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Strategic consumers' reactions to conservation incentives
m
U T T E R W O R T H E I N E M A N
Utilities Policy, Vol. 5, No. 2, pp. 109-113, 1995 N
0957-1787(95)00021-6
Copyright © 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0957-1787/95 $10.00 + 0.00
Strategic consumers' reactions to conservation incentives Franz Wirl
Many papers and scientists proclaim the efficiency and the economic prospects of utility demand-side conservation. This proposition is obtained under the assumption that consumers act passively and in particular not strategically. However, strategic consumer behaviour seems quite likely if conservation receives a level playing field with supply expansion, as often advocated. More precisely, consumers who know o f a coming D S M programme will refrain from their own conservation efforts and investments in order to gain from the incentives provided by the utility. As a consequence, the utility ends up financing conservation entirely, and not only incrementally as suggested in the conservation literature. Keywords: Demand-side-conservation programme; Economic efficiency; Regulation
Many electric utilities offer demand-side management (DSM) programmes, primarily in the USA.L The aim of DSM programme, which cover a wide spread of measures (audits, rebates, subsidies or even replacement of different end-use appliances such as lighting, heating and air conditioning, motors, storage cooling, and home insulation, is twofold: load management and conservation. This note concentrates on conservation. Indeed, DSM is one of the most topical issues in applied utility regulation, and a bulky literature documents this. It was (to my knowledge) A m o r y Lovins who first advocated the idea of DSM in the 1970s. Cicchetti and Hogan 2 summarized the arguments of this heated debate critically and proposed an interesting bidding procedure. WirP introduced an analytical framework in order to compare different DSM Franz Wirl is with the Otto-von-Guericke University of Magdeburg, Department of Economics, Universit~it Platz 2, D-3P106 Magdeburg, Germany.
instruments (conservation, standards, subsidies, bidding, etc). Moskovitz4 discussed different possible ways to include DSM in least-cost planning. The New York State Energy Research and Development Authority5 and Joskow and Matron6 compared the different conservation programmes in the USA. Recently, Lewis and Sappington7 analysed, within a principal-agent framework, the optimal regulatory regimes that enhance demand-side conservation up to the point that maximizes consumers' net welfare and subject to participation (or breakeven) constraints for the utility. The following logic is typical for this literature. First, the consumers purchase an inefficient s equipment (either socially or from the utility's perspective) because of electricity price regulation or other market failures (eg the high discount rates employed by consumersg). In the second step the utility or the regulator figures out that it is possible, and perhaps profitable too, to cut energy requirements through an investment in conservation: for example, replacing 75 W bulbs with SL-18 bulbs. However, this overlooks the fact that DSM, advertised to correct for market failures, introduces new distortions as it removes all incentives to install costsaving devices.
The argument: an example The fundamental shortcoming of the conventional assumption - that DSM does not affect the consumers' initial choice of equipment - can be made clear with the help of an example: SL-18 versus 75 W bulbs. The basic logic holds in a similar manner for many other electric appliances. We assume that the consumer uses a particular rule to decide between conventional 75 W bulbs and SL-18 bulbs, and that this rule is possibly 'suboptimal' in some sense. For example, following the argument of Hausman, the consumers discount energy conservation investments too heavily J0 Figure 1 plots the net present value of 'savings' from the use of an SL-18 109
Strategic consumers' reactions to conservation incentives
//oo.somor
i
Figure 1. Optimal replacement of 75 W bulbs by SL-18 bulbs from the individual and the regulator's or utility's perspective.
bulb compared with a conventional light bulb vs the utilization h (hours per day): for example, bulbs in the toilets, the bathroom, pantry, cellar, etc. presumably burn less than 1 h every day, while bulbs in the corridor, the living room etc. have a much higher utilization rate. These subjective individual savings have a breakeven point at h = h0, so that thc consumer applies the following rule (in the absence of DSM): buy SL-18 bulbs wherever the utilization exceeds h0 hours; otherwise, buy conventional and much cheaper 75 W bulbs. Assume further, as is done in the DSM literature, that conservation beyond the consumer's choice is desirable (for whatever reason), so that all bulbs down to h~ should be replaced by SL-18 bulbs. This is shown in Figure 1 by the regulator's or utility's objective, which becomes positive for h>h~. Of course, no intervention is necessary if h~>ho: thus we assume h~
of the demand-side conservation programme and of its logic - it is efficient to replace 75 W bulbs down to a utilization of hi hours per day - will buy no SL18 bulbs in the first place. Therefore, a level playing field for conservation investments with supply expansion will leave the utility to shoulder the entire conservation effort. This implies for the example in Figure 1 that the utility has to install SL bulbs for the interval (h~, 24) instead of (hi, h0), because the consumers will minimize their own expenditures: ie h0 = 24 becomes optimal when the utility offers such a lighting programme. Hence this proposal of the DSM literature and of Lewis and Sappingtonll that the utility must upgrade inefficient equipment to a proper efficiency standard presumably creates tremendous costs for the utility, because rational consumers cease any individual conservation effort. In fact, very inefficient equipment (ie high energy waste) will draw the attention of the utility to do something about it. Of course, from a traditional welfare perspective one should not worry about the costs to the utility, because of the indifference whether the consumers or the utility pay for the efficiency enhancements. However, if we assume reasonably that consumers for the sake of the argument we acknowledge all documented shortcomings and irrationalities - have nevertheless some advantages concerning conservation (private information,13 conservation provided by additional inputs such as time), then substantial social waste due to DSM becomes likely because these efficient measures are deterred. Moreover, many utility conservation measures involve a duplication of capital: for example, still-functioning bulbs (or other kinds of equipment, washing machines, electric motors, etc) are replaced because of the conceived benefits of such a programme. The following proposition summarizes the conclusion from the above example and of the formal argument that is developed in the Appendix. Proposition Consider a price-cap-regulated utility that is committed to demand-side conservation programmes in the sense that it undertakes those DSM measures that are profitable; conservation may be profitable, if the price cap does not cover the marginal costs of supplying electricity. Consumers have a natural strategic advantage because they buy the equipment in the first place that subsequently becomes the target of the utility's conservation programme. This strategic advantage induces consumers to minimize their own expenses for efficiency, and they let the utility pay for (or at least subsidize) the upgrade, if DSM programmes are offered. UTILITIES POLICY April 1995
Strategic consumers' reactions to conservation incentives
This p r o p o s i t i o n states t h a t t h e u t i l i t y ' s i n t e n t i o n to i n c l u d e D S M in l e a s t - c o s t p l a n n i n g activities, w h i c h r e q u i r e s t h e m to b a l a n c e t h e loss f r o m selling t h e (last) k W h a g a i n s t t h e costs of c o n s e r v i n g a kWh, crowds out consumers' conservation intentions. T h e r e f o r e , t h e e x p e n s e s for p e r m a n e n t D S M will b e l a r g e r t h a n t h e t r a d i t i o n a l e v a l u a t i o n o f such p r o g r a m m e s r e v e a l s b e c a u s e c o n s u m e r s will in t h e long r u n r e t r a c t all t h e i r o w n ( a n d so far o b s e r v e d ) c o n s e r v a t i o n activities. This in t u r n will a g g r a v a t e ' a p p a r e n t ' m a r k e t failure, j u s t i f y i n g D S M t h r o u g h a self-fulfilling p r o p h e c y . I n the t e r m i n o l o g y o f t h e D S M l i t e r a t u r e , e v e r y b o d y will b e c o m e a ' f r e e r i d e r ' , at l e a s t to s o m e extent. This p r o b l e m o f freer i d i n g - all p a r t i c i p a n t s a r e r e w a r d e d i r r e s p e c t i v e o f w h e t h e r t h e i r i n v e s t m e n t has b e e n a c t u a l l y t r i g g e r e d ( e n t i r e l y , o r p a r t i a l l y ) b y t h e p r o g r a m m e - is p a r t i a l l y a c k n o w l e d g e d in t h e l i t e r a t u r e . In fact, f r e e - r i d i n g a l r e a d y a p p e a r s to b e s u b s t a n t i a l in t h o s e p r o g r a m m e s w h e r e d a t a a r e available.14,~5 T h e p e r m a n e n c e o f D S M p r o g r a m m e s will i n d u c e e v e r y c u s t o m e r to f r e e - r i d e o n t h e b a c k o f the u t i l i t y ' s c o n s e r v a t i o n p r o g r a m m e , a c c o r d i n g to the a b o v e a r g u m e n t . A l t h o u g h this r e s u l t is e s t a b l i s h e d in t h e A p p e n d i x for p r i c e - c a p r e g u l a t i o n a n d for full c o v e r a g e o f efficiency i m p r o v e m e n t s b y t h e utility, the precise regulatory constraints and incentives do n o t s e e m to b e crucial in t r i g g e r i n g t h e a d d r e s s e d strategic reaction by consumers. The reason seems simple. T h e k n o w l e d g e o f f i n a n c i a l i n c e n t i v e s for c o n s e r v a t i o n will l e a d to a s i t u a t i o n w h e r e e v e r y c o n s u m e r tries to r e c e i v e this s u b s i d y for e a c h ' c o n s e r v a t i o n ' effort, e v e n for t h o s e t h a t w o u l d h a v e b e e n u n d e r t a k e n in t h e a b s e n c e o f subsidies. A s a c o n s e q u e n c e , it a p p e a r s i m p o s s i b l e to assess t h e a m o u n t o f c o n s e r v a t i o n t h a t is a c t u a l l y t r i g g e r e d b y such p r o g r a m m e s .
Final critical remarks D S M p r o g r a m m e s , w h i c h try to c o r r e c t for m a r k e t failures ( p a r t i a l l y c r e a t e d b y t h e r e g u l a t o r s ) , i n t r o duce new distortions that encourage strategic c o n s u m e r b e h a v i o u r to m i n i m i z e t h e i r o w n c o n s e r v a t i o n efforts: e a c h c o n s u m e r tries to f r e e - r i d e o n t h e b a c k o f a u t i l i t y ' s c o n s e r v a t i o n p r o g r a m m e . This in t u r n a g g r a v a t e s a l r e a d y existing m a r k e t f a i l u r e s a n d t h e r e b y ' j u s t i f i e s ' D S M p r o g r a m m e s like a selffulfilling p r o p h e c y . S u r p r i s i n g l y , this s i m p l e c o n s e q u e n c e o f D S M p r o g r a m m e s has b e e n o v e r l o o k e d so far. This f i n d i n g suggests t h a t t h e e c o n o m i c p r o s p e c t s for t h e utility f r o m ( p e r m a n e n t ) D S M s h o u l d b e p o o r , b e c a u s e t h e utility e n d s up n o t o n l y f i n a n c i n g i n c r e m e n t a l b u t e n t i r e c o n s e r v a t i o n , o w i n g to t h e UTILITIES POLICY April 1995
s t r a t e g i c r e a c t i o n of c o n s u m e r s . T h e r e f o r e , o n e w o u l d e x p e c t t h a t utilities c o m m i t t h e m s e l v e s to n o DSM programme d e s p i t e the ( p r i m a facie) p r o f i t a b i l i t y of s o m e m e a s u r e s ) 5 Y e t c o n s e r v a t i o n p r o g r a m m e s a r e c a r r i e d o u t o n a w i d e scale in the U S A . This s e e m i n g c o n t r a d i c t i o n m a y d e p e n d o n the r e g u l a t o r y p r a c t i c e in t h e U S A : r a t e - o f - r e t u r n r e g u l a t i o n o f utilities, a n d r e g u l a t o r s ' bias for c o n s e r v a t i o n i n v e s t m e n t s o v e r i n v e s t m e n t s in s u p p l y c a p a c i t y . I n d e e d , Wir116 shows t h a t D S M m a y b e d u e to a r e g u l a t o r y bias a n d lacks e c o n o m i c efficiency. This criticism d o e s n o t i m p l y t h a t I o p p o s e e n e r g y c o n s e r v a t i o n , b u t r a t h e r t h e c o n t r a r y : the g o o d i n t e n t i o n s a n d in p a r t i c u l a r t h e o f t e n e s p o u s e d c l a i m t h a t c o n s e r v a t i o n is c h e a p a n d e v e n profitable17 m a y in the e n d h a r m t h e g o a l of c o n s e r v a t i o n . This n o t e suggests t h a t at l e a s t s o m e p r a c t i s e d D S M programmes encourage strategic and counterproductive consumers' reactions. Therefore, the emphasis on proper contracts and incentives must start with t h e c o n s u m e r - u t i l i t y r e a c t i o n : t h a t is, we s h o u l d l o o k for c o n t r a c t s t h a t can m i t i g a t e or e v e n solve t h e p r o b l e m a d d r e s s e d a b o v e .
~PG&E, Annual Summary Report on Demand Side Management Programs 1989, 1989; Central Maine Power Company, 1989 Energy Management report, 1990. zCbarles J Cicchetti and William W Hogan, 'Including unbundied demand side options in electric utility bidding programs', Public Utilities Fortnightly, 8 June 1989, pp 9-20. 3Franz Wirl, 'Analytics of demand-side conservation programs', Energy Systems & Policy, Vol 13, 1989, pp 285-300. 4David Moskovitz, Profits and Progress through Least-Cost Planning, National Association of Regulatory Utility Commissioners, Washington, DC, 1989. SNew York State Energy Research and Development Authority, 1990. 6paul L Joskow and Donald B Marron, 'What does a megawatt really cost? Evidence from utility conservation programs', The Energy Journal, Vol 13, No 4, 1992, pp 41-74. 7Tracey R Lewis and David E M Sappington, 'Incentives for conservation and quality improvement by public utilities', American Economic Review, Vol 82, 1992, pp 1321-1340. ~Of course, one should be very careful when calling individual choices of appliances irrational, because of the tangible costs (design, brand, inconvenience etc) that are associated with any kind of equipment, and because Hayek reminded us that '...an economic actor on average knows better the environment in which he is acting and the probable consequences of his actions than does an outsider, no matter how clever the outsider may be': von Friedrich Hayek, 'The use of knowledge in society', American Economic Review, Vol 35, 1945, pp 519-530. ~Jerry A Hausman, 'Individual discount rates and the purchase and utilization of energy-using durables', Bell Journal of Economics, Vol 10, 1979, pp 3354. 1°Of course, if they don't, no DSM programme is necessary, and moreover not each observed high implicit discount rate constitutes a market failure. ,Lewis and Sappington, op cit, ref 7. 121bid.
13This advantage of consumers on conservation is a cornerstone in the bidding proposal of Cicchetti and Hogan: op cit, ref 2. 111
Strategic c o n s u m e r s ' reactions to conservation incentives ~4New York State Energy Research and Development Agency, op cit, ref 5; Joskow and Marron, op cit, ref 6. ~SFranz Wirl, 'On the unprofitability of utility demand-side-conservation programs', Energy Economics, Vol 16, 1994, pp 46-53. 16Franz Wirl, 'Impact of regulation on demand side conservation programs', Journal of Regulatory Economics, Vol 7, 43-62, 1995. ~7Amory Lovins, 'Saving gigabucks with megawatts', Public Utilities Fortnightly, Vol 115, No 6, 1985, pp 19-26. 'sWirl, op cit, ref 15. ~gLewis and Sappington, op cit, ref 7. 2~'Ofcourse, the efficiency ",1 depends on the various attributes of a particular appliance - 'quality' - often in the sense that better
quality increases the energy requirements. This in turn blurs many engineering comparisons of the efficiency of equipment over the purchase price that led some to the conclusion that efficiency is a public good. However, higher efficiency cannot be free! 21This need not hold in general; see Wirl, op cit, ref 3, and the following discussion under the heading 'Consumers'. =The objective (A6) assumes a quasi-linear representation between the considered service s and all the other services and commodities demanded by a consumer: that is, a partial equilibrium framework. 23Wirl, op tit, ref 3.
Appendix A formal proof of the proposition The following formal a r g u m e n t is similar to that of Wirl, ~s except for a different service framework. W e consider a price-cap-regulated utility that is obliged to m e e t the associated electricity d e m a n d e. The function c(e) determines the corresponding production costs. The price cap, p, is set below the marginal costs of electricity, pO, K " > 0 for the utility; and F(-q) for the consumer, F'>0 and F"_>0. Presumably F > K at least for some high values of ~1: for example, because the consumers employ higher discount rates than the utility such that capital-intensive but m o r e efficient e q u i p m e n t is subjectively cheaper to the utility than to the consumer. M o r e o v e r , there exists a minimal technical standard ~ for each type of equipment, either due to regulation or for other technological and economical reasons: n_>~
112
(A2)
The utility The objective of the utility is to choose a D S M p r o g r a m m e that the utility's profits are maximized. This conservation p r o g r a m m e improves efficiency by a magnitude dx~ over and above the consumer's choice -q~, which in turn affects electricity demand, e = E(+qc + A+q). The electricity d e m a n d depends only on efficiency because the price is assumed to be constant; moreover, we assume E'<021 and E " > 0 (reflecting the law of diminishing returns). The costs to the utility for improving efficiency are given by K(+qc + A~)-S(~c), where K denotes the costs to the utility in providing the final efficiency ~u = ~c + A-q, and S denotes the saving to the utility when the consumers have already invested in an efficiency TIc.These savings S(~qc), satisfy the inequalities O0. A n (interior) solution of the utility's p r o b l e m follows from the equality: (c'-p) = -K__' E'
(A3) optimization
(A4)
This equality simply expresses that the loss from selling an additional kWh (left-hand side in E q u a t i o n (A4)) must equal the costs of conserving the last kWh ( - K ' / E ' ) . This in turn justifies conservation only if c'>p. The assumptions ensure that the right-hand side E q u a t i o n (A4), the costs for conserving an additional kWh, increase. This states that conservation is particularly profitable in those households that choose highly inefficient appliances. The lefthand side E q u a t i o n (A4) declines, so that a solution of (A4), assumed to exist, is unique and depends only on the aggregate efficiency +qu. The solution of (A4) is superscripted by an asterisk, "qu*, so that the optimal utility conservation p r o g r a m m e A+q*, given the consumers' own efforts -% is given by: UTILITIES POLICY April 1995
Strategic c o n s u m e r s ' reactions to conservation incentives
~(.qc) = A~q. = { ~ u* - ~qc if ~u* -> "q~ ~= if lqu* < vl~
if u'e-F' (-q) from u'=F'/e
0.
(A8)
>
Hence ~' = -1 for interior solutions.
The game The consumers The representative consumer maximizes the surplus for services s, u(s), u'>0, u"
(A6)
subject to the technological constraints (A1), (A2). This optimization problem corresponds to the initial situation of no conservation programme. The function F(~q) measures the household's investment for an appliance with an efficiency vI. All investments are expressed in flows; for example, if s is measured in annual terms then F(~) represents the corresponding (subjective) annuity. Therefore, these outlays F account implicitly for individual characteristics like discounting and planning horizon and associated market failures, but also for informational advantages. In particular, the inequality F > K for some vI characterizes one of the much-addressed market failures. A standard marginal productivity condition describes the optimal electricity consumption of price-taking households: u' = P.
(AT)
One potential setting of this game is that the consumers have the first move (ie a Stackelberg equilibrium) so that the consumers first buy the efficiency "qc, knowing the utility's DSM programme. Although the consumers are price-takers (and so is, by the way, the utility owing to the assumption of price-cap regulation), their efforts affect their participation and potential gain from the conservation programme. Therefore, we consider a game where the consumers first choose their efficiency "qc and the associated electricity consumption, and the utility decides then on further conservation investments, A~I. In order to exclude trivial cases we assume active DSM: A~q>0. The electricity demand for a given and constant electricity price p depends solely on the efficiency of the equipment, and can be defined in the following way: E0q c + A~q) =arg max u [('qc + A~q)e] -pe,
Substitution of the optimal choice of electricity defined in (A9) into the consumer's objective (A6) leads to the indirect utility function v depending on efficiency: v ('qc + A-q)= max u [(~c + A-q)e] - p e - F ("qc) e
( ( ~ + A~q)E(~ -pe(~qc + A.q).
= u
First note that standard assumptions about u do not guarantee that conservation investments do indeed lower fuel consumption. In fact, energy conservation may increase energy consumption, but in any case falls short of the savings suggested by engineering efficiency comparisons. 23 The reason is that a higher efficiency ~q lowers the marginal costs of the service, p/'q, and thus the demand for the service s increases according to Equation (A7). The consumer's choice of the equipment ~¢ reflects either the boundary solution, -q=~, or follows from a usual marginal utility condition:
UTILITIES POLICY April 1995
E'<0. (A9)
e
+ A~]))
-F(-qc) (A10)
This definition (A10) reduces the consumer's decision to the choice of the efficiency "qc, which must account explicitly for the utility's reaction A~q=~(-q~). Furthermore, the consumer knows that the utility will always upgrade the efficiency to ~qu*, so that substitution of this response into (A10) yields v [Tic+B(xlc)] =u [(Xlu*)E(-qu*)] -F(vlc) -pe('qu*).
(A11)
Thus, the indirect utility function in (A1 l) is maximized at the boundary "qc = ~1, since F'>0.
113
U T T E R W O R T H E I N E M A N
Utilities Policy, Vol. 5, No. 2, pp. 109-113, 1995 N
0957-1787(95)00021-6
Copyright © 1995 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0957-1787/95 $10.00 + 0.00
Strategic consumers' reactions to conservation incentives Franz Wirl
Many papers and scientists proclaim the efficiency and the economic prospects of utility demand-side conservation. This proposition is obtained under the assumption that consumers act passively and in particular not strategically. However, strategic consumer behaviour seems quite likely if conservation receives a level playing field with supply expansion, as often advocated. More precisely, consumers who know o f a coming D S M programme will refrain from their own conservation efforts and investments in order to gain from the incentives provided by the utility. As a consequence, the utility ends up financing conservation entirely, and not only incrementally as suggested in the conservation literature. Keywords: Demand-side-conservation programme; Economic efficiency; Regulation
Many electric utilities offer demand-side management (DSM) programmes, primarily in the USA.L The aim of DSM programme, which cover a wide spread of measures (audits, rebates, subsidies or even replacement of different end-use appliances such as lighting, heating and air conditioning, motors, storage cooling, and home insulation, is twofold: load management and conservation. This note concentrates on conservation. Indeed, DSM is one of the most topical issues in applied utility regulation, and a bulky literature documents this. It was (to my knowledge) A m o r y Lovins who first advocated the idea of DSM in the 1970s. Cicchetti and Hogan 2 summarized the arguments of this heated debate critically and proposed an interesting bidding procedure. WirP introduced an analytical framework in order to compare different DSM Franz Wirl is with the Otto-von-Guericke University of Magdeburg, Department of Economics, Universit~it Platz 2, D-3P106 Magdeburg, Germany.
instruments (conservation, standards, subsidies, bidding, etc). Moskovitz4 discussed different possible ways to include DSM in least-cost planning. The New York State Energy Research and Development Authority5 and Joskow and Matron6 compared the different conservation programmes in the USA. Recently, Lewis and Sappington7 analysed, within a principal-agent framework, the optimal regulatory regimes that enhance demand-side conservation up to the point that maximizes consumers' net welfare and subject to participation (or breakeven) constraints for the utility. The following logic is typical for this literature. First, the consumers purchase an inefficient s equipment (either socially or from the utility's perspective) because of electricity price regulation or other market failures (eg the high discount rates employed by consumersg). In the second step the utility or the regulator figures out that it is possible, and perhaps profitable too, to cut energy requirements through an investment in conservation: for example, replacing 75 W bulbs with SL-18 bulbs. However, this overlooks the fact that DSM, advertised to correct for market failures, introduces new distortions as it removes all incentives to install costsaving devices.
The argument: an example The fundamental shortcoming of the conventional assumption - that DSM does not affect the consumers' initial choice of equipment - can be made clear with the help of an example: SL-18 versus 75 W bulbs. The basic logic holds in a similar manner for many other electric appliances. We assume that the consumer uses a particular rule to decide between conventional 75 W bulbs and SL-18 bulbs, and that this rule is possibly 'suboptimal' in some sense. For example, following the argument of Hausman, the consumers discount energy conservation investments too heavily J0 Figure 1 plots the net present value of 'savings' from the use of an SL-18 109
Strategic consumers' reactions to conservation incentives
//oo.somor
i
Figure 1. Optimal replacement of 75 W bulbs by SL-18 bulbs from the individual and the regulator's or utility's perspective.
bulb compared with a conventional light bulb vs the utilization h (hours per day): for example, bulbs in the toilets, the bathroom, pantry, cellar, etc. presumably burn less than 1 h every day, while bulbs in the corridor, the living room etc. have a much higher utilization rate. These subjective individual savings have a breakeven point at h = h0, so that thc consumer applies the following rule (in the absence of DSM): buy SL-18 bulbs wherever the utilization exceeds h0 hours; otherwise, buy conventional and much cheaper 75 W bulbs. Assume further, as is done in the DSM literature, that conservation beyond the consumer's choice is desirable (for whatever reason), so that all bulbs down to h~ should be replaced by SL-18 bulbs. This is shown in Figure 1 by the regulator's or utility's objective, which becomes positive for h>h~. Of course, no intervention is necessary if h~>ho: thus we assume h~
of the demand-side conservation programme and of its logic - it is efficient to replace 75 W bulbs down to a utilization of hi hours per day - will buy no SL18 bulbs in the first place. Therefore, a level playing field for conservation investments with supply expansion will leave the utility to shoulder the entire conservation effort. This implies for the example in Figure 1 that the utility has to install SL bulbs for the interval (h~, 24) instead of (hi, h0), because the consumers will minimize their own expenditures: ie h0 = 24 becomes optimal when the utility offers such a lighting programme. Hence this proposal of the DSM literature and of Lewis and Sappingtonll that the utility must upgrade inefficient equipment to a proper efficiency standard presumably creates tremendous costs for the utility, because rational consumers cease any individual conservation effort. In fact, very inefficient equipment (ie high energy waste) will draw the attention of the utility to do something about it. Of course, from a traditional welfare perspective one should not worry about the costs to the utility, because of the indifference whether the consumers or the utility pay for the efficiency enhancements. However, if we assume reasonably that consumers for the sake of the argument we acknowledge all documented shortcomings and irrationalities - have nevertheless some advantages concerning conservation (private information,13 conservation provided by additional inputs such as time), then substantial social waste due to DSM becomes likely because these efficient measures are deterred. Moreover, many utility conservation measures involve a duplication of capital: for example, still-functioning bulbs (or other kinds of equipment, washing machines, electric motors, etc) are replaced because of the conceived benefits of such a programme. The following proposition summarizes the conclusion from the above example and of the formal argument that is developed in the Appendix. Proposition Consider a price-cap-regulated utility that is committed to demand-side conservation programmes in the sense that it undertakes those DSM measures that are profitable; conservation may be profitable, if the price cap does not cover the marginal costs of supplying electricity. Consumers have a natural strategic advantage because they buy the equipment in the first place that subsequently becomes the target of the utility's conservation programme. This strategic advantage induces consumers to minimize their own expenses for efficiency, and they let the utility pay for (or at least subsidize) the upgrade, if DSM programmes are offered. UTILITIES POLICY April 1995
Strategic consumers' reactions to conservation incentives
This p r o p o s i t i o n states t h a t t h e u t i l i t y ' s i n t e n t i o n to i n c l u d e D S M in l e a s t - c o s t p l a n n i n g activities, w h i c h r e q u i r e s t h e m to b a l a n c e t h e loss f r o m selling t h e (last) k W h a g a i n s t t h e costs of c o n s e r v i n g a kWh, crowds out consumers' conservation intentions. T h e r e f o r e , t h e e x p e n s e s for p e r m a n e n t D S M will b e l a r g e r t h a n t h e t r a d i t i o n a l e v a l u a t i o n o f such p r o g r a m m e s r e v e a l s b e c a u s e c o n s u m e r s will in t h e long r u n r e t r a c t all t h e i r o w n ( a n d so far o b s e r v e d ) c o n s e r v a t i o n activities. This in t u r n will a g g r a v a t e ' a p p a r e n t ' m a r k e t failure, j u s t i f y i n g D S M t h r o u g h a self-fulfilling p r o p h e c y . I n the t e r m i n o l o g y o f t h e D S M l i t e r a t u r e , e v e r y b o d y will b e c o m e a ' f r e e r i d e r ' , at l e a s t to s o m e extent. This p r o b l e m o f freer i d i n g - all p a r t i c i p a n t s a r e r e w a r d e d i r r e s p e c t i v e o f w h e t h e r t h e i r i n v e s t m e n t has b e e n a c t u a l l y t r i g g e r e d ( e n t i r e l y , o r p a r t i a l l y ) b y t h e p r o g r a m m e - is p a r t i a l l y a c k n o w l e d g e d in t h e l i t e r a t u r e . In fact, f r e e - r i d i n g a l r e a d y a p p e a r s to b e s u b s t a n t i a l in t h o s e p r o g r a m m e s w h e r e d a t a a r e available.14,~5 T h e p e r m a n e n c e o f D S M p r o g r a m m e s will i n d u c e e v e r y c u s t o m e r to f r e e - r i d e o n t h e b a c k o f the u t i l i t y ' s c o n s e r v a t i o n p r o g r a m m e , a c c o r d i n g to the a b o v e a r g u m e n t . A l t h o u g h this r e s u l t is e s t a b l i s h e d in t h e A p p e n d i x for p r i c e - c a p r e g u l a t i o n a n d for full c o v e r a g e o f efficiency i m p r o v e m e n t s b y t h e utility, the precise regulatory constraints and incentives do n o t s e e m to b e crucial in t r i g g e r i n g t h e a d d r e s s e d strategic reaction by consumers. The reason seems simple. T h e k n o w l e d g e o f f i n a n c i a l i n c e n t i v e s for c o n s e r v a t i o n will l e a d to a s i t u a t i o n w h e r e e v e r y c o n s u m e r tries to r e c e i v e this s u b s i d y for e a c h ' c o n s e r v a t i o n ' effort, e v e n for t h o s e t h a t w o u l d h a v e b e e n u n d e r t a k e n in t h e a b s e n c e o f subsidies. A s a c o n s e q u e n c e , it a p p e a r s i m p o s s i b l e to assess t h e a m o u n t o f c o n s e r v a t i o n t h a t is a c t u a l l y t r i g g e r e d b y such p r o g r a m m e s .
Final critical remarks D S M p r o g r a m m e s , w h i c h try to c o r r e c t for m a r k e t failures ( p a r t i a l l y c r e a t e d b y t h e r e g u l a t o r s ) , i n t r o duce new distortions that encourage strategic c o n s u m e r b e h a v i o u r to m i n i m i z e t h e i r o w n c o n s e r v a t i o n efforts: e a c h c o n s u m e r tries to f r e e - r i d e o n t h e b a c k o f a u t i l i t y ' s c o n s e r v a t i o n p r o g r a m m e . This in t u r n a g g r a v a t e s a l r e a d y existing m a r k e t f a i l u r e s a n d t h e r e b y ' j u s t i f i e s ' D S M p r o g r a m m e s like a selffulfilling p r o p h e c y . S u r p r i s i n g l y , this s i m p l e c o n s e q u e n c e o f D S M p r o g r a m m e s has b e e n o v e r l o o k e d so far. This f i n d i n g suggests t h a t t h e e c o n o m i c p r o s p e c t s for t h e utility f r o m ( p e r m a n e n t ) D S M s h o u l d b e p o o r , b e c a u s e t h e utility e n d s up n o t o n l y f i n a n c i n g i n c r e m e n t a l b u t e n t i r e c o n s e r v a t i o n , o w i n g to t h e UTILITIES POLICY April 1995
s t r a t e g i c r e a c t i o n of c o n s u m e r s . T h e r e f o r e , o n e w o u l d e x p e c t t h a t utilities c o m m i t t h e m s e l v e s to n o DSM programme d e s p i t e the ( p r i m a facie) p r o f i t a b i l i t y of s o m e m e a s u r e s ) 5 Y e t c o n s e r v a t i o n p r o g r a m m e s a r e c a r r i e d o u t o n a w i d e scale in the U S A . This s e e m i n g c o n t r a d i c t i o n m a y d e p e n d o n the r e g u l a t o r y p r a c t i c e in t h e U S A : r a t e - o f - r e t u r n r e g u l a t i o n o f utilities, a n d r e g u l a t o r s ' bias for c o n s e r v a t i o n i n v e s t m e n t s o v e r i n v e s t m e n t s in s u p p l y c a p a c i t y . I n d e e d , Wir116 shows t h a t D S M m a y b e d u e to a r e g u l a t o r y bias a n d lacks e c o n o m i c efficiency. This criticism d o e s n o t i m p l y t h a t I o p p o s e e n e r g y c o n s e r v a t i o n , b u t r a t h e r t h e c o n t r a r y : the g o o d i n t e n t i o n s a n d in p a r t i c u l a r t h e o f t e n e s p o u s e d c l a i m t h a t c o n s e r v a t i o n is c h e a p a n d e v e n profitable17 m a y in the e n d h a r m t h e g o a l of c o n s e r v a t i o n . This n o t e suggests t h a t at l e a s t s o m e p r a c t i s e d D S M programmes encourage strategic and counterproductive consumers' reactions. Therefore, the emphasis on proper contracts and incentives must start with t h e c o n s u m e r - u t i l i t y r e a c t i o n : t h a t is, we s h o u l d l o o k for c o n t r a c t s t h a t can m i t i g a t e or e v e n solve t h e p r o b l e m a d d r e s s e d a b o v e .
~PG&E, Annual Summary Report on Demand Side Management Programs 1989, 1989; Central Maine Power Company, 1989 Energy Management report, 1990. zCbarles J Cicchetti and William W Hogan, 'Including unbundied demand side options in electric utility bidding programs', Public Utilities Fortnightly, 8 June 1989, pp 9-20. 3Franz Wirl, 'Analytics of demand-side conservation programs', Energy Systems & Policy, Vol 13, 1989, pp 285-300. 4David Moskovitz, Profits and Progress through Least-Cost Planning, National Association of Regulatory Utility Commissioners, Washington, DC, 1989. SNew York State Energy Research and Development Authority, 1990. 6paul L Joskow and Donald B Marron, 'What does a megawatt really cost? Evidence from utility conservation programs', The Energy Journal, Vol 13, No 4, 1992, pp 41-74. 7Tracey R Lewis and David E M Sappington, 'Incentives for conservation and quality improvement by public utilities', American Economic Review, Vol 82, 1992, pp 1321-1340. ~Of course, one should be very careful when calling individual choices of appliances irrational, because of the tangible costs (design, brand, inconvenience etc) that are associated with any kind of equipment, and because Hayek reminded us that '...an economic actor on average knows better the environment in which he is acting and the probable consequences of his actions than does an outsider, no matter how clever the outsider may be': von Friedrich Hayek, 'The use of knowledge in society', American Economic Review, Vol 35, 1945, pp 519-530. ~Jerry A Hausman, 'Individual discount rates and the purchase and utilization of energy-using durables', Bell Journal of Economics, Vol 10, 1979, pp 3354. 1°Of course, if they don't, no DSM programme is necessary, and moreover not each observed high implicit discount rate constitutes a market failure. ,Lewis and Sappington, op cit, ref 7. 121bid.
13This advantage of consumers on conservation is a cornerstone in the bidding proposal of Cicchetti and Hogan: op cit, ref 2. 111
Strategic c o n s u m e r s ' reactions to conservation incentives ~4New York State Energy Research and Development Agency, op cit, ref 5; Joskow and Marron, op cit, ref 6. ~SFranz Wirl, 'On the unprofitability of utility demand-side-conservation programs', Energy Economics, Vol 16, 1994, pp 46-53. 16Franz Wirl, 'Impact of regulation on demand side conservation programs', Journal of Regulatory Economics, Vol 7, 43-62, 1995. ~7Amory Lovins, 'Saving gigabucks with megawatts', Public Utilities Fortnightly, Vol 115, No 6, 1985, pp 19-26. 'sWirl, op cit, ref 15. ~gLewis and Sappington, op cit, ref 7. 2~'Ofcourse, the efficiency ",1 depends on the various attributes of a particular appliance - 'quality' - often in the sense that better
quality increases the energy requirements. This in turn blurs many engineering comparisons of the efficiency of equipment over the purchase price that led some to the conclusion that efficiency is a public good. However, higher efficiency cannot be free! 21This need not hold in general; see Wirl, op cit, ref 3, and the following discussion under the heading 'Consumers'. =The objective (A6) assumes a quasi-linear representation between the considered service s and all the other services and commodities demanded by a consumer: that is, a partial equilibrium framework. 23Wirl, op tit, ref 3.
Appendix A formal proof of the proposition The following formal a r g u m e n t is similar to that of Wirl, ~s except for a different service framework. W e consider a price-cap-regulated utility that is obliged to m e e t the associated electricity d e m a n d e. The function c(e) determines the corresponding production costs. The price cap, p, is set below the marginal costs of electricity, p
112
(A2)
The utility The objective of the utility is to choose a D S M p r o g r a m m e that the utility's profits are maximized. This conservation p r o g r a m m e improves efficiency by a magnitude dx~ over and above the consumer's choice -q~, which in turn affects electricity demand, e = E(+qc + A+q). The electricity d e m a n d depends only on efficiency because the price is assumed to be constant; moreover, we assume E'<021 and E " > 0 (reflecting the law of diminishing returns). The costs to the utility for improving efficiency are given by K(+qc + A~)-S(~c), where K denotes the costs to the utility in providing the final efficiency ~u = ~c + A-q, and S denotes the saving to the utility when the consumers have already invested in an efficiency TIc.These savings S(~qc), satisfy the inequalities O
(A3) optimization
(A4)
This equality simply expresses that the loss from selling an additional kWh (left-hand side in E q u a t i o n (A4)) must equal the costs of conserving the last kWh ( - K ' / E ' ) . This in turn justifies conservation only if c'>p. The assumptions ensure that the right-hand side E q u a t i o n (A4), the costs for conserving an additional kWh, increase. This states that conservation is particularly profitable in those households that choose highly inefficient appliances. The lefthand side E q u a t i o n (A4) declines, so that a solution of (A4), assumed to exist, is unique and depends only on the aggregate efficiency +qu. The solution of (A4) is superscripted by an asterisk, "qu*, so that the optimal utility conservation p r o g r a m m e A+q*, given the consumers' own efforts -% is given by: UTILITIES POLICY April 1995
Strategic c o n s u m e r s ' reactions to conservation incentives
~(.qc) = A~q. = { ~ u* - ~qc if ~u* -> "q~ ~= if lqu* < vl~
if u'e-F' (-q) from u'=F'/e
0.
(A8)
>
Hence ~' = -1 for interior solutions.
The game The consumers The representative consumer maximizes the surplus for services s, u(s), u'>0, u"
(A6)
subject to the technological constraints (A1), (A2). This optimization problem corresponds to the initial situation of no conservation programme. The function F(~q) measures the household's investment for an appliance with an efficiency vI. All investments are expressed in flows; for example, if s is measured in annual terms then F(~) represents the corresponding (subjective) annuity. Therefore, these outlays F account implicitly for individual characteristics like discounting and planning horizon and associated market failures, but also for informational advantages. In particular, the inequality F > K for some vI characterizes one of the much-addressed market failures. A standard marginal productivity condition describes the optimal electricity consumption of price-taking households: u' = P.
(AT)
One potential setting of this game is that the consumers have the first move (ie a Stackelberg equilibrium) so that the consumers first buy the efficiency "qc, knowing the utility's DSM programme. Although the consumers are price-takers (and so is, by the way, the utility owing to the assumption of price-cap regulation), their efforts affect their participation and potential gain from the conservation programme. Therefore, we consider a game where the consumers first choose their efficiency "qc and the associated electricity consumption, and the utility decides then on further conservation investments, A~I. In order to exclude trivial cases we assume active DSM: A~q>0. The electricity demand for a given and constant electricity price p depends solely on the efficiency of the equipment, and can be defined in the following way: E0q c + A~q) =arg max u [('qc + A~q)e] -pe,
Substitution of the optimal choice of electricity defined in (A9) into the consumer's objective (A6) leads to the indirect utility function v depending on efficiency: v ('qc + A-q)= max u [(~c + A-q)e] - p e - F ("qc) e
( ( ~ + A~q)E(~ -pe(~qc + A.q).
= u
First note that standard assumptions about u do not guarantee that conservation investments do indeed lower fuel consumption. In fact, energy conservation may increase energy consumption, but in any case falls short of the savings suggested by engineering efficiency comparisons. 23 The reason is that a higher efficiency ~q lowers the marginal costs of the service, p/'q, and thus the demand for the service s increases according to Equation (A7). The consumer's choice of the equipment ~¢ reflects either the boundary solution, -q=~, or follows from a usual marginal utility condition:
UTILITIES POLICY April 1995
E'<0. (A9)
e
+ A~]))
-F(-qc) (A10)
This definition (A10) reduces the consumer's decision to the choice of the efficiency "qc, which must account explicitly for the utility's reaction A~q=~(-q~). Furthermore, the consumer knows that the utility will always upgrade the efficiency to ~qu*, so that substitution of this response into (A10) yields v [Tic+B(xlc)] =u [(Xlu*)E(-qu*)] -F(vlc) -pe('qu*).
(A11)
Thus, the indirect utility function in (A1 l) is maximized at the boundary "qc = ~1, since F'>0.
113