The following is a contributed article by Kenneth W. Costello, a regulatory economist and independent consultant who has worked for the National Regulatory Research Institute, the Illinois Commerce Commission, Argonne National Laboratory and Commonwealth Edison.
Many analysts have deep concerns with utility energy-efficiency (EE) programs. These concerns — both theoretical and empirical in origin — are legitimate and warrant a revisiting of the justification for utility programs by state utility regulators.
The common perception is that these programs are a "free lunch" in producing benefits for energy consumers and society that far exceed their costs. Most recently, many supporters claim EE is the most cost-saving way to reduce carbon emissions — specifically, that by simultaneously reducing energy consumption and emissions, EE programs more than pay for themselves.
Yet these free lunches should seem suspicious to anyone. They do to many analysts, including myself, who have studied the benefits and costs of EE initiatives. If these efforts are such a good deal, then why must utilities subsidize EE?
I recommend that state utility regulators, at this juncture, seriously consider whether utility EE programs should continue in their present form, be scaled down, or even exist at all. Specifically, they should ask themselves the following four questions:
- Are the rationales for utility EE programs still valid today?
- How can consumers receive more benefits from the dollars expended to fund EE initiatives — i.e., what is the optimal allocation of funds to different EE initiatives to get the most "bang for the buck"?
- Should utilities scale up, scale down or terminate their EE programs?
- Are utilities providing objective, unbiased and accurate information on the benefits and costs of their EE programs?
My advice to regulators derives from a combination of economics theory, empirical evidence from peer-reviewed studies, and my personal research and observations.
I have seen the general acceptance of utility EE programs since the 1980s. There has been little pushback on these programs since that time, as the general perception is that they have produced large benefits relative to their costs.
Even though utility EE programs are still in vogue, regulators should ask the basic question of whether it is equitable and good public policy to compel utility customers to pay for EE programs.
Many of these initiatives benefit only a relatively few customers, most of whom can afford to pay for EE without any financial assistance. Besides, energy consumers are able to make rational decisions, just like they do when they invest in other activities.
One is therefore compelled to inquire: Why should utilities offer their customers subsidies and why should other customers bear the costs?
Six recommendations to regulators
My recommendations are as follows:
- Regulators should consider eliminating the EE programs, scale them down or redirect them to better address the market and behavioral problems that they are supposed to rectify. Economists have advocated that the best outside actions to improve market performance are those individually tailored to address specific market failures or consumer-behavioral problems such as insufficient information to consumers, myopia and faulty pricing. For utility EE programs, economic theory and common sense tell us that pinpointing initiatives on specific market and behavioral failures maximizes cost effectiveness; otherwise, we risk creating bad programs. Educational and information programs are more beneficial, for example, when consumers lack good information on the benefits of energy-efficiency investments, or when that information is difficult or time-consuming to acquire. It is commonplace for utility EE programs to not match a particular problem, and is one reason why regulators should question their efficacy.
- Regulators should look harder at EE initiatives funded by utility customers, rather than assuming that they are beneficial to energy consumers as a whole and in the public interest. Many existing EE programs may not actually be cost-effective today, even if they were in the past. Regulators should therefore ask whether utilities, especially gas utilities, should eliminate or downsize some of their EE programs. Rationales for EE programs are less convincing today than when they were first implemented, for various reasons: Consumers have better information on the benefits and costs of EE investments, natural gas prices have significantly dropped since 2008, the most cost-effective actions have already been exploited and, overall, market failures for EE have diminished over time. The fact that the market for EE has functioned well like most other markets, mitigates the need for utility intervention.
- Regulators should be aware that academic reviews of EE programs conclude that such programs are not the "low-hanging" fruit that many people believe. They show that utilities grossly overstate energy savings from many EE programs because they rely on engineering estimates that omit consumer behavior in using, say, their heating systems more intensively because of lower operating costs from a more energy-efficient technology. Studies also find "free riders" to be a common problem with EE programs. These are individuals who would have purchased energy efficient appliances or heating and air conditioning systems in the absence of utility EE programs. Their energy savings should, therefore, not count as benefits from a utility program. Studies also note that utilities often fail to consider "hidden costs" for consumers from the time and effort spent on both energy audits and investments. The combination of these factors, according to some academic studies, have led to utilities understating the true costs of EE programs by as much as 50% or more.
- Since utilities may exhibit bias behavior in evaluating their own EE programs and reporting the results to their regulators, regulators should require independent analysis by a third party because of the incentives of utilities to overstate the cost-effectiveness of their programs. Especially in those states where utilities have opportunities to profit from "good" programs, utilities would have an incentive to inflate the benefits of their programs. That should not come as a surprise since privately-owned utilities have a fiduciary obligation to their shareholders. The task of regulators, as for other utility activities, is to assure customers that utilities are not profiting at their expense.
- Regulators should distinguish between market barriers and market failures, which has implications for utility EE programs. It may be rational for some consumers to not invest in EE when at first sight it seems that they should. There are three major reasons for this behavior: (a) uncertainty and consumer risk aversion (accounting for an implicit high discount rate that diminishes future benefits), (b) heterogeneity (e.g., some customers use relatively small amounts of energy), and (c) omission of certain costs, like transaction costs (e.g., the time spent by households in searching for energy-efficient appliances). Studies have shown that these are real-world factors in consumers’ decisions on whether to invest in EE. Even though those who invest in energy-efficient technologies benefit, that should not infer that other consumers are depriving themselves of similar benefits. The latter group can face different conditions (e.g., low household energy use) that explain their hesitation to invest in those technologies. This is an example where outside-of-market intervention either by government or utilities with subsidies to accelerate the adoption of energy-efficient technologies would likely result in higher costs than benefits. While the recipients of the subsidies would benefit, the costs to the funders (e.g., utility ratepayers) plus the inefficiencies induced by the subsidies would cause this action to compromise the public interest.
- Since we pretty much know that markets are not perfect and consumers are not perfectly rational for almost any commodity or service they purchase — and generally we do not interfere in those markets from the outside to affect consumption — regulators should ask what makes the energy end-use market so different to warrant outside intervention. What evidence is there that utility consumers are leaving large amounts of dollars on the table by not investing in EE? After all, EE is the choice of consumers to use less energy in satisfying their energy-service demands (e.g., space and water heating). It involves the decision of energy consumers to invest money upfront to save on their energy bills over time. Before anything else, regulators should evaluate whether market imperfections, consumer-behavioral problems or, yes, even regulatory obstacles (e.g., pricing utility service below marginal cost during peak periods) are unduly discouraging consumers from investing in cost-beneficial EE.
Results count, not "happy talk"
I will end by recommending that regulators heed the words once made by a Nobel Prize-winning economist: "One of the great mistakes is to judge policies and programs by their intentions rather than their results."
No one disagrees that EE can be socially desirable, but only if the benefits exceed the costs. For many observers, EE programs transmit good feelings ("happy talk") about using less energy.
But for those programs that fail to pass muster from an economic efficiency and "fairness" perspective, regulators should terminate them — the sooner the better — for the good of the public interest.