Price Regulation and the Incentives to Pursue Energy Efficiency by Minimizing Network Losses.

• Author: Dutra, Joisa

1. INTRODUCTION

   Energy efficiency programs have returned to the forefront of public policy. (1) Such public interest in energy efficiency programs has not been seen since their introduction in the 1970s as a response to the oil shocks. Energy efficiency is seen today as a cost-effective approach to sustainable energy use and greenhouse gas emission reductions. For instance, Metz Bert and Intergovernmental Panel on Climate ChangeWorking Group III (2001) argue that energy efficiency improvement could potentially contribute to half of greenhouse gas emission reduction by 2020.

   Despite their high profile, energy efficiency opportunities have by and large not materialized (Interlaboratory Working Group, 2000). This is particularly the case in the electricity sector where between 20 and 60 percent of total electricity used could be conserved by cost-effective initiatives (see, for example, Rosenfeld 1993). For a critical review of the extent to which there is such an energy efficiency gap, see Greenstone and Allcott (2012).

   This paper distinguishes between two types of approaches that can be used by utilities to pursue energy efficiency. The first approach focuses on the consumer-end and the second approach on the utility's internal efficiencies such as minimizing network losses. While considerable attention has been paid to the first approach, the pursuit of internal efficiencies by the utilities has not attracted the same degree of attention despite its potential impact on energy conservation. This paper focuses on this second approach.

   The first approach includes demand side management (DSM) programs. (2) While such programs may be able to reduce consumption at a cost per kilowatt-hour lower than the cost of supplying that electricity, they are still not widely used (Freeman et al., 2010).

   There are several reasons why this may be the case. First, electricity suppliers (especially network service providers) need to make a range of infrastructure investments that are required to integrate distributed energy resources, including energy storage technologies, the digital hardware and software for improving transmission and distribution system reliability and security, and the supply-side and customer-side systems needed for full customer connectivity (Lester and Hart, 2012). Second, these firms operate in a regulated environment where prices are usually set by a regulatory agency or government department that may not reward such investments by not considering them prudent or efficient. Finally, investment in energy efficiency may not be recouped if demand for electricity falls in the future or if the regulatory regime changes.

   Indeed, creating incentives for suppliers/distributors to undertake energy efficiency initiatives at the consumer end can be complex as these incentives interact with the form of price regulation. For example, in a context where firms are allowed to recover, via prices, all the costs of supplying electricity to consumers, regulated firms may have little incentive to undertake energy efficiency investment that promotes end-user energy conservation. Indeed, there is a large literature (see, for example, Wirl, 1995; Eto et al., 1997; Brennan, 2010; Sullivan et al., 2011) that points out that price cap regulation is ineffective at inducing the electricity supplier to promote end-user conservation and, instead, provides incentives for suppliers to maximize sales as long as sale prices are above marginal cost. This had led to proposals to decouple allowed revenue from sales quantity, which would tend to favour revenue cap or rate of return regulation. (3)

   In contrast, this paper analyses the incentives embedded in different regulatory regimes--rate of return, price cap and mandated target regulation--for the electricity supplier to undertake energy conservation programs to minimize network losses.

   Network losses are significant. Estimates of the overall losses between the power plant and final consumers are in the range of 8 to 15% (with half of that attributed to distribution losses) according to the International Electrotechnical Commission (International Electrotechnical Commission, 2007). (4) For a survey, general background and comparative analysis of the available techniques to reduce network losses, see Kalambe and Agnihotri (2014).

   While the interaction between network losses and price regulation is an important policy issue, this is the first paper to the best of our knowledge that focuses on incentives to pursue energy efficiency at the supply-side rather than at the end-user side. (5)

   We pursue this by building a theoretical model of a monopolist who can choose whether or not to undertake an investment in energy efficiency. The investment is not observable by the regulator who can only determine whether the investment has been successful in terms of the level of energy efficiency achieved. More specifically, the firm's choice of effort affects the probability of a successful outcome with a higher effort resulting in a higher probability of achieving a better energy efficiency outcome. (6)

   In this setting, regulatory regimes cannot explicitly compensate the firm for the effort it has put into energy efficiency. We explore how different existing regulatory regimes perform in terms of the expected amount of energy efficiency and total welfare. In particular, we show that the monopolist more often chooses to exert effort under price cap regulation than under no regulation and that she exerts no effort under rate of return regulation. (7)

   However, the comparison, in terms of the embedded incentives to pursue energy efficiency, between price cap and rate of return regulation, and between rate of return regulation and an unregulated monopolist, is ambiguous and complex as demonstrated in the paper. In contrast, we show unambiguously that mandated target regulation is always dominated by both price cap and rate of return regulation in terms of expected welfare although a mandated target regulatory regime can do better than an unregulated monopolist. The key reason is that mandated target regulation is too coarse and the trade off between providing incentives to invest in energy efficiency and rent extraction is less pronounced than under existing regulatory regimes such as price cap and rate of return regulation. (8) More generally, we provide a full characterization of the optimal effort, optimal prices (regulated or unregulated) and expected welfare for the different regimes and show the tradeoffs between rent extraction and incentives.

   It is important to note that our results are different from the familiar corollary to the leading theme in regulatory economics over the last three decades, namely that price-caps restore incentives to control costs that are diminished or eliminated by rate of return regulation. Instead, our analysis highlights that policies that encourage utilities to promote end-user energy conservation (e.g., by switching from price cap to rate of return regulation) may reduce the incentives for the electricity suppliers to improve energy efficiency through the minimization of network losses.

   This paper is organized as follows. Section 2 describes the key elements of the model. Section 3 develops the benchmark case of an unregulated monopolist, and describes the monopolist's choice of optimal effort and profit-maximizing quantity and price. In Section 4, we characterize outcomes under three distinct regulatory regimes, namely, rate of return, price cap and mandated target regulations. Section 5 compares the welfare under the different regulatory regimes, and Section 6 concludes.

2. THE MODEL

   This Section develops a model of a regulated monopolist that supplies electricity to final consumers. The model shares many features of the large literature on moral hazard and incentives for cost reduction by a regulated monopolist. See, for example, Laffont and Tirole (1993). In particular, a monopolist chooses how much effort to exert in order to reduce costs via the minimization of network losses. The effort entails a cost, borne by the monopolist. The regulator observes the total cost (net of network losses) but not the effort.

   Our approach differs from the standard model in two ways. First, while in the standard model the regulator has access to two instruments (a fixed payment and a price), we instead focus on the case where the regulator has only one instrument, namely the price that the regulated firm is allowed to charge consumers. As discussed in the 2015 Nobel Prize citation for Jean Tirole, regulators in practice do not have access to fixed payments (transfers). (9) Thus, a key point of departure from the standard framework is that we consider the incentives faced by the regulated firm under two stylized forms of price regulation that are used in practice, rather than considering what would be the optimal mechanism to minimize network losses. This is an important distinction as we take a positive rather than a normative approach to regulatory economics in the sense that we recognize that the optimal mechanism, which will involve a price and an optimal transfer, may not be implementable.

   Second, while the standard model focuses on a price/transfer mechanism to incentivize the regulated firm to exert efforts to reduce the marginal cost of production, here the focus is the incentives embedded in different price mechanisms (with no transfers) to reduce costs via minimizing network losses only. While, in principle, a more general formulation could allow the firm to choose amongst different types of actions to reduce costs, perhaps each entailing different costs, the emphasis here is exclusively on network losses.

   We now turn to the particulars of the model. For simplicity, the demand function for electricity in the market is assumed to be linear, and the inverse demand function is given by:

   P(Q) = a-bQ, with a>0, b>0,

   where Q denotes the amount of electricity that...