“Lowest total cost” should govern planning

THE

GREAT

DEMAND-SIDE

BIDDI

both “rational” consumer decision-

real discount rate and a long-term

making and the possibility of

inflation rate of 5%.

NG

DEBATE

from increasing more than they would have if new generating

decisionmaking imperfections.

Strategy 1: All Generation

resources had been at 6 cents per

They take account of the interests

Assuming the system grows by

kWh. Advocates of this rule base

ticipants in utility-sponsored con-

met with new generation costing

their position on two objectives. The first is to provide for equity

servation programs. They recognize that a utility is not always the

6.0 cents per kWh, the annual

and economic efficiency among

revenue requirement will increase

all ratepayers of a utility. The

best institution to correct decision-

by $600 million to a total of $5.6

second, explicitly or implicitly, is

making imperfections. I think

billion per year. This means that

to minimize rates, as opposed to

these principles can be used in

the average rate for all customers,

minimizing the total cost of ener-

place of the “all-source” bidding

under the generation strategy,

gy services.

program to achieve the objectives

would increase to 5.09 cents per

that we all share.

kWh. The total present value

achievable for less than 1 cent per

(Editor’s Note: Paul L. Joskow is Professor of Economics at Massachusetts Institute of Technology and Special Consultant to National Economic Research Associates, Inc. This material was adapted from Professor Joskow’s testimony before the Subcommittee on Energy and Power, Committee on Energy and Commerce, U.S. House of Representatives,March 31 and May II,19884

revenue requirement of the

kWh is estimated to be 1,667

of both participants and non-par-

“Lowest Total Cost” Should Govern Planning Northwest Power Planning Council

T

he following example will show how different resource

acquisition paths affect total societal costs and also how non-participants in conservation programs may be affected. The example demonstrates that while limited conservation investment under the “no losers test” may yield a rate minimization strategy it does not lead to the lowest cost service to all consumers. The calculations below, and in Table 1 on page 39, assume a 3% 38

10,000 GWh and load growth is

For Strategy 2, the conservation

generation strategy increases,

GWh (a figure derived from a

above the existing level of $55.5

linear supply curve assumed for

billion, to $62.2 billion.

this example). Therefore, an addi-

Strategy 2: “No Losers”

tional 8,333 GWh of generation

The second strategy involves

are needed at 6 cents per kWh.

selecting all conservation

Since the supply function is as-

measures that do not violate the

sumed to be linear, the average

decision rule known as the “no

cost of all conservation measures

losers test.” This test, in its

costing less than 1 cents per kWh

simplest form, would restrict pay-

is 0.5 cents per kWh. The respec-

ment for new conservation

tive increases in total annual

measures to no more than the dif-

revenue requirement for generat-

ference between the marginal cost

ing and conservation resources

of new generation and the current

are $0.5 billion (8,333 GWh times

rate of the existing system. As in

6 cents) and $0.008 billion (1,667

the previous example, the average

GWh times 0.5 cents) per year

rate of the existing system is 5

respectively

This means that the

cents per kWh. Subtracting this

total annual requirement of the

average rate from the marginal

combined system is $5.508 billion

cost of new generation of 6 cents per kWh, leaves a maximum pay-

per year with an average rate of 5.08 cents per kWh. Compared

ment of 1 cent per kWh for conser-

with Strategy 1, Strategy 2 has

vation measures. Acquiring only

preserved a lower rate for all cus-

those conservation measures with

tomers after the acquisition of con-

an expected cost under 1 cent per

servation measures. Strategy 2

kWh will prevent the rates of

also has a lower present value sys-

those who do not participate in

tem cost of $61.1 billion,

conservation (non-participants)

$1 .l billion less than Strategy 1.

I

The Electricity ]ournal

THE

GREAT

DEMAND-SIDE

BIDDING

DEBATE

TABLE k Three Strategks for meeting Energy Growth Needs Strategy 1 Base Power System 100,000

Existing load (GWh) Load Growth (GWh)

Generation Strategy l~,~ 10,000

100,~ 10,000

100,000 10,000

1,667

10,000

10,000

8,333

0

110,000 5.0

108,333 5.0

100,000 5.0

0.6

0.5

Conservation (GWh) Generation (GM%)

100,000 5.0

Total load (GWh) Existing annual

Strategy 3 Strategy 2 Conservation Marginal Conservation Strategy “No Losers up to Marginal Test” Generation

revenue requirement ($ billion) Generation revenue requirement ($bi~ion/ year) Conservation revenue requirement ($billion/year)

.008

0.3

Total annual revenue requirement ($billion/year)

5.0

5.6

5.508

5.3

Average rate (cents/kWh)

5.0

5.09 62.2

5.08

5.3

61.1

58.8

Total present value revenue requirement ($ billion)

55.5

In this example, the base power system has an existing load of 100,000gigawatt-hours (GWh) and is or one million kilowattexpected to grow by 10,~ GWh. A gigawa~-hog is l,OOOrn~awa~-hog, hours (kwh).

Strategy 2, involving the acquisi-

10,000 GWh of energy efficiency

tent with our experience with

tion of all conservation measures

improvements at less than 6 cents

costs for conservation measures in

which do not violate the “no

per kWh. Since the marginal cost

the ~or~w~t).

losers test,”therefore helps both to reduce rates and to reduce the total present value cost of all ener-

of new generation was assumed total amount of load growth was

of such measures is $300 million.

gy services, in comparison with

assumed to be 10,000 GWh, it is

The total annual revenue require-

the “all generation” strategy

possible to meet the entire load

ment of the system, therefore, in-

Strategy 3: AELC~~~ati~n

to be 6 cents per kwh, and the

The means that the annual revenue required for the purchase

growth through conservation.

creases to $5.3 billion and, since

Strategy 3 is to acquire at cost all conservation measures with a

Again, assuming a linear supply function, the average cost of all

there has been a reduction of the total system load, the average rate

marginal cost up to the marginal

conservation measures that are

increases to 5.3 cents per kWh.

cost of new generation.

less than 6 cents per kWh is es-

The

Significantly, however, the total

linear supply function we used

timated to be 3 cents per kWh

present value system cost for

shows that it is possible to acquire

(which is, coinciden~lly, consis-

providing exactly the same ener-

--_____._ 39

THE

GREAT

DEMAND-SIDE

BIDDZ

NG

DEBATE

gy services, as were provided in

tomer-as-supplier would offer the

the marginal or avoided cost is 7

Strategy 1, has declined to $58.8

conservation investment in the

cents compared to the average

billion.

bidding process to be considered

rate of 5 cents.

By acquiring all conservation

on the same terms as other sour-

Buying the coal would raise the

measures up to the marginal cost

ces of supply The winning

total cost and revenue require-

of generation, the present value of

projects would receive the bid

ment from 5000 to 5700. When

the total cost of meeting society’s

price as determined by the rules

spread over the 1100 kWh

energy service requirements is

of the bidding process without

demand, average rates would be

reducedby $3.4 billion when com-

respect to the source of supply

5700/1100 = 5.18 cents per kWh.

pared with the all-generation

other things being equal.

strategy in Strategy 1, and by $2.3

Introducing brokers or energy

Now suppose that there is a conservation investment available at

billion when compared with

service companies between the

4 cents per kWh. Clearly, the effi-

Strategy 2. This reduction in total

utility and the consumer presents

cient choice would be to adopt

societal cost (and in consumers’

no difficulties. They would even

the conservation investment in

total electric bills) happens with

be encouraged if there are

place of the coal purchase, even if

only a 4 percent increase in rates

economies of scale and scope. As

we include the cost of conserva-

and frees $2-3 billion for other

long as energy conservation in-

tion in the revenue requirement.

uses by consumers.

vestments are unbundled from

What happens under the alterna-

(Editor’s Note: This analysis was adaptedfromTestimony of Northwest Power Planning Council before the Subcommittee on Energy and Power, Committee on Energy and Commerce, U.S. House of Representatives, June 10,298B.I

the sale of energy services, the in-

tive bidding proposals?

“Unbundled” Conservation Can Be Considered In Resource Biddine

centives align with the pursuit of

In the Lovins auction, the con-

economic efficiency. Conservation investments which cost less

vestment in competition with the

than the supply-side alternatives

coal purchase. According to

can compete on an equal basis

Lovins, the bid might be

sumer offers the conservation in-

and win. But there is no incentive

anywhere from 4 cents, the cost of

for inefficient conservation invest-

the conservation, to 7 cents, the

ments.

avoided cost. In either case, the

Perhaps an example would il-

conservation proposal would win

lustrate the concept further and

the bid, the conserver would be

summarize the key differences be-

paid the price of the bid, and

tween the unbundled auction proposed here and the bundled

electric load would stay at 1000 kWh. The results in terms of (1)

n our ‘unbundled” auction, the

auction proposed by Lovins. Con-

generation, (2) sales, (3) fixed cost,

customer-as-consumer

sider a utility with an initial load

(4) variable cost, (5) conservation

pay the same rate for the energy

of 1000 kWh, a fixed cost alloca-

payments, (6) revenue require-

conservation service provided,

tion of 2 cents per kWh, and an

ment, (7) average rate, and (8)

based on an estimate of savings,

energy cost of 3 cents per kWh.

total resource cost to society ap-

as for the electron flow provided.

Hence the average rate is 5 cents

pear in Table 2. Notice that for the

There would be no necessity to

per kWh. The utility faces an in-

last column, the total resource

identify this rate in advance or in-

cremental demand for 100 kWh.

costs--the

corporate this rate in the bidding

To meet this demand, the utility is

efficiency-are

process.

considering buying coal-based

the range of high to low bids in

power at 7 cents per kWh. Hence

the Lovins auction. The bid af-

Enemy and Environmental Policy Center, Harvard University

I

would

Conceptually separate, the cus-

40

measure of economic the same across

TheElectricity Journal