Energy efficiency in Britain: creating profitable alternatives

Energy efficiency in Britain Creating profitable alternatives Tim Woolf and Ellen DeRosa Lutz Recent actions by the Office of Electricity Regulation (OFFER) indicate that it is beginning to see energy efficiency as a valuable resource option, and is examining the best ways to allow for energy efficiency while maintaining corporate profitability. This paper analyses the complex economic issues surrounding the involvement of the electricity industry in energy efficiency programmes, and proposes policy options that will jointly benefit the industry, its customers and society. The authors conclude that OFFER can play an instrumental role by removing market barriers to energy efficiency through the institution of changes to the pricing formula and by providing regulatory guidance to the PESs. Keywords:

Britain; Energy efficiency; Electricity industry

The decentralization of the British electricity industry in 1989 sought to pave the way for greater operational efficiency and reduced electricity costs to consumers. The government held a laissez-faire attitude towards energy efficiency, believing that market forces would dictate the need for such investments. Today, four years later, the Office of Electricity Regulation (OFFER) is rethinking its position on energy efficiency. Over the past year and a half OFFER has produced a series of policy and technical papers on energy efficiency.’ In November 1992 its Director General announced that OFFER intended to take energy-efficiency considerations fully into account during its 1994-1995 price control reviews.’ In addition, the electric distribution companies are participating in a joint Energy Saving Trust with British Gas, which may eventually provide up to f300 milliomyr to fund efficiency projects.3 Tim Woolf is with the Tellus Institute, 89 Broad Street, Boston, MA 02110, USA. Ellen DeRosa Lutz is an Associate with ILEX Associates, 104 Gloucester Green, Oxford OX1 2RH, UK.

0957-l 787/93/030233-l 0 0 1993 Butterworth-Heinemann

Ltd

To assess the opportunities for energy efficiency within the electricity industry, OFFER commissioned a study in late 1992 which examined the potential for cost-effective utility-run energyefficiency programmes. The study estimated that at least 6% of existing electricity use can be realistically saved through efficiency improvements within the next ten years, and suggested that other options exist to increase that estimate.4 Achieving these efficiency savings was estimated to cost the electricity industry f2.7 billion, but to save &3.8 billion in electricity costs. This would result in a net reduction in electricity costs to the industry and its customers of fl.1 billion. This is a conservative estimate of the potential for efficiency savings in the UK electricity industry. For example, studies conducted by the UK Department of Energy have estimated that efficiency improvements could reduce electricity consumption by 20% - at a cost less than that of electricity generation.5 An independent study submitted to OFFER concluded that the UK can reduce electricity consumption by 8-12% over 10 years and achieve cost savings of fltLf15 billion. This would require an investment of f450&732 million per annum.6 To date, public electricity suppliers (PESs) have promoted some energy-efficiency improvements through fuel substitution and load-management programmes, but have shied away from programmes that are specifically designed to reduce the consumption of electricity. Fuel substitution and load management are demand-side management (DSM) techniques that offer some benefits in terms of reducing costs, but they only represent a small portion of the total efficiency savings available, and they may in fact cause environmental costs to increase if they result in increased electricity production. Energy-saving programmes, by contrast, offer the greatest potential for improving energy efficiency, and can provide significant benefits in terms of reducing electricity costs, reducing environmental costs, and providing PESs with a competitive edge. The privatized structure of the British electricity

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industry is unlike any other in the world, and it requires a unique perspective to identify ways in which British utilities can benefit financially from investments in energy efficiency. The 12 PESs are best placed to institute DSM programmes, because they can avoid purchases from more expensive generators if demand is reduced through energy efficiency. The industry is now presented with the challenge of finding a way to reduce the sales of its major commodity, electricity, without affecting its profitability. Experience in the USA and other countries suggests that this can be achieved with some creative regulatory support.7 In fact, without significant regulatory changes, the British electricity industry is unlikely to tap into even a fraction of this important resource.

Barriers to energy-efficiency investment Given that energy efficiency offers many economic and environmental benefits, why hasn’t it been exploited more fully? Why don’t electric utilities and their customers invest in such a cheap, clean and plentiful resource? The answer is that a number of significant market barriers exist that preempt market forces from stimulating the optimal level of investment. The main consumer market barriers to energy efficiency8 can be summarized as follows.

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Lack of access to information. Many consumers lack knowledge of the potential savings that can accrue from energy-efficiency investments, as well as the information and technical expertise to choose and install energy-efficient equipment. Limited access to capital. Customers are often hindered by a lack of access to capital and a requirement for a rapid payback, which is generally as short as 6 months to 3 years.’ This pales in comparison with electric utility investments in generation plants, which are made with expected payback periods of 10 years or more. Lack of responsibility. Renters and landlords have little incentive to install energy-efficiency measures, because renters do not own the building, and landlords do not pay the electricity bills. Inappropriate price signals. Electricity rates often do not fully reflect the marginal cost of producing electricity (for example, the cost of environmental impacts), nor do they fully reflect the variation in costs between peak, shoulder and off-peak periods.

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Lack of rational decision-making. The electricity bill is often a small part of customers’ overall budgets, and rarely receives appropriate attention. Instead, customers often place attention on non-economic issues, such as trends, fashion, appearance and habit. Lack of access to and trust in efficiency equipment. Because some energy-efficiency measures are relatively new to the market, they can be difficult to purchase, and they can be viewed as too risky by many customers.

Electric utilities can play an instrumental role in overcoming these barriers by implementing programmes for their customers which provide the information, financial assistance, and technical assistance necessary to install energy-efficiency measures. For example, a utility could design a programme for residential customers which offered the following services:

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an energy audit that identified the potential for all cost-effective efficiency savings in a house; free installation of low-cost efficiency measures (such as draughtproofing and efficient lightbulbs) during the audit; installation of additional efficiency measures by utility contractors (cavity wall insulation, for example); provision of financial support (such as subsidies or low-interest loans) to pay for the contractor.

These efforts will overcome the primary market barriers facing residential customers and ensure that efficiency savings are achieved. The advantage of such programmes is that they reduce a utility’s electricity requirements at a cost less than the alternative cost of purchasing the same amount of electricity. Therefore, the total cost of providing electricity is reduced. However, the utilities themselves face significant barriers to DSM programmes. At present, there are two major financial disincentives that impede utility energy-saving programmes in Britain. The first of these is the fact that increased sales will significantly increase profits, while lower sales will significantly erode a utility’s profits. Under the present pricing conditions, PESs earn sizeable profit margins from their distribution businesses. lo The second financial disincentive to energy-saving investments is that expenditures for DSM programmes are not recoverable through the pricing formula, leaving PES without a way to recoup their DSM expenses. These two disincentives overwhelm the UTILITIES

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positive benefits to PESs of energy-saving DSM programmes and are the principal reason why PESs have specifically avoided investment in this area to date. The following discussion examines a number of ways in which PESs can be allowed to recover their costs and make a profit from energy-ef~~iency investments, while adding value in the service to customers and minimizing rate increases.

Benefits

of energy-efficiency

investment

Customers are concerned about the overall size of their electricity bills, not the cost per kilowatt-hour. PESs could add value to their service by helping customers reduce their kiIowatt-hours, thus resulting in a lower bill with fewer kilowatt-hours even if it was at a higher price per unit. This would increase the value of each unit supplied, and hence increase the profitability as a percentage of sales value (as distinct from total profit value). This concept, known as ‘added value services, aims to add value to customers’ perceptions of the utility as a whole. The customer perceives that the utility’s product and service is ‘differentiated’ from others and the difference justifies paying a premium to the customer. Such differentiation also provides a PES with an edge over its competitors. Benefits for society Reduced e~~i~~~~~~t~~ ~~p~~t~. Energy use and production contribute to 60% of all greenhouse gases adding to global warming, 62.9% of all particulates and 99.6% of sulphur oxides.‘” It is widely accepted that the most effective and economical way to reduce these environmental impacts is to reduce society’s demand for energy through energy efficiency. Over ten European countries” and 32 US States have begun to take some action to account for environmental costs when selecting among future electricity resource options.‘” As environmental standards increase over time, power plants will have to be retrofitted or replaced to meet them, at a cost to electricity customers. These costs can be significantly reduced if environmental externalities can be accounted for at the time of resource selection. It is much less expensive to devetop a clean resource to begin with than to retrofit or replace an existing resource. Therefore, developing environmentally clean resources now offers economic benefits to future electricity customers, as well as environmental benefits to society in general. UTILITIES POLICY July 1993

E~~loy~~ent impacts. Electricity

efficiency is much more labour-intensive per dollar of expenditure than traditional supply-side options. New jobs are created in manufacturing, delivering and installing energy efficiency products. An analysis by the Goodman Group of the job creation resulting from energy efficiency investment by the electricity industry in the USA concluded that, by investing $3.1 billion in DSM, the industry had generated 80 000 new jobs in 1992 alone, and had displaced $5 billion of traditional electricity supply expenditures.r4

The primary reason for a PES to invest in energy efficiency is that cost-effective DSM can lower electricity purchase costs and therefore reduce the total cost of electricity supplies. FESS in England and Wales purchase much of their electricity from the power pool. These purchase costs are ‘avoidable’ because the companies have no obligation to purchase a particular amount. Therefore, DSM programmes which cost less than electricity from the power pool will allow PESs to lower their net electricity supply costs, while still providing the same level of electricity services to customers. For example, assume that a PES’s average purchase price from the pool is 3.5 p/kWh.” If a PES develops au energy-efficiency pro~ramme that reduces electricity demand at a cost of only 1.5 plkWh, then the overall effect will be a net reduction in electricity supply costs of 2.0 p/kWh for each unit of energy saved. This is equivalent to the net reduction in electricity generation costs that vertically integrated utilities enjoy as a resuh of their DSM programmes. In addition to reducing PESs’ purchase costs, energy efficiency atso allows PESs to compete more effectively with gas by lowering the total cost to customers of using electricity. It also offers PESs in certain geographical areas the benefit of reducing the costs of maintenance, operation and upgrade of the distribution network.

The following simple example illustrates the financia1 impact of a DSM programme on a PES. Table 1 presents a simple profit and loss statement of a typical PES in the absence of any DSM initiatives. Our example assumes that this hypothetical PES has an annual demand of 20 000 kWh, which it supplies at an average price of 5.0 pikWh. At current sales and price levels this PES makes roughly a 9% profit margin on salesI 235

Energy efficiency in Britain Table 3. Profit and loss statement group.

Table 1. Simple profit and loss statement. E (millions) Annual revenue (20 Ooo GWh for 5.0 p/kWh) Cost of sales Purchases (20 000 GWh for 3.5 p/kWh) Fixed costs (1.1 p/kWh at current sales/prices) Total Annual profit: sales/prices)

(0.4 p/kWh

No DSM

1 000

Revenue Cost of sales Purchases Fixed costs DSM programme ‘Total costs

700 -220

focused on targeted customer

920

at current

70 22 0

costs

Note: All figures

90 63 22 3 X8

92 -s

Profit

80

With DSM

100

;!

are in & millions.

Lowered electricity purchase costs If the same PES in Table 1 initiated an energy-saving DSM programme, it would experience a net reduction in its electricity supply costs, as demonstrated in Table 2. We assume that such a programme has the following features.

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The programme provides subsidies to commercial customers with an annual demand of approximately 2000 GWh (10% of utility’s total demand) to replace old lights with more efficient ones. The programme saves 200 GWh per year through more efficient lighting (that is, 10% of the customer group’s demand) The total costs to the PES of implementing the programme are 1.5 p/kWh on average.17 The example in Table 2 ‘compresses’ all costs and savings into one year (that is, it assumes that the programme is fully implemented and the savings are achieved in one year), for the purposes of simplicity. In reality, the costs would be incurred and the savings would be achieved over a number of years. The figures used here can be seen as the present values of the annual streams of costs and benefits that would realistically occur.

The results in Table 2 indicate that this programme costs the PES f3 million, but reduces electricity purchase costs by $7 million. The net effect is lower electricity supply costs of &4 million, which represents a 133% ‘return’ on the DSM investment. Table 2. Electricity supply costs to serve targeted customer group. Cost to serve targeted customer Without DSM Electricity purchase

group

&m for 3.5 p/kWh)

70

With DSM Electricity purchase costs (1800 GWh for 3.5 p/kWh) DSM costs (200 GWh for 1.5 p/kWh) Total costs

63 3 w

Net reduction

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costs (2000 GWh

in costs due to DSM

4

The primary benefit of the reduced costs of purchases would accrue to the supply business. However, under the present supply-pricing formula, the PESs are not especially concerned with reducing their costs of purchases, because they are simply passed on directly to customers. This is a crucial factor for OFFER to consider in its current revision of the supply-pricing formula.

Recovering lost revenues Although total supply costs are reduced by f4 million, this is greatly offset by the fall in revenues caused by lower electricity sales. Revenues fal1 by 210 million, which reduces profits by &6 million, as shown in Table 3. The reduction in total supply costs is not reflected in the PES’s bottom line, owing to fallen revenues and the fact that DSM programme costs are not recovered. The example illustrates that in order for a PES to have a financial incentive to invest in DSM, it is necessary for it somehow to recover the cost of the programme, as well as the ‘lost revenues’ that result from the programme. Lost revenues are the fixed costs and profit components of price which are lost as sales are reduced. To assess the magnitude of lost revenues that can be expected from a particular programme, it is necessary to calculate the programme’s expected energy savings. Lost revenues can then be calculated as the fixed cost and profit components of price, multiplied by the energy saved. In our example above, it is 1.1 p/kWh x 200 GWh + 0.4 p/kWh x 200 GWh = f3 million. Table 4 presents the lost revenues resulting from the sample DSM programme. This table is the same as Table 3 with an additional column to identify the lost revenues. As sales are reduced, gross revenues are reduced by &lo million. If the reduction in purchase costs of E7 million is subtracted from the 00 million of gross lost revenues, then the resulting net lost revenues are f3 million. It is clear from this example that if the

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Energy efficiency in Britain Table 4. Profit and loss statement with lost revenues identified.

for targeted customer

No DSM Revenue Cost of sales Purchases Fixed costs DSM programme costs Total costs

With DSM

100 70 22

63 22

0

Profit Net lost revenue

90

group,

Lost revenues 10 7

3 92 s

88 2 3

Note: All costs are in millions

recovery of lost revenues from energy-saving programmes is not addressed, then the utility’s profitability will be reduced. Lost revenues from DSM programmes will accrue mostly to the distribution business, because this is where PESs have most of their fixed costs. The PESs are particularly concerned with the effects that DSM will have on their distribution businesses, because this is where they earn most of their profits. If utilities are not permitted to collect lost revenues, they will have a strong financial incentive to ensure that their DSM programmes do not actually save energy, causing them to continue focusing entirely on fuel substitution and load management programmes. This has already occurred in British Gas, where recently proposed DSM programmes are, in total, ‘load neutral’. In other words, these proposed programmes will improve the efficiency of certain gas end uses, but they will also increase the amount of gas used through fuel substitution. The result is no net reduction in gas sales. Electricity

rate impacts

Policies that allow PESs to recover DSM programme costs and lost revenues will affect electricity prices. This effect is presented in Table 5. This table demonstrates how revenues have been increased from f90 million to &96 million, by including the DSM programme costs (f3 million) and net lost revenues (f3 million) in the rates charged to customers. As a result, the utility’s profits of &8 million are maintained both with and without DSM. In order to obtain this additional revenue, prices will need to be raised by less than 1% in this example. This price impact would increase approximately proportionally with the size of the DSM programme. However, as programme size increases so will the number of targeted customers who will realize average reductions in their bills. The price increase is offset by the reduction in total revenues

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(from flO0 million to f96 million) to be collected from customers. This reduction in total revenue is the main benefit to customers from DSM, and is the primary reason why OFFER should be encouraging more DSM investment. Experience in the USA suggests that rate impacts from DSM programmes are usually quite small. This is especially true when they are compared with the benefits of reducing total costs to customers. For example, Kraus and Eto reviewed two studies of rate impacts for DSM programmes at the Bonneville Power Administration and Pacific Gas and Electric, and found that significant investments in DSM result in rate increases of a maximum of 1.5%) with combined effects of a 1% increase.‘s In another analysis, Hirst models both the price impacts and the reduction in total electricity costs caused by various DSM programmes. This analysis demonstrates that reductions in total resource costs tend to be large, while price impacts of DSM tend to be small (in the order of l-2% for all but the most aggressive programmes). Hirst therefore argues that the appropriate

question to ask in regulatory proceedings and utility boardrooms is: Is a one percent average increase in electricity price justified by a five percent decrease in electricity costs over the next 20 years?” To demonstrate the potential for price increases in the UK, we take the sample utility DSM programme described in Tables 2-5. In this example, the DSM programme (which was targeted to customers representing 10% of the utility’s total demand) will result in a price increase of less than l%, even after allowing the PES to recover lost revenues and programme costs. The impact upon customers’ rates is demonstrated in Table 6. It is important to note that the price increase in this example is caused by the reduction in electricity sales, not by the costs of the DSM programme. The total revenue to be collected from customers is actually decreased by fl million. Table 5. Profit and loss statement for targeted customer group, with the pricing formula revised to allow for the collection of DSM programme costs and lost revenues. No DSM Revenue Cost of sales Purchases Fixed costs DSM programme Total costs

With DSM

100

costs

70 22 0

96 63 22 3

92

88

Note: All costs are in f millions.

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Table 6. Price impact of sample DSM programme No DSM Costs to be recovered: Purchases Fixed costs DSM programme costs Lost revenues Profits Total costs Unit sales (GWh) Average (p/kWh) Percentage price

(f million). With DSM

700 220 0 0 80

693 220 3 3 80

1 000 20 000

999 19 800

unit price 5.0 increase

5.05

in 1.0%

With price increases of l%, PESs should not be overly concerned about the effects of DSM investments upon competition, even if costs and lost revenues are allowed to be recovered. Another rate-impact issue is the effects that DSM programme price increases will have upon nonparticipants who will not experience bill reductions. This issue, known as ‘cross-subsidization’, should not pose any obstacles to DSM investments for many reasons. The first is that because price increases from DSM are likely to be very small they should not create significant inequity problems. Secondly, the PESs’ package of DSM programmes should be properly designed to reach all customer classes and types, and give all customers the opportunity to lower their energy bills. Thirdly, cross-subsidization occurs in many instances in the electricity industry, and it would be inconsistent and inappropriate to use this concern as an obstacle for DSM. Finally, and most importantly, the economic benefit which will accrue to the majority of customers far outweighs the disadvantage of potential inequities for a small number of customers.

Recommendations energy efficiency

for the promotion of

Whenever a market in a particular good is not working efficiently because of market barriers or market imperfections, then the government (ie, OFFER) has the responsibility to intervene in the market in order to ensure an efficient outcome. The market barriers to energy efficiency, along with the government mandate for an Energy Saving Trust, provide the justification and the rationale for OFFER to take action to promote utility development of DSM. The primary question for OFFER is: what is the right mix of incentives and regulatory mechanisms to achieve that aim?

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In order to motivate utilities to develop energy-saving DSM programmes, the objectives should be achieved.

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PESs should have an explicit obligation to invest in all DSM programmes which cost less than the cost of purchasing electricity. The dependence of profits upon sales should be removed: that is, profits should be ‘decoupled’ from sales. DSM programme costs should be recovered. Lost revenues should be recovered. Rate increases should be minimized.

Each of these objectives is an important element of the energy-efficiency puzzle within the electricity industry. These objectives must be met to ensure effective, profitable programmes that will benefit shareholders, customers and the companies themselves. All of the above objectives can be achieved by OFFER by modifying the existing retail pricing formulae and by providing appropriate regulatory guidance. Pricing formula changes Decoupling profits from sales. In order fully to remove the incentive to profit from increased sales, it is necessary to ‘decouple’, or separate, the dependence of profits from sales. This involves restructuring the distribution pricing formula to ensure that increased sales do not increase a utility’s profits, and decreased sales do not reduce them. Northern Ireland Electric (NIE) has attempted to decouple profits from sales through a ‘flexible revenue cap’ on its distribution sales. This cap ties extra revenues in with extra costs, insofar as NIE can receive extra revenues from sales if they incur extra costs for those sales. When the size of the cap is determined, the fixed costs of the distribution system are separated from the variable costs. The amount of fixed costs collected is set at a certain level, regardless of sales volume, while the variable costs collected are determined by the volume of sales. The revenue cap is only allowed to increase by the amount of the variable costs incurred due to the increase in sales. Likewise, if sales are lowered, the revenue cap will only decrease by the avoided costs due to the decrease in sales.20 This formula goes a long way towards addressing the problem of sales volume incentive beyond the revenue cap now used in the UK. It also diminishes the problem of lost revenues, since revenues will only be decreased by the costs avoided when sales decrease. However, the NIE formula falls short of being an all-inclusive pricing formula solution for energy-

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efficiency investment for a number of reasons. First of all, the variable-cost component of the revenue cap is based solely on the volume of sales. This does not accurately reflect NIE’s variable distribution costs because variable costs in the distribution business are also dependent upon the number of customers served. Secondly, NIE still has an incentive to increase its sales to the point where actual revenues meet allowed revenues of the cap. The barriers to DSM created by volume incentives and lost revenues will exist as long as the company’s actual revenues are less than the revenue cap. Although there is a built-in ‘correction factor’ to correct for this result, it does not ensure that revenues will actually match the cap. And finally, Northern Ireland’s regulations do not allow NIE to recover the costs of its DSM investments. If Britain were to adopt a similar pricing formula, it would be necessary to correct for these deficiencies. E factor.

Perhaps the most talked about proposal for instigating energy efficiency within the electricity industry is the inclusion of an E factor in the retail pricing formula. This is the approach adopted by British Gas to ensure that the pricing formula encourages energy efficiency as well as supply options. *’ The E factor attemp ts to even the playing field between DSM and supply by providing the capital necessary to conduct DSM programmes. Electric utilities could take a similar approach, thereby minimizing the need for detailed review of DSM programme proposals by OFFER. The mechanism is already in place for the Energy Saving Trust to review proposals for DSM programmes financed by the E factor for British Gas. The disadvantages of an E factor are relatively minor compared with other methods. Some argue that an E factor would cause retail rates to increase, raising concerns about customer impacts and competition. However, it is important to remember that, with cost-effective DSM programmes, rates increase because of a reduction in electricity sales, not because of the programme costs. Therefore increased rates should only result from successful efficiency savings, regardless of how the costs are recovered by the PES. In addition, as described above, any price increase will be small and relatively insignificant, when compared with the benefits of energy efficiency. Energy-efficiency

levy. An energy-efficiency levy is a direct method for providing the up-front capital needed for investment in energy efficiency. This approach is being used in the Netherlands, where

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energy-distribution companies (supply, electricity, gas and heat) have been allowed to increase their tariff rates to finance energy-efficiency investments. The rate at which the levy is imposed depends upon the situation of each distribution company, but has been restricted to a maximum of 2% of the ultimate consumer tariff. In Britain, a similar 2% levy on bills would yield more than f200 million/year for energyefficiency investments in the electricity industry, providing a reliable level of capital for DSM investments. An energy-efficiency levy would be similar to an E factor, with the exception that the size of the levy would be predetermined by OFFER and would be the same across all PESs. To date, E factors and levies have been proposed only for the purpose of allowing utilities to recover the costs of running DSM programmes. However, either of these mechanisms could also be used to allow utilities to recover lost revenues that result from DSM programmes. This would require calculating the amount of lost revenues, as described above, and recovering them along with the programme costs. The best way to account for lost revenues, however, is to ensure that they never occur. This can be achieved by effectively decoupling profits from sales. A flexible revenue cap, like the one in Northern Ireland, which distinguishes fixed costs from variable costs, is a good example of how this can be achieved. Such a pricing formula will ensure that revenues accurately reflect actual costs, thereby ensuring that lost revenues do not occur. It is recommended, therefore, that OFFER consider a flexible revenue cap for the PESs’ distribution pricing formula. This would address both the disincentive of lost revenues and the incentive to increase distribution sales. This measure should be combined with an energy-efficiency levy or an E factor in the supply distribution formula, in order to allow PESs to recover the costs of their DSM programmes. The Director General of OFFER has recently indicated that he is willing to allow PESs to recover the costs of DSM investments by including them as appropriate business costs in the supply-pricing formula. This is an important recognition of the need to recover DSM costs. However, if the Director General intends these costs to be subject to the RPI-X price cap, then he is likely to introduce a different barrier to DSM investments. In particular, utilities which are sceptical of the benefits of DSM to begin with are unlikely to invest significant funds in DSM if they must compete with funding for other parts of the business.

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Energy efficiency in Britain

Regulatory guidance Although OFFER’s instrumental role lies with removing existing barriers to energy efficiency, it will also need to take that role one step further and provide regulatory guidance for the PESs. OFFER has recently made a number of statements encouraging utility DSM. However, at the time of writing this article OFFER has not clarified the fundamental objective for PESs to invest in DSM. If the primary objective is to reduce the total cost of electricity to customers, then PESs should be made keenly aware of this. Without a stated objective, PESs will pursue programmes which meet their own objectives: for example, fuel substitution programmes to compete with British Gas. As a result, customers will not enjoy the most significant portion of energy-efficiency benefits. In order to promote DSM most effectively, OFFER should clearly state that PESs should seek to achieve all efficiency savings which cost less than alternative energy options. This is consistent with the PESs’ current purchasing obligation to provide low-cost electricity to customers. Standards of performance. Before PESs begin to develop specific DSM programmes, it is important for OFFER to set general programme objectives and standards of performance. This will ensure that all PESs have a uniform concept of what constitutes cost-effective energy-saving programmes, and that programme costs are spent in the best interest of customers served. Standards of performance should be both general and specific, with OFFER providing general guidelines, and PESs setting specific programme targets. General standards of performance developed by OFFER should essentially be policy statements that set the objectives for DSM programmes. For example, it will be important to establish the following: a definition of what constitutes a cost-effective DSM programme; guidelines for maximizing cost-effective energy savings and minimizing the cost of electricity supply; and rough targets for minimum demand reductions expected from DSM programmes in the first five years. DSM resource plans. In order for OFFER properly to assess the success of each PES in meeting its general objectives, the PESs should be required to submit a yearly DSM resource plan to OFFER. Such a plan would explain the DSM programmes designed for that year, and give an estimate of the expected costs, savings and customer impacts of each programme. This would require the PESs to set specific

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standards of performance, or targets, for each programme. These targets should include, for example, the number of customers expected to participate, the expected energy savings and demand reductions, the number of measures installed, and the net economic benefits expected. Each resource plan should also give a synopsis of the past year’s DSM programmes and their actual costs, savings and customer impacts. In this way, a database could be established which would help OFFER and the PESs to design future programmes more effectively. The Director General currently has the power to require PESs to submit standards of performance, but a requirement for DSM resource plans would need the agreement of each PES.

Conclusion Since the passage of the Electricity Act of 1989, the philosophical approach of the British government has been to allow the market to dictate the need for energy efficiency. Owing to a number of market barriers, the uptake of energy efficiency measures by electric utilities and their customers has been insignificant to date. These barriers must be removed to ensure that energy-saving programmes (instituted by the Energy Saving Trust or other initiatives) are developed to their full cost-effective potential and do not adversely affect either corporate profitability or consumers’ rates. There are two strategies which OFFER should implement to ensure operational efficiency of the electricity marketplace. The first of these is to set the market conditions which will give the electricity industry the appropriate financial incentives and signals. This can be achieved by modifying the pricing formulae. The most effective modifications would be a flexible revenue cap for the distribution pricing formula, combined with an additional measure, such as an E factor, to allow PESs to recover DSM costs through the supply-pricing formula. The Director General’s recent suggestions for allowing DSM costs to be included in the supply-pricing formula is a positive step in the right direction. Once the appropriate market conditions are established, through the pricing formula, OFFER’s second strategy should be to provide regulatory guidance to the PESs in areas where market forces alone are still insufficient to lead to the appropriate outcome. The importance of such regulatory guidance cannot be overstated. The complex issues raised in the debate on energy efficiency clearly indicate that PESs are subject to many different, sometimes conflicting, incentives,

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POLICY July 1993

Energy efficiency in Britain

objectives and pressures. As a result, it is very unlikely that an ideal formula (if one exists) will create the appropriate incentives to encourage the desirable amount of energy efficiency, along with meeting all OFFER’s other regulatory objectives. Therefore, in addition to the pricing modificatians, OFFER should provide clear: cons&tent, and firm regulatory guidance to promote energy efficiency. This is important now, and it wilt be important in the future under any pricing structure. ‘OFFER, Energy Efficiency Ci)nsuitatj~n Paper, B~rming~aln, December 1992. OFFER, Energy Efficiency: The Way Frtrwrd, Birmingham, October 1992. LE Energy and SRC fnternatianai ApS, Demand Side Measures: A report to the Office of Electricity Regulation, Birmingham, 12 October 1992. “Professor S. Littierhiid, Director General of EIectricity Supply, ‘EIectricity regulation: a developing market’. presented at -the NEMEX 1992 conference, 24 and 25 November 1992. At the time of writing, OFFER is undergoing a review of the supply price control formula. In the NEMEX speech cited in this reference, Professor Littlechild stated, ‘The revised supply price control wilt take energy efficiency issues futiy into account’. OFFER is expected to announce its recommendations for the supply pricing formula by Summer 1993, and to have the new supply formula in place by April 1994. The UK Energy Efficiency Office, British Gas and 11 of the public electricity suppliers in England and Wales are in the process of ~stablish~n~ an independent Energy Saving Trust. The Trust will develop and fund programmes to promote the efficient use of energy. 4LE Energy and SRC International. op tit, p 12. sThe UK government accepts that energy efficiency coufd be used to reduce the UK’s total electricity consnmptjon by at least 20%, at a cost less than that of generation (Rt Honourable J. Wakeham, launching the government’s ‘Corporate Commitment Camaign’, February 1992). ! Energy Efficiency: Down to Derails, a response to the Director General of Eiectricity Suppty’s Request for comments on energy efficiency performance standards. Joint submission of the Foundation for International Environmental Law and Development and the Conservation Law Foundation, April 1993, p 13. ‘In the USA, which has over a l&year history of regulatory support for utility energy-efficiency programmes, the average DSM programme costs-$n.Ol-$O.ffZiicW~, while the average fossil-fuelled plant costs $0.04$O.l;?/kWh. Taken from E. DeRosa Lutz, i)pportunities for Least Cost Planning in the UK Electricity Supply Industry, MSc Thesis, 1992, p 4. ‘For a more in-depth discussion on the issue of market harriers, see: E. Hirst and M. Brown, CIasirzg the Energy Efficiency Gap: Barriers to Energy Efjciency, Oak Ridge Natiortal Laboratory, Oak Ridge, Tennessee, USA, 1990; Amulya Reddy, ‘Barriers to improvements in energy efficiency’, Ene& Policy. VoI 19, No IO, December 1991, nt, 953-961; T. Jackson and M. Jacobs. ‘Carbon taxes and the *assumptions of environmental economics’, Energy Futures for Ecunamic Growth: Britain in 2010, edited by Terrv Barker, Cambridge Econometrics, 1991. ‘National Association -of Regulatory Utility Commissioners (NARUC). Least Cosr Utility Pfnaninnr A ~~r~~~~k for Pub& btifify Co~naiss~oners, Volt&e 2, prepared by F. Krause and .I. Eta, Washington, DC, December 1988. ‘“An example of the PESs’ distribution profit margins can be found in the 1991 Annuat Report and Accounts Gf Midland
UTILITIES

POLICY July 1993

“‘Nationat carbon taxes: the countries to watch’, G&al Enviranmental Ckange Reporf, 21 func 1991. ‘aT. Woolf, Accounting for the Environmental Externalities of Electricity Production: A Summary of US Practice, Association for the Conservation of Energy, prepared for the European Commission, Directorate General for Research and Deveiopment, June 1992. These actions take the form of carbon taxes for consumers or the assignment of positive credits or bonus points for environmentally a&eptahic proposals in the evaluatian and selection of future resource options. Some US states even require utitities to estimate monetary values for environmental impacts, and to add these to the conventional costs when se&zing future electricity resources. 14B, Krier and I. Goodman, Energy Efficiency: Opportunities for Employment, orenared for Greenpeace UWInternationaI bv the s Gobdman Grdup’Ltd, London, November 1992, p 13. rFThisc is\ a conservative estimate of efectricity purchase prices. The average purchase costs of generation by RECs in 1990/91 and 1991/92 were 3.3 p/kWh and 3.71 pikWh respectively. The estimates furnished bv RECs before the start of the 1992/93 financial year suggested that costs might rise to 3.82 p/kWh. These figures refli;t the cost per unit of electricity delivered to the customer. and not one bought at a Dower station. Thev include payment for uplift and an element to account for electricity losses. Taken from OFFER, Review of Economic Purchasing: Further Statement, February 1993, pp 4s4I( ‘The figures here represent an aggregate of both supply and distribution areas. For a complete discussion regarding this example, see T. Woolf and C. Mickle, Promoting Energy Efficiency in the UK Electricity Industry: Recommendations to the Office of Electricity Regulation Regarding Its Consultation Paper on Energy Efficiency, Association for the Conservation of Energo, 13 May 1992. ’ This is a conservative (ie, high) estimate for a pilot lighting programme. It has been estimated that US utilities can achieve a 15% reduction in demand for 1.5 centslkwh on average. See A. White, How Wili tke UK Market Evolve in rke 19#s, Speakers’ Papers, World Electricity Conference, London, November 1991. Our estimate of 2 p/kWh is equivalent to 3.5 cents/kWh. “National Association of Regulatory Utility Commissioners (NARUC), op cit. 19F-1 Hirst 3 The Effects of Lit&y D&M Programs on E&ric$v Costsand Prices, Oak Ridge NationaI Laboratory, Tennessee, USA, November 1991, p 33. ‘qhe distribution pricing formula adopted by NIE is significantly different from that used in Britain, in that it is based on the principal of a ‘Ilexibie revenue cap’, as opposed to a price cap. It is designed so that in any year the company’s dist~butjon revenue will not exceed a certain maximum ahowable revenue, regardless of the number of distribution units sold. The revenue can is determined by the following formula: IW = 0.75 F i- 0.25 li & -

T + R

where A4 is the maximum allowable revenue for the given year; F is intended to represent the fixed portion of distribution costs to the Company (in the first year of implementation it wili be set through negotiations between NIE and the Deoartment of Economic Dkvei~pment. In al1 subsequent years it’wiil be allowed to increase by RPI-X, where X is also determined by the Department of Economic Development): V is intended to reoresent the variable portion of distribution costs to the Company (as with fixed costs, the first year’s vatue is determined by the Department of Economic Development, and in all subsequent years it will be allowed to increase by RPI-X. The value for V is on a per unit basis, and therefore is multiplied by the amount of distribution sales to determine the variable portion of revenues); Q represents the amount of distribution safes; T is an adjustment for transmission and distribution losses; K is an adjustment for over- or undercollection in any one year. If actual revenues in one year are above (or below) the maximum allowable revenue, then the difference is subtracted from (or added to) the maximum allow-

Energy

efficiency

in Britain

able revenue cap for the next year. ‘IBritish Gas’ formula is RPM

242

+ GPI -

1 + E

RPI represents the Retail Price Index minus 5 percentage points. GPI is British Gas’ gas costs, or a Gas Price Index, which is meant to represent typical gas prices that British Gas faces, minus one percentage point. E is the energy efficiency, or E factor.

UTlLlTlES

POLICY July 1993