Energy efficiency in regulated and deregulated markets.

• Author: Rotenberg, Edan

1. INTRODUCTION AND THESIS

   The efficient use of electricity is a moral and environmental concern of contested economic validity. Opponents argue that the pursuit of energy efficiency is the pursuit of economic inefficiency. Proponents counter that the pursuit of economic efficiency in the electricity sector is an environmental disaster due to market failures caused by environmental externalities and transaction costs. In the interests of brevity, this paper focuses solely on end-use efficiency, not generation or distribution efficiency. This paper takes the position that there is merit in the pursuit of end-use energy efficiency measures in the electricity sector. Those measures are often called demand side management or DSM. Energy efficiency measures can be effective tools to correct market failures and achieve environmental goals, both in regulated and deregulated markets. Although they are useful tools, energy efficiency measures are certainly not the only tools needed to correct these failures and achieve environmental goals.

   This paper also explores the effect of the new deregulatory era on the achievement of energy efficiency, arguing that this worthwhile goal can and should be kept. The new deregulated environment has created a different market for electricity, but one that still has problems from an environmental and an economic point of view. An effective policy must provide incentives to the actors who are best suited to overcome market failures in the new regulatory environment. Those incentives must be developed in a way that harmonizes energy efficiency policy with new environmental policies, particularly the development of emissions trading markets and renewable portfolio standards.

   Part Two of this paper defines energy efficiency. Although there are multiple, conflicting definitions of energy efficiency, here the term is used in a hybrid economic and environmental sense. That is, energy efficiency policies aim at setting social use of electricity at the level that would be set by consumers in a perfect market where price reflects the true social cost of electricity. Since that price does not exist, and cannot be ascertained precisely, energy efficiency measures seek to approximate it.

   Part Three identifies the relevant features of the regulated and deregulated eras. "Deregulation" does not signal the end of regulation in the electricity sector. It instead represents a new regulatory regime that requires an end to vertically integrated electric monopolies to allow a greater degree of competition, particularly in electricity generation. Distribution is still monopolized, often operated by a regulated non-profit corporation. Retail supply is also monopolized in most American jurisdictions. Thus, there is a substantial role for regulators in a deregulated electricity sector. However, energy efficiency measures developed in the regulated past of the electricity industry require re-examination and change during the new era of deregulation.

   After establishing what energy efficiency, regulation, and deregulation mean, Part Four examines the policy justifications for energy efficiency regulations. The underlying assumption of this section is that there has always been a role for environmental policy in the regulation of the electricity sector. Determining the optimal way to provide electricity has always been treated by our society as a multi-criteria problem because it is a political problem. The interests of capitalists, consumers, and those affected by the environmental disruption of electricity production are in conflict. Environmental considerations have always been, and will always be, a part of electricity policy.

   Most justifications for energy efficiency involve market imperfections, although energy security is often mentioned. The core question of any electricity policy in a capitalistic society is the optimal price for electricity. In both a regulated and deregulated market, private actors will step in, where there is sufficient profit, to pursue energy efficiency measures. Thus, the core regulatory concern in a regulated or deregulated market should be correcting distortions in the price of electricity caused by poor regulation, unavoidable structural flaws in the market, and externalities. In particular, environmental externalities are a serious consideration given that most of our electricity comes from fossil fuel combustion, nuclear power, and large hydro.

   Even if environmental externalities were adequately accounted for in electricity prices, there is a problem with social response to price signals in the electricity market. High transaction and information costs mean that price signals do not necessarily induce the expected response. Electricity users demand high rates of return on efficiency investments, often 30% or greater. In other words, demand is less elastic than one would think for a number of reasons. Some key reasons are the high information and transaction costs encountered by end-users. Electricity use is rarely a central business or home maintenance concern. Gaining the information necessary to make energy saving decisions is expensive. Further, decision makers must sort through numerous ways to invest their money. Combined, these facts mean that decision makers set high hurdles for efficiency investments.

   Having examined the market failures and environmental externalities that motivate energy efficiency policy, I move on to consider the practical solutions regulators used to solve these problems. Part Five of this paper provides an overview of end-use energy efficiency in a regulated market. Some of the inefficiencies of the regulated era were consequences of regulation, while others were consequences of market failures and externalities that had nothing to do with regulation. Cost-based ratemaking complicated efforts at end-use efficiency because of the perverse incentives of utilities.

   Despite the complexities of an energy efficiency policy in a regulated market, empirical evidence suggests that such policies were of net social benefit, although some were far more effective than others. There is little dispute that government information provision programs aimed at lowering information costs to end-users were of net social benefit. While there is considerably more debate about the cost effectiveness of utility DSM programs, utilities successfully encouraged customers to pursue many cost effective measures although these policies were not optimal.

   Part Six considers the changes of deregulation. Many of the energy efficiency lessons learned in the past are still valid today. Despite facial change in the deregulatory era, the fundamentals of energy efficiency policy have largely stayed the same because retail competition is still not prevalent. The principle of least social cost investment that lay behind avoided-cost measures can be used under a new name, such as "Strategic Energy Assessment" or "Resource Portfolio Management."

   Where retail competition has occurred, there are new considerations related to consumer response to price signals and the lack of a monopoly utility to manage a portfolio of resources. However, many of the core considerations are the same as in monopolized markets. The problems of transaction costs and environmental externalities loom large in both markets.

   The most significant change induced by deregulation is the end of the "avoided-cost" variation on traditional cost-based ratemaking that was used to induce energy efficiency and renewable energy measures. In practice, deregulation means that regulators are not the key coordinators of other actors but play a secondary role. Prices take on the central coordinating function in the place of regulators, and regulators must instead seek to influence prices either directly through taxes and charges or indirectly through substantive rules such as environmental market mechanisms.

   However, the price signals regulators want to send in a deregulated market are not primarily conservation signals. The primary concern of regulators in a deregulated market is to avoid the structural problem of highly inelastic short-term demand and supply that leads to the ability of suppliers to game the market by withholding power. Long-term supply contracts and giving better information to consumers about bottlenecks in the system help deal with those inelasticities. (1) Retail price reforms seek primarily to tackle this problem, and the price signals sent to consumers are aimed at decreasing peak demand, not lowering overall demand. Hence, deregulation coincides with a move to Real Time Pricing (RTP).

   RTP and similar price signals are likely to lead to increased efficiency of electricity use but not to socially optimal demand for electricity. There will still be space for end-use energy efficiency measures. Those measures may be market based environmental mechanisms, like pollution taxes, information provision, or more traditional DSM options. Empirical evidence from California suggests that price signals for peak periods tend to induce load shifting and only a negligible overall load reduction. (2) Thus, RTP promises to increase the efficiency of electricity use by reducing the use of very expensive kilowatts. This is undoubtedly a good thing. However, it also means that to the extent that price in a deregulated market does not match marginal social costs, there will be a less than optimal outcome. Given that the overall effect of RTP is to lower average electricity prices, the incentive to invest in energy efficiency measures is also lower. In other words, RTP without accounting for externalities does little to improve environmental outcomes and may even exacerbate problems.

   Thus, regulators should continue to use policy tools such as emissions trading and energy efficiency portfolios (EEPS) to dictate performance and price when prices cannot be suitably adjusted or fail to account for high transaction and...