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 minimum average cost output on AC2 has increased, reflecting the internalization of the DSM programme costs. Given the assumed cost-of-service pricing model, the intersection point of MC and the new AC curves represents the limit for energy efficiency DSM programmes: to do more would push both prices and costs higher. If the DSM programme had been costless. and assuming output X,. price would be P3 and the gain would expand accordingly. The limit to such gains is represented by the area (I in this figure or the amount by which cost exceeds the price P, for output X,. As the area c1 equals area h when P1 = P,, the price that would have been charged in the absence of the DSM programme represents the limit to the cost of the DSM programme. If the resultant price is any higher than P,, then the cost of the DSM programme (area 6) exceeds the supply cost of meeting the original demand D,D,. which was cross-subsidized by consumers (area LI). In other words. the utility would incur lower costs meeting the demand through the next-least-cost supply option than through the DSM option under evaluation, and consumers would pay lower prices4

    UTILITIES POLICY October 1994 263

  • W&z DSM. who rzeeds IRP?

    A symmetrical outcome arises when output falls in the area where average costs are falling and DSM programmes could be used to increase output and social welfare through economies of scale, for example. In Figure 5, with output at X, and price at P, for an assumed demand of D,, prices for all consumers would decline with additional output. Assume a DSM programme of fixed cost h, which would result in a new average cost curve of AC, and shift demand to D, at an average DSM programme cost of (P2 - P3) at output level X,. At price P2. the consumers of output X, are in an improved situa- tion: that is, their consumer surplus has been increased. The additional output (X, - X,) will cover all incremental costs at price P,: both the incremen- tal cost of production and the shaded area under MC, as well as the cost of the DSM programme. The amount LI paid by consumers of the incremental output (X, - X,) just equals the area X, X (P, - PJ, or the amount by which the price of X, would be reduced if the DSM programme cost were zero. If the cost of the DSM programme results in a price less than P,. there is a net gain. Similarly, if the DSM programme results in a price higher than P,. there is a net social welfare loss: not only would consumers of X, pay a higher price than in the absence of DSM, but the costs would exceed any benefits derived.

    To summarize. if price after the implementation of a DSM programme would be less than the price in the absence of the DSM programme, the programme in question should be retained for consideration. This outcome has sometimes been called the no-losers test: that is, the price to non- participants should not be increased as a result of the implementation of a DSM programme over what it would have been in the absence of the DSM programme.

    The corollary of this operational rule is that the DSM costs and rate impact need to be compared to the marginal cost of supplying the incremental demand in question and the corresponding rate impact of the next least-cost supply options in order to determine whether this rule is contravened or not. Both the demand-side and supply-side options would be ranked in order to eliminate many of the unlikely candidates for active consideration to meet a potential/forecast demand for a specific customer class in a particular geographical area. A few of the top-ranked options on both sides would be retained for detailed evaluation. To this observer. it would seem that these evaluations are fairly straightfor- ward technical and economic evaluations. best performed within the utilities because of the infor- mation and data required and the potential for

    economies of scope across regions or customer groups. This decentralized process has the added advantage of emulating a competitive market solution, with all of the attendant allocative efficien- cies. where incremental costs and revenues can be compared at a disaggregated level.

    Any regulatory scrutiny need be no more than that of a prudence nature, perhaps after the fact, to ensure that all options were given fair considera- tion. For example, given the monopoly power of a utility, it might be worthwhile to verify that third- party supply- and demand-side options were evalu- ated on the same basis as in-house options: however, even this scrutiny could be done on a sample audit or complaints basis. As DSM expenditures would presumably be internalized as either expenses or capital expenditures, utilities would have no partic- ular reason to be DSM averse or avid.

    Externalities and energy-efficiency market imperfections

    It might be argued that the form of market-based least-cost planning (LCP) described above does not take into account such externalities as the lower cost of transmission and distribution facilities associ- ated with lower throughput, nor the lower cost of environmental damage caused by lower levels of consumption. If the avoided costs of transmission and distribution are not incorporated into the cost estimates, and consequently the rate impact, the problem is not with the concept of LCP. but rather with its implementation: shoddy workmanship. in other words. The decentralized approach is fully compatible with evaluation of economies of scope and any associated upstream or downstream debits and credits to the calculations.

    To compensate for the environmental externali- ties associated with energy consumption. some regulatory authorities have tried to force internal- ization of a kind by explicit rules in their integrated resource planning (IRP) process. Vermonts commission, for instance, requires that utilities add 5% to the costs of supply-side resources to reflect environmental impacts and deduct 10% from DSM resources to account for their lower risk. At first blush, this type of action is often viewed as commendable and socially responsible regulation. Upon reflection, however. it is akin to trying to drive a nail with a shoe - the wrong tool for the task at hand. Even assuming that full information is available so that the level of the emissions of carbon dioxide, sulphur, mercury or whatever can be precisely known. as well as the costs of the environ- mental degradation incurred. it does not follow that

    264 UTILITIES POLICY October 1994

  • an IRP process is an appropriate policy instrument to correct the problem. Only one or two commodi- ties at best would be IRPd. leading consumers to shift to substitutes such as coal and oil, which may have even worse environmental impacts. destroying the argument in this instance that every little bit helps. Further. as the tools and policies appropriate to the problem are developed and implemented. the IRP process would then be overcompensating. Suppose for example that a global carbon tax were imposed to correct for global CO, emissions: the IRP environmental externalities correction for regulated commodities would then need to be corrected.

    If regulatory agencies were to ensure that regulated monopolies approach competitive market outcomes in terms of costs. prices and resources allocated. the overall result would be more efficient than trying to solve social problems raised by public interest intervenors, who may find the regulatory process more responsive to their persuasions than legislators, on the one side. or the market. on the other. While some IRP proponents have claimed that providing various interest groups with a forum to intervene in utilities planning is a worthy exercise in itself. the objective could be achieved in existing rate or facilities fora at a much lower social cost.

    In a similar vein, it could be argued that there are significant market imperfections for energy- efficiency technologies that would justify an IRP approach to ensure that utilities appropriately subsi- dize energy-efficiency measures through DSM programmes. For example. the initial cost of a house may, from both a builders and a consumers perspective, carry a greater weight in the decision- making process than the full life-cycle cost of operating all the embodied energy-using technolo- gies in that house. The mere existence of such market imperfections. which may reflect in part differences in private vs social discount rates. does not necessarily justify a highly centralized IRP process that at best can apply to one or two energy sources. A more appropriate policy response would call for consumer education programmes. improved building codes and/or appliance standards. for example, that apply across all forms of energy avail- able in the marketplace. In that context, utilities would in their own self-interest incorporate such factors into the design of DSM programmes appro- priate to their costs and local market conditions in order to increase market share and profits in individual categories of demand, as would compet- ing firms offering alternative energy sources. The final choice (and responsibility) would then rest

    with the consumer, who ultimately bears most of the costs associated with less-than-perfect decisions.

    To summarize, issues concerning environmental externalities and imperfections in markets for energy efficiency need to be addressed but in a forum (or fora) that applies to all sources of pollu- tion and forms of energy. not just those that happen to be regulated natural monopolies. To do otherwise creates new imperfections that need to be corrected by further intervention.

    Conclusions

    Demand-side management tools and analysis can be utilized to improve upon the inherent allocative inefficiencies associated with cost-of-service pricing for a regulated monopoly. The process. to be effec- tive, requires a rigour and analytical framework that approaches that of a competitive market-based solution. There would not appear to be any appre- ciable benefit to a highly centralized IRP in terms of allocative efficiency over the decentralized approach discussed in this paper. In all probability. the inefficiencies and costs inherent in centralized planning processes would overwhelm any incremen- tal benefits that might be identified over the decen- tralized rigorous application of DSM proposed in this paper. Other social objectives often associated with a centralized IRP process should be addressed in fora more appropriate to the objectives sought, to avoid the creation of yet another costly regulatory planning process.

    The vleus eqvwwd III thla paper are those ot the author and do not ncwsaar~ly reprecent thaw of NKCdn The author w\hes to acknowlcdgr the helpful comment\ of 3 colleague. Anne Boucher. on an rarhcl version ot this paper

    Gary E Vollan\. Demand-side mana~rmcnt: a tool to correct for muted prlcr 5lpnala to conwmers. Lrrl/rrc~ /o/rc~,. \ol 3. No 7. April 1993. pp I 13P117. Strictly sprakin_g. the mtcrxctlon ot the Lawus demand curve hlth the marynal cost CUIVC would detmr rfflcwnt Ievelu of output Jnd the corrr\pondmp prlcrx Instltutwnally. this outcome I\ often ovrrrlddcn by the cost-of-serwce prlcmg model for repulated monopollr~. Only at output .I, would prxe equal marginal cwt m this prlang flamcwork Coven thl\ generally accepted In\tltutlonal armnpement. DSM could he used to dlacourqr OI- reduce demand when prlcr falls short ot margnal coat and to rncouragc OI- mcreaw demand when prlcr evxcd~ mqlnal coct. iArea CFE = ,J# MC P, X (.Y, - &L) (where hlC margln,J

    co\t )

    Therefore CFE = ABCD. and = 0 when AC = MC

    UTILITIES POLICY October 1994 265

  • WA DShl. who rwrris IRP?

    Constdrr an example where a trunklme prpelme system rs extended to meet an incremental demand just beyond the reach of the ewrstmg system. The rulletf-UI or average cost-of-service prrcmg mechanism would be perceived as a cross-subsrdy by mtramargmal users. despite the fact that rn the comprtrtr\e model. the prrce would be set even higher. where DD tntersects wrth MC (at W) and that output would fall accordingly to X;,. It IS tnterestmg to note that the greater the prrce elastrcrty of DD. the greater the area of pure social welfare loss becomes: m effect. the greater the degree of substrtutron. the greater the socral melfare loss asaucratcd with cost-of-serttce prtctng. Area CFE = Py X (x2 A',) ,,,f2MC

    = PI>