passes the RIM Test, and it does is cost effective, it passes the RIM Test, and it does not require cross-subsidy (under the assumption of not require cross-subsidy (under the assumption of no external costs). no external costs).


TThere are no impediments to the utility here are no impediments to the utility charging customers the correct price for charging customers the correct price for DSM. The utility knows who receives the DSM. The utility knows who receives the service and how much it costs. service and how much it costs.

There is There is no need for cross-no need for cross-subsidizationsubsidization if a program is truly cost if a program is truly cost effective!effective!

Impacts of Free DSMImpacts of Free DSM(Cross Subsidy)(Cross Subsidy) Free DSM can have real economic impacts.Free DSM can have real economic impacts. Consider the economic impacts on current Consider the economic impacts on current

energy conservation service providers.energy conservation service providers. What will happen if utilities begin giving What will happen if utilities begin giving

away DSM services for free?away DSM services for free?

For the interested For the interested ViewerViewer

For a comprehensive discussion on these and For a comprehensive discussion on these and other related issues, we refer the interested other related issues, we refer the interested viewer to these articles by Larry E. Ruff:viewer to these articles by Larry E. Ruff:– Equity vs. Efficiency: Getting DSM Pricing RightEquity vs. Efficiency: Getting DSM Pricing Right, ,

Electricity Journal, Nov. 1992 Electricity Journal, Nov. 1992 – Least-cost Planning and Demand-side Management: Least-cost Planning and Demand-side Management:

Six Common Fallacies and One Simple TruthSix Common Fallacies and One Simple Truth, Public , Public Utilities Fortnightly, April 28, 1988Utilities Fortnightly, April 28, 1988

– Planning and Pricing in the Energy Conservation Planning and Pricing in the Energy Conservation BusinessBusiness, Conference on The Economics of Energy , Conference on The Economics of Energy Conservation, Berkeley, CA, June 1992Conservation, Berkeley, CA, June 1992

– Economic Principles of Demand Response in Economic Principles of Demand Response in ElectricityElectricity, EEI, October 2002, EEI, October 2002

Documents

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