The Economics of Conservation Programs

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.

Although this book focuses on electricity demand, this section considers the demand for energy in general. There are various reasons for this extension. First, energy demand can be described by a similar framework. Second, energy conservation is a topical issue far beyond the focus of utility conservation programs with various environmental concerns such as local (smog, air quality), international (transboundary pollution, e.g. sulfur dioxide emissions of power plants and factories), and global (the greenhouse effect attributed largely to carbon dioxide emissions from burning fossil fuels) externalities.

A necessary condition to justify public interventions such as the setting of standards or the introduction of DSM programs is that the consumers’ decisions, which are described by the conditions (2.25) and (2.26), denoted by (e₀, η₀), are exposed to market failures. Indeed, Hirst (1992) claims that “energy markets do not operate properly.” This entire chapter, except for some remarks in section 1, applies traditional, normative welfare economics. However, the often tacit assumptions, implicitly applied in the conservation literature, are made explicit here. In particular, while consumers are ignorant, stupid or simply erring (e.g., due to bounded rationality) and thus cause market failures, public institutions — like governments, regulators and bureaucracies — are always benevolent, omniscient and omnipotent. These assumptions lead to a serious, in practice often unjustifiable, bias towards interventions. Therefore, the results of normative economics should be applied cautiously. Unfortunately, normative economics is often considered to yield sufficient conditions for public interventions, although these conditions are merely necessary. The conservation literature is no exception. Therefore, an entire chapter, chapter 10, is devoted to positive aspects in order to contrast the traditional normative, and sometimes naive, point of view.

The idea implicit to DSM is that consumers choose inefficient levels of efficiency and that the utility should correct for these market failures. For example, Eric Hirst (1992, p77) writes: “Thus energy markets do not operate properly and require utility involvement. Utilities can help overcome these barriers and do so at low cost.” Therefore, least cost planning or integrated resource planning should include DSM in order to allow for rate reductions, at least in principle. The purpose of this chapter is to investigate whether it is indeed economical for a utility to invest in conservation programs, even if the utility receives neither additional incentives nor subsidies for them.

Chapter 4 considered utility conservation from the perspective of least cost planning, i.e., when conservation is profitable to the utility and this engagement is neither distorted by regulatory biases nor rewarded by additional incentives. This analysis implies the necessary criterion for profitability of DSM., that the regulated price does not cover the avoided costs and, if existing, the optimal DSM program balances the costs of conserving a kWh against the difference between the avoided costs and the regulated price (this difference is the loss from supplying that kWh). In other words, if the avoided costs of a kWh equal say 10 cents, yet the regulated price is 8 cents, conservation is profitable if it costs less than the 2 cents loss incurred from selling a kWh. This condition implies that few programs would pass this test in practice, even under the extremely favorable (but unrealistic) assumption that the utility has perfect information. However, least cost planning does not implement the (second best) social optimum, because the utility does not account for the consumer’s benefit from conservation. These two facts, i.e., that least cost planning will not induce a substantial amount of conservation and that it does not implement the social optimum, seem to justify providing additional incentives to the utility in order to increase conservation up to the social optimum. Indeed, many utilities in the United States receive various kinds of financial incentives; in addition, conservation is rewarded not only financially but may also ease the strain with a regulatory commission and could even be a sensible public relations measure. Although these aspects of DSM seem to be an important ingredient in practice, this chapter is restricted to studying the impact of direct financial incentives.

Whatever the faults of Lovins and other DSM advocates may be, given market failures it is necessary for the utility to consider not only conventional supply expansion but also conservation in order to obtain an efficient solution, or even to maximize its profits. Indeed, the normative analysis in chapter 3 already indicated how incentives can improve the consumer’s decision and even implement a social optimum. The analysis of utility-sponsored conservation programs has so far largely been restricted to the special case where the utility is technologically and financially responsible for the entire improvement in efficiencies. Therefore, it is necessary to investigate how different incentives, provided by a utility or the government, change the consumer’s choice of efficiencies and foster conservation.

The typical argument for DSM programs of utilities (see e.g., Cicchetti and Hogan (1989), Lewis and Sappington (1992) and more recently Braithwait and Caves (1994)) assumes implicitly the following sequence of decisions shown in Fig. 7.1. First, the consumers purchase a particular piece of equipment with the energy efficiency η₀, which is presumably inefficient (either socially or for the utility) because of market failures (e.g., electricity price regulation) or other reasons (high discounting by consumers and other irrationalities).¹ The consumer’s choice of equipment induces (too high) energy consumption e₀. In a second step the utility finds out that it is profitable to cut energy consumption through improving efficiency by the amount Δη. An economic reason for this intervention is that selling this kWh induces the loss (c′-p) such that conservation of this kWh is profitable if the corresponding costs of conservation fall below the loss from delivering this kWh.

The previous chapter revealed that the practice of demand-side management faces serious economic obstacles. In doing so, the analysis was limited to criticizing the practice. In contrast, the objective of this chapter is to derive incentives that mitigate this kind of strategic behavior. However, the derivation of efficient incentives accounting for the major interdependencies is hard, since a minimum of three parties is involved: the regulatory commission, the utility and the consumer, see Fig. 8.1; to this add political institutions and the dual role of the individual as a consumer and as a voter (the ultimate principal), which are neglected in this chapter. A brief positive analysis is the subject of chapter 10. The analysis in Lewis-Sappington (1992), which was investigated in chapter 5, is restricted to the interdependencies between regulatory oversight and the utility. In contrast, the analysis in Wirl (1996a,b), briefly sketched in the following sections 2–4, emphasizes the interactions between utility and consumers. However, we start this investigation with the normative case bypassing the utility and ask what incentives the regulatory commission would offer to consumers in order to implement the social optimum, yet trying to deter the cheating addressed in chapter 7.

The task of this chapter is to find out whether the regulatory practice in the United States explains the conservation activities. Indeed, an explanation is necessary to resolve the puzzle that DSM operates within a small margin and must cope with all the potential adversities addressed so far (in particular the rebound effect addressed in chapter 2 and the consequences of asymmetric information investigated in chapter 7) and yet the United States’ utilities spend significant amounts on related activities. The first section considers, in line with chapter 4, i.e., no particular incentives and bonuses for DSM., the scope of DSM under the traditional rate-of-return regulation. It will be shown that this is insufficient to trigger DSM. Section 2 considers, in line with the regulatory practice in some states, additional incentives which can explain the activities of the U.S. utilities, yet these incentives in turn encourage the utilities to engage in strategic behavior and lead to a distortion of the programs.

Since PURPA 1978, demand side management and in particular conservation programs became a prominent issue in United States utility regulation (and subsequently in Europe and all over the world). However, considering the a priori expectations of conservation costs by Lovins and EPRI, reproduced in many papers, see Fig. 10.1, or the ex-post reported costs of conservation, see e.g., the comprehensive survey of Nadel (reproduced in Fig. 10.2), the resulting actual conservation seems to be very meager considering the large amounts of money spent on conservation. This is the content of section 1 that proves that the entire United States’ DSM enterprise did not result in significant conservation, let alone delivered the promised conservation.

The efficiency of demand side management programs (abbreviated DSM) is one of the most topical and heavily debated issues in applied utility regulation. The ongoing and voluminous academic discussions have had a strong impact on public debate and regulatory practice (particularly in Europe). The Public Utility Regulatory Policy Act of 1978 (PURPA) provided the political and legal framework to set energy conservation as a national and regulatory goal and thereby encouraged regulatory commissions to initiate utility conservation programs. Although PURPA set energy conservation as a national priority, 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 (largely a new label for the same thing as DSM), 9 were in the process and further 9 considered implementing it, EPRI (1993b) and approximately US$ 2 billion were spent during 1992 by United States’ utilities according to Gilbert-Stoft (1992). Moreover the 1992 Energy Policy Act states that integrated resource planning, i.e., taking explicit account of DSM on a level playing field with supply, should be the preferred method of electric power planning. Following the Clean Air Act of 1990, 24 states consider including external costs in integrated resource planning. Recently, European utilities try to copy this American’ success’.