With DSM, who needs IRP?

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  • Utzhfiet Pollc:\. Vol. 4. No. 4. pp. 21-166 Copyright 0 1995 Elsevlrr Science Ltd

    PrInted in Great Brltam. All righta reserved 0957-I 787191 $10.00 + 0 00

    With DSM, who needs IRP?

    Gamy E Vollans

    Demand-side nmrmgenzer~t (DSM) provides regultrtecl natruzl rmilopolies with n means to improve resource allocatio~l mid to lower prices to comumers. This paper provides a rnnthemat- ical proof to determine the limit to DSM expen- ditures (where the cost exceeds benefits to be nchieved) for situations of both economies ad riisecmoniies to scale. In the latter case, where costs increase with additioril output, supply-side options provide an upper limit to demiml-side expemlitru-es. In this context. some ratiormles for irltegrclted resource planning (IRP) are discussed with a view to determining whether the potential hemfits wmmt the additional regrda- toy burderl.

    Kry~~rtir Kegulatlon: Plannmg: Management

    Conceptually. a more efficient allocation of resources in the economy could be derived where ~lppvoprirrtr demand-side management (DSM) techniques are used by regulated monopolies subject to prices established using the traditional cost-of-service pricing model. As in most economic endeavours, one would expect the law of diminish- ing returns to apply to investments in DSM. In this paper. a mathematical proof is provided to deter- mine economic *limits to DSM budgets and rate impacts for both demand-increasing and demand- decreasing DSM techniques. Operational rules of thumb can be derived to provide regulators and industry DSM practitioners with practical guide- posts in applying these limits and to ensure that all customers benefit from lower prices. Where costs are increasing with additional throughput. the evalu- ation of demand-side options in conjunction with supply-side options provides a natural limit to DSM expenditures. In this context, the incremental benefits to be derived from integrated resource planning (IRP) in terms of both energy and economic efficiency are evaluated. The rationale of

    The author 1s wth the Energy Sector. Department of Natural Resourcea Canada. Otta&a. Canada KlA OEl.

    using a centralized IRP process to evaluate exter- nalities such as environmental costs and other market imperfections is examined in the last section of the paper.

    Regulated monopoly cost-of-service model

    Figure I portrays stylized cost curves for a hypothet- ical regulated monopoly. It is assumed that prices are set on the basis of a cost-of-service model, so that the average cost curve becomes in effect the price curve for each class of service. The lowest potential price in this situation would be P2 at output level X3, where marginal cost equals average cost. Any other output level. such as those associ- ated with higher or lower demands Dz or D,, would result in a higher price, P,. If demand for the product could be manipulated to approach output X3, cost-of-service prices would be at their lowest possible level for the design capacity in place as represented by these cost curves.? While X3 repre- sents the direction in which demand could be moved to improve allocative efficiency, the appropriate extent of the move can only be determined through evaluation of the associated costs and benefits.

    REGULATED MONOPOLY

    I I I I

    Xl x3 x2 0

    Figure 1. Regulated natural monopoly.

    261

  • Ulth DSM. who iweds IRP?

    $- MC

    D AC AC

    Figure 2. Average cost rising. Figure 3. Average cost falling

    DSM cost constraints

    The manipulation of demand. whether through advertising or through DSM programmes. has cost implications, and one would expect the law of diminishing returns to apply. In order to determine how much might be spent on such endeavours before the additional costs exceed the benefits to be derived, it would be helpful to have an evaluation framework to determine those limits before under- taking major expenditures.

    As portrayed above. DSM could be used to increase demand when average costs are declining with additional output and to decrease demand when average costs are rising. In the latter case. it would be useful to compare the potential DSM programme cost to alternative supply options. For example. while energy-efficiency DSM options could offset potential demand increases, they could conceivably cost more than simply increasing supply: i.e. while they are energy-efficient. they are not necessarily economically efficient.

    It is possible to portray the social welfare ineffi- ciencies associated with higher or lower output levels and the assumed cost-of-service pricing struc- ture. In Figure 2, where demand DD intersects the cost curves in the area where both average and marginal costs increase with additional output, price would be set at P, for output X,. The marginal cost of the last unit produced, however, exceeds the price charged, by the amount EF. The area CFE repre- sents the total amount by which cost exceeds price for all output greater than _X. As all costs are covered at average price P,, output less than x, where price would just equal marginal cost, would be priced higher than marginal cost or the area represented by ABCD. In effect, P2 represents the minimum price required to call forth output X, in the cost-of-service pricing model. Between X, and

    X. higher prices would be required as traced by the marginal cost curve from B to C. The area ABCD represents the excess paid above minimum cost for output _X and is exactly equal to the area of CFE. As the gap between marginal and average cost (EF) widens with increasing output, thereby pushing up the price on all use, intramarginal customers may argue that they are in effect cross-subsidizing output (X, - _X) at the average price P,.J

    This type of reaction reflects a general sensitivity to rising prices and involves questions of equity with which regulators must deal. The area CFE is divided into two areas by the demand curve DD, which will vary proportionally depending upon the price elasticity of DD. The area to the right of DD (or WFE) represents pure social welfare cost to the economy arising from the average cost pricing policy. The area to the left of DD (or CWE) repre- sents part of consumer surplus, an amount that consumers would be willing to pay but do not5 As DD shifts horizontally with increases or decreases in demand. the areas of CFE and ABCD increase or decrease accordingly, always remaining equal to one another.

    A similar phenomenon occurs where the demand curve DD intercepts the average cost (price) curve to the left of X,, the point of minimum average cost. In this range of output, average costs are falling with increases in output. In Figure 3. P, represents the minimum price level based upon the cost-of-service model. The area ABCD represents the amount that consumers would overpay for output X,, given the assumed demand DD. Correspondingly. the area CFE, the amount by which the lowest cost-of- service price exceeds marginal cost over the range of output X, through X,, is exactly equal to the area of ABCD.h In effect. the users of output X, could profitably cross-subsidize incremental use to expand

    262 UTILITIES POLICY October 1994

  • Pf

    5 .,..,.......... *..*.

    4 . . . . . . . . . . . *..* . . . . .

    Xl 5 a

    XI 6 Figure 5. Demand-increasmg DSM programme. Figure 4. Demand-decreasing DSM programme.

    output, thereby leading to lower average costs of production. to the limit of CFE. All consumers would benefit by lower prices under the cost-of- service price model in this scenario,

    Limits to DSM

    As DSM programmes shift demand towards lower cost levels on the average cost curve from either direction, the respective areas identified (CFE) approach zero. social welfare improves and alloca- tive efficiency is better.? DSM programmes can be used to shift demand in the appropriate direction, and there would be an improvement in social welfare if the cost of the DSM programme in question did not exceed the benefit to be gained. This section will demonstrate the limits to spending on a DSM programme for there to be a net social welfare benefit. for both demand-reducing and demand-increasing DSM programmes.

    In Figure 4. it is assumed that for demand D,D, and capacity as reflected by AC,, cost-of-service regulation would have led to output and price settling at X, and P, respectively. Assume a DSM programme that improves upon energy-use efficiency with fixed cost h and an estimated demand reduction impact that would shift demand to D2D2.n The leftward shift represents the quantity of energy not consumed because of the improved energy efficiency. In effect. the same level of consumer satisfaction or utility is now met at the reduced level of energy use D2 and some implicit consumption of the energy efficiency measure/technology must be suitably amortised. Costs would increase by h and result in an upward shift of the average cost curve to AC?. The point of intersection of the two new curves, DD, and AC,, would yield the new output X2 and price P. The difference between the two

    average cost curves represents the average cost of the DSM programme under evaluation. At output X2, the average cost of the DSM programme is P, - P,. or (h + output X,). In the case portrayed. Pz is less than P,, so it is quite obvious that all consumers have benefited by the lower price. Further, as all consumers demands continue to be met at the lower level of output, there is effectively an increase in consumer surplus of X2 X (P, - P2). The area of pure social welfare loss (area WFE in Figure 2) has been reduced proportional to the shift in the demand curve. The efficient level of output (X,, in Figure 2) determined by the intersection of D and MC has now shifted to the left as well. Furthermore, the new