Can California Ignore its Neighbors?

Today’s post is coauthored by Benjamin Hobbs from Johns Hopkins University

The U.S., almost alone among developed economies, has operated its power system as a collection of balkanized fiefdoms. Evidence from around the country, from work by Mansur and White , and ongoing work by Steven Cicala,  indicates that merging utility system operations can be a big win economically by reducing the amount of fuel burned, improving network utilization, and increasing reliability. A more efficient system makes it easier to fully use varying wind and solar power sources, and lowers the cost of reducing pollution from fossil plants, as the Obama administration hopes to do with its recently announced Clean Power Plan.

pca_outline

Too Many Cooks? United States Electric Control Areas Circa 1999. (source: Cicala, 2015).

This long and twisted road toward more rational operation of our regional electricity grid is now approaching a new milestone. The next major proposed step is full integration of both the day-ahead and real-time markets of the California Independent System Operator (ISO) with the areas operated by PacifiCorp.  Essentially, the California ISO market would expand to embrace power plants and consumers in five states. Such moves are really long overdue.

The ISO has already linked its market for “real-time” sales of electricity (up to approximately a half-hour ahead of when power is produced by power plants and used by consumers) with PacifiCorp.  This “energy imbalance market” (EIM) allows western utilities for the first time to transact power on a more real-time basis. A Nevada utility will EIMmapbe the next member of the EIM, and utilities in Washington and Arizona are considering joining.  However, only some of the benefits of coordination can be gained in the last few minutes before power is produced and used. Only about 5% of the ISO’s volume is scheduled in the fifteen minute-ahead and five minute “real-time” markets of the EIM. Many decisions about how to produce power–for instance from slow moving large fossil fueled plants–and how to use it–for example to change the timing of shifts at a factory–need to be made twenty four hours or more ahead of time.  Thus the logical next step is full integration of the day-ahead, hour-ahead, and real-time markets through an expanded ISO.

So why would California not jump at such an opportunity? There have been two concerns raised. One is that expanding the California ISO would require some sharing of governance and policy decisions with other states.   A second is that tighter integration would harm the environment by somehow making the west more hospitable for coal-based power plants. We’ll address this second concern first.

While it is true that the PacifiCorp system, and much of the western U.S., leans more heavily on coal generation than does California, it is hard to imagine a scenario where ISO expansion increases coal output and several ways in which expansion would likely expand the role of renewable energy.   To understand why this is, one needs to understand what ISO’s do differently than other electric systems.

Utility systems have been trading power, albeit inefficiently, without ISOs for quite some time. California has imported almost a third of its power for decades, a greater fraction than any other state. Without an ISO, however, those trades can be time consuming and difficult to put together, and are vulnerable to the whims of a large transmission owner who may not want to share its grid. ISOs, like California’s, can provide an unbiased, transparent, and timely allocation of transmission resources that was impossible to achieve in the old informal trading regimes.

That means that, in the old world, transactions tended to involve relatively large and stable sources of power in order to make it worth the hassle. Large coal plants, which usually run flat out, have been able to make deals in this kind of ad-hoc environment. Life, though, was more difficult for renewable resources, which are smaller and subject to the vagaries of nature. Renewable resources require “balancing” services to fill in the fluctuations of their output, and these are much easier (and usually cheaper) to acquire in an ISO environment.    In this way, ISOs help renewables compete more successfully against fossil-fueled plants, including coal plants.

A second reason to expect that ISO expansion would not drive an increase in coal output is that western coal plants are already heavily utilized. This is especially true for PacifiCorp. Environmental Protection Agency data show that PacifiCorp’s coal plants were producing at three-quarters or more of their capacity in 2012; this fraction is typical for coal plants that are producing all they can, accounting for downtimes for maintenance and mechanical breakdowns. Therefore, even if California utilities were eager to buy coal output (which they are not), there is little extra supply to be provided right now.

On the other hand, there will be a growing amount of renewable generation coming online as a result of policies in California and other western states. ISO expansion would smooth the way for this extra renewable energy to be marketed in currently coal-heavy states.   There are many times, mainly in the middle of the day when solar panels are producing at their maximums, when supply is so much in excess that prices are negative, and users are actually paid to consume power.   This is because other power plants have to be operated in very inefficient ways to ensure that supply and demand are balanced throughout the day. As California moves towards meeting its 33% renewable electricity goal by 2020, and likely works toward a 50% goal by 2030, such periods will become much more frequent.   Studies show that large amounts of wind and solar power will need to be “spilled” at such times—that is, such plants will be turned down and produce less than they could. Policy makers and the public are rightly concerned about this waste.

There are triple benefits to being able to more easily export this excess power.  First, it will actually lower costs for Californians by improving the efficiency of those other plants. Second, it will lower costs for other states because they can reduce output from their conventional plants. Third, air pollution and greenhouse gas emissions will go down because California plants will operate more efficiently while plants elsewhere will operate less.

One way to estimate the impact of California’s renewable policy on the climate is to look at the energy sources likely to be displaced by renewable energy. A series of papers by Erin Mansur, Stephen Holland, and others, has estimated the marginal source of electricity that responds to increases in demand (say for electric cars) in different regions. They break down this response for California and the rest of the west.

Using their data, one can see that, on the margin, changes in demand in California have very little impact on coal output anywhere in the west.  On average, about 5-10% of a change in California demand in the early morning and less than 1% during mid-day, is met by Coal.   This implies that as we increase our renewable output, we will be displacing increasingly more efficient natural gas plants. Unless something changes, with more integration, that renewable output can get us much more carbon bang for the buck elsewhere. In particular, in the rest of the west, between 20 and 40% of a marginal change in demand is met by coal-based units. Therefore, exporting our renewables to the west (or promoting the development of renewables outside of California) would be much more likely to displace coal generation, roughly doubling the reduction in CO2 emissions.  More studies addressing the specific impacts on CO2 emissions are likely coming.

In sum, we think there are many reasons to believe that expanding power markets will be good for renewable energy and will reduce costs to consumers.   Speculation that coal plant pollution might temporarily increase because of greater trade should not stand in the way of achieving these benefits. This is especially true because it is more likely that pollution will instead decrease in the near term, and because it is widely agreed that integrating markets is essential for achieving all the economic and environmental benefits of renewable energy in the long term as state and federal environmental policy move our power sector towards sustainability.

The other concern about ISO expansion is the fact that California would have to share some decision making with representatives from other states. This should be embraced as an opportunity, not used as a barrier. For one thing, it is important not to overstate California’s control over the CAISO. While it operates as a state-chartered non-profit corporation, the CAISO, like any other electricity system operator is ultimately answerable to the Federal Energy Regulatory Commission. Nor is state control a guarantee against problems. Recall that California went through an electricity crisis with its own state chartered Power Exchange and ISO.

Second, and most importantly, dealing with the energy and climate challenges that are facing us today requires that California and other western states work together.  Electricity flow doesn’t stop at state borders, and nor do greenhouse gasses. The U.S. EPA’s Clean Power Plan encourages States to coordinate their climate policies, but it can also create perverse incentives that could result in smaller carbon reductions and higher costs. Such a disappointing outcome can be avoided if western states work together.

Consider the alternative. In the long run, what is the benefit to the climate of California, alone, achieving emissions reductions through means that intentionally make our electric system run less efficiently, raises costs, and essentially wastes a portion of our zero-carbon renewable production? That is not a model that is likely to appeal to other states and countries. In many dimensions, there is a pressing need for state-level policy coordination and an expanded ISO would provide an institutional setting in which that can happen. Let’s hope provincial concerns don’t trump the potential for game-changing reforms of power markets and air pollution regulation.

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The Decline of Sloppy Electricity Rate Making

Back in the “good old days” most customers had no choice about how to buy electricity and a regulator’s life was pretty easy.  The utility needed sufficient revenue to cover its costs, but the regulator approving rates was mostly just deciding whose ox to gore.    How much should industrial customers cover versus commercial or residential customers?  Is a fixed charge fair to those who don’t consume much?  That sort of thing.

Of course, even back in the old days some customers had choices, particularly large industrial firms.  They could self-generate if the utility tried to charge them a price that was too high.  And if they hadn’t already set up shop in the utility’s territory or weren’t too invested in the area, they could take their demand elsewhere.  Regulators were pressured not to foist too much cost on the large customers who had an option to bypass the utility in whole or in part.  That showed up in rate design and, sometimes, in customer-specific arrangements.

CustSpecFixedCosts

For those customers, rates were set to reduce so-called “inefficient bypass,” which described when a customer would find an alternative supplier (or self-generation) that wasn’t actually lower cost than the utility, but offered a lower price.  Avoiding inefficient bypass meant the utility tried to keep customers for which it was the lowest-cost supplier by setting price close to that cost.

Luckily for utilities — and for the stress level of regulators — few customers had real bypass opportunities in those days, certainly not residential or small commercial customers.  But that luck has run out; technology is now making every customer a potential bypasser.

Rooftop solar panels are the leading bypass mechanism for small customers.  They make economic sense for the customer so long as the retail price of the kilowatt-hours crowded out by the solar generation is greater than the cost of solar electricity.  But, as I’ve discussed previously, they are only efficient for society if they lower the overall cost of supplying the electricity needed on the grid.  The gap between retail price and avoided cost opens the door for inefficient bypass.

And solar panels aren’t the only bypass news.   With low natural gas prices, combined heat and power (CHP) installations onsite can lower bills for some customers.   Fuel cell technology continues to advance, pushing closer to the retail cost of electricity.  Batteries can store power from the grid or from onsite generation at lower and lower costs, making it easier for customers to rely less on the grid or to choose when they want to rely on the grid.

spiral

Except for some very particular narrow applications, none of these technologies lowers total grid costs by as much as it lowers customer bills, which means bypass leaves the utility with a revenue shortfall.  The potential shortfall, and the need to then raise prices, and the resulting incentive for more bypass, has been dubbed “the utility death spiral.”

The drama, and implied visuals, of a utility spiraling into the abyss (exactly what? a power plant?) creates lots of excitement, but the phrase leads us away from the real issue.  No technology available today — or likely to be available for years to come — will lead more than a fraction of the customer base to fully cut the cord, and operate without the utility.   Decades from now, most customers will still want access to the grid, and will still need the utility.

Something is dying alright, just not the utility.  It’s the ability of regulators, utilities, and interest groups to push around revenue collection among customers without the customers pushing back.

  • Try to punish high-consuming households by raising their price many times above cost – as has been done in California for the last 15 years – and they will now install solar to reduce their grid purchases, undermining revenue collection.
  • Try to use “demand charges” that are based on a customer’s peak usage — regardless of whether its peak coincides with system peak — and soon they will be installing batteries to smooth their peak, but in many cases without helping to lower grid costs.
  • Try to raise retail rates for most customers in order to offer discount electricity to low-income households and the high-price customers will turn to all forms of distributed generation instead of subsidizing the poor.
  • Try to stick commercial and industrial customers with more of the utility costs and they will invest in CHP and other onsite technologies.
  • Try to encourage demand shifting to off peak with exaggerated peak-period prices during all summer weekdays and the customer will use batteries to shift not just on the hottest high-demand days, but also on days when there is no benefit to society, though still an arbitrage play for the customer.

Smart Meter

You may agree with the equity goals behind some rate design choices and may disagree with others.  That’s not the point.  The point is that technology is making it ever easier for customers to respond to prices, and to arbitrage between price differences.  That’s great news when those prices and price differences reflect real cost impacts, because customers can respond to efficient cost-based prices with efficient actions.  But when the prices don’t reflect costs, customers are still going to respond, and that will undermine system efficiency.

That means that the flexibility regulators have had in designing retail rates to pursue other goals – whether helping the poor, subsidizing grid-scale renewables, paying for energy efficiency programs, or just keeping rate design “simple” – is going to come under increasing pressure by market participants ready to exploit any price wedge, whether it is based on a real cost differential or not.

Economists have for years argued that utility rate design should follow cost causation principles, because departures from cost will lead to inefficient customer response.  Regulators have often paid little heed largely because the inefficiency was small when customer ability to respond was limited.  That left regulators a free hand to harness rates for pursuit of other policy agendas.

7375c0916emostat_jpg

Distributed generation, storage, electric vehicle charging, and smart customer-side usage technologies (think controllable communicating thermostats) mean that the inefficiencies from sloppy rate design – prices that depart substantially from cost – will be magnified.

But the flip side is that the opportunity to incent efficient customer-side participation in the market with smart rate design is greater than ever.  And that opportunity will grow exponentially in the next few years as we see continued improvement in generation technologies, batteries, and sensors that can control a panoply of household activities.  Accurate cost-based pricing can not only lower costs, but can also use customer-side participation to gain the flexibility that will be required to integrate more wind and solar power.

The pressures to align utility rates with costs are only going to increase.  Here’s hoping regulators will harness these changes to reduce total system costs and smooth the integration of intermittent generation.

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Why the Pope is Wrong on Markets

On a recent speaking engagement in Germany I ran into Prof. John Schellnhuber, who was pope francison his way to the Vatican to present Pope Francis’ major coming out document on climate change. After I got over feeling oh so cool for being one degree of Kevin Bacon removed from one of the most powerful figures in the world, I did my homework and read the Laudato Si, which carries the subtitle “On care for our common home”. This is a well researched position paper which touches on a variety of topics and makes it very clear that the pope cares much more about distributional issues than the average economist. This is not difficult as we are too often obsessed with efficiency (maximizing the size of the pie) rather than equity (who gets what size slice). Even though I am a Bavarian protestant married to a lovely South African Jewish lady, I have been a big fan of Pope Francis until I got to point 190 in the Laudato Si:

“it should always be kept in mind that “environmental protection cannot be assured solely on the basis of financial calculations of costs and benefits. The environment is one of those goods that cannot be adequately safeguarded or promoted by market forces”. […] Once more, we need to reject a magical conception of the market, which would suggest that problems can be solved simply by an increase in the profits of companies or individuals. Is it realistic to hope that those who are obsessed with maximizing profits will stop to reflect on the environmental damage which they will leave behind for future generations?”

I went and sat in front of a wall and meditated on this statement for a little while (yes, my mom tried to make a Zen monk out of me). I agree with some of this sentiment. It is clear that profit/utility maximization has led to much of the environmental conundrum we find ourselves in. In a perfect world, firms pay for the full costs of their activities (which we call social cost of production). Consumers then only buy the product if these costs are at most as large as their willingness to pay for the good. If firms don’t have to pay for the full cost of their production (e.g. they get to use the atmosphere as a free dumping ground for greenhouse gases) the cost of production is artificially low and consumers buy more than they should at artificially low prices. Does this happen? Well yes! Most places in the world do not charge firms for their carbon emissions. California, Europe, parts of Canada are some noteworthy exceptions, though even in these places the price is well below the environmental cost of the emissions. Most Chinese firms, for example do not currently pay for their use of the atmosphere. Neither do India’s, Japan’s, Australia’s…. This leads to an overproduction of greenhouse gases.

decadal-with-forcing-small

Is the optimal level of greenhouse gas emissions zero? The economist’s answer is a clear no. We derive great benefits from the combustion of fossil fuels. Light to read, heat to cook, gasoline combustion for transport. But is the price of fossil fuels too low? Nearly everywhere, the answer is yes.

The clear answer to fix this is to put a price on carbon, which makes producers (and in turn consumers) pay for the full cost of their use of the atmosphere. This ain’t rocket science. My undergrads get this. President Obama gets this. In fact, Michael Greenstone – one of the most prominent environmental economists in the world and frequent EI visitor – led a federal working group to determine what the social cost of carbon is. The answer he and his coauthors came up with is approximately $40. What this means is that we should be adding approximately $40 to each ton of CO2 produced. This would raise the price of gas by roughly 40 cents per gallon.

The two ways economists argue one does this is by either charging a carbon tax or putting in place a cap and trade system. The word tax is political suicide, so we are most optimistic about the prospects of cap and trade. What you do is you issue a permit for each ton of CO2 and let firms trade these permits. This has been shown to be quite effective at reaching a prescribed amount of pollution reduction. At least cost. The trick is to issue just enough permits, so the price in the market reflects the social cost of carbon. Most economists are on board with this. It’s a Nobel worthy idea.

Well, the Pope does not agree.

“The strategy of buying and selling “carbon credits” can lead to a new form of speculation which would not help reduce the emission of polluting gases worldwide. This system seems to provide a quick and easy solution under the guise of a certain commitment to the environment, but in no way does it allow for the radical change which present circumstances require. Rather, it may simply become a ploy which permits maintaining the excessive consumption of some countries and sectors.”

And I just don’t agree with Pope Francis. I think this hostility towards market-based instruments comes from three possible lines of thought:

  1. Imperfect markets are the source of the current dire state of the environment, hence why would we use markets as a fix?
  2. There was evidence of some fraud in the ETS, showing that these markets are subject to manipulation.
  3. There is no way a cap and trade market will get us to 80% emissions reductions by 2050. You just have to tell people what to do. Command and control is better at that.

My response to 1) is simple. The reason the environment is in such bad shape is that some markets fail. We teach this to undergraduates as they walk through the door. You can use cap and trade markets to fix market failures! This is what they are designed to do. Markets to fix markets! We sometimes use dynamite to extinguish bad fires! The response to 2) is simple. Yes. Markets can be manipulated. But we learn and design better more foolproof instruments over time. No regulation is perfect. My response to 3) is that standards are expensive, provide little incentive for technological innovation and are a pain to enforce. Don’t get me wrong. Emissions trading is not the only policy we should engage in. I am strongly in favor of significantly subsidizing R&D for example.

What I wish the pope would have said is that market failures are the source of environmental degradation and we need to do everything we can to fix this. Our own governor Jerry Brown, who left a catholic seminary after three years to study classics at Berkeley is a staunch supporter of cap and trade.

So I would humbly ask Pope Francis to leave it up to science not faith to help us figure out how to fix the biggest environmental market failure mankind has faced in its history.

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If Someone Replaced Your Car with a Prius, Would You Drive More?

Source: Caranddriver.com

Most of us drive cars that are less fuel efficient than a Prius, but this is likely to change over the next decade as the new Corporate Average Fuel Economy (CAFE) standards are phased in. Regulators project that these new standards will increase the average fuel economy of new vehicles to 39 miles per gallon (MPG) by 2025, compared to 26 MPG in 2010. A new Prius C is rated at 46 MPG on the highway.

While the Clean Power Plan has been getting a lot of attention this past week, the new CAFE standards are another major component of the Obama Administration’s climate action plan. Increased vehicle fuel efficiency could account for nearly the same reductions in GHG emissions as the Clean Power Plan.

There is a lot of guesswork involved in coming up with the projected reductions in GHG’s achieved by the new CAFE regulations. Some of it involves estimating how much people will drive as they buy more fuel-efficient vehicles.

One factor is what’s known at the “rebound effect”: as cars get more fuel efficient, the price of driving a mile goes down. Economists project that a price reduction will lead people to consume more, which in this context means they will drive their fuel-efficient cars more. Regulators estimate that they will drive about 10% more.

I’m not sure this effect would hold in my family, though.

We rented a Prius one summer vacation in Maine. The back roads of Maine can be fun to drive, as they are built over the landscape and not through it, so they twist and turn over the rocky countryside. There’s an aptly named “thrill hill” near our vacation spot that leaves your stomach in your mouth better than most roller coasters.

A Prius in Maine?

A Prius in Maine?

My husband – who prides himself on being an “aggressive” driver – taught my kids some new adjectives to modify “engine” the summer we had the Prius. One was “lawn-mower” and the rest aren’t printable. Uncharacteristically in our family, he let me drive for some of the longer trips.

“Prius” has now become synonymous with “wimpy” in my household, as in, “Mom, why didn’t you pull out in front of that car? It’s a Prius.”

It’s not as though my husband goes out joyriding, but I would guess that if a Prius magically showed up to replace his higher horsepower car, there would be a couple instances each month where he would opt to carpool or ride his bike to work where he wouldn’t have otherwise.

Is this Monster Prius photoshopped?

Is this Monster Prius photoshopped?

A recent paper by Jeremy West, Mark Hoekstra, Jonathan Meer and Steve Puller (WHMP) suggests that my husband is not alone. It finds that higher fuel-efficiency cars similarly turn off other drivers. Counter to the predictions of the rebound effect, they find that drivers who were nudged into more fuel efficient cars by the Cash for Clunkers program end up driving if anything less than similar new-car owners who bought less efficient cars.

As WHMP point out, fuel efficiency is correlated with other vehicle attributes that drivers tend to dislike, including lower weight, which recent papers (see here and here) confirm is not good for occupants in an accident, and lower horsepower, which makes it harder to accelerate enough to get thrill-hill bumps.

As an aside, the authors use a clever empirical strategy to show that more fuel-efficient cars led people to drive less. The difficulty is that most people buy cars anticipating how much they are likely to drive. So, just looking at the raw correlation between the fuel efficiency of a new car and the number of miles it is subsequently driven may wildly over-state the rebound effect if people who know they have long commutes purposely buy fuel efficient cars.

WHMP look at Texans in the year following the Cash for Clunkers program, which gave large incentives to households that turned in a clunker – defined as a car that got less than 18 MPG – as long as they replaced it with something considerably more fuel efficient. WHMP compare two groups of new car purchasers – those who were barely eligible for the program because their old car was 18 MPG and those who barely missed being eligible because their old car was 19 MPG. The households with 18 MPG clunkers bought new cars that were more fuel efficient (plus smaller and less powerful), while the households who just missed being eligible did not get nudged into fuel-efficient cars, so they serve as a kind of control group. Other than the fact that one group is eligible for the program and the other isn’t, the two groups of households are very similar.

WHMP’s findings do not mean that the rebound effect is wrong – it’s just misapplied in this case. A pure rebound effect describes changes in the energy efficiency of a good, but leaves all other attributes unchanged.

Similarly, some people are quick to differentiate energy efficiency from energy conservation. Ideally, an energy efficiency investment leaves everything else unchanged, and simply reduces the energy consumed to perform a particular function, like driving a mile.

If WHMP’s result holds as the CAFE standards nudge more of us into fuel-efficient cars (at least given the current fleet), this will be good news for reducing greenhouse gas emissions. They don’t report an implied increase in savings, but, roughly, I would guess they’d be about 10% higher if the current estimates embed a 10% increase in driving.

While good news for the climate, this result is bad news for drivers like my husband who dislike driving less powerful cars. In econ-speak, there is lost welfare as people are pushed into cars they don’t like. That’s OK – solving the climate crisis is bound to involve some sacrifices, but we should aim to select regulations that minimize what people have to forego.

On this dimension, both CAFE and the Clean Power Plan are lacking. Both are examples of standards, which are a form of what’s known as “command and control” regulation. An ideal regulation would put a price on GHG emissions, either explicitly with a carbon tax or implicitly through a cap-and-trade program. Then, people and firms would make decisions appropriately embedding the damage they are imposing on the climate. (Note, however, that one compliance option under the Clean Power Plan is for states to join a cap-and-trade program.)

IMG_0067Regulation with standards may be the only device remaining in the Obama Administration’s climate tool chest given the political environment (e.g., the Senate’s failure to pass climate legislation in 2010), but the approach is necessarily worse. Figuring out how much worse is difficult, as WHMP’s paper points out. It involves estimating things like how people are driving in cars subject to the regulations and how much worse off they are. It’s important to keep these kinds of unintended consequences in mind, even if they hard to quantify.

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What We Can Learn from Germany’s Windy, Sunny Electric Grid

Today’s release of the final Clean Power Plan by President Obama ushers in an exciting period of change on US power grids. Wind and solar energy will get a big boost through the plan. The plan recognizes that to sustain public support for this strategy, the costs of integrating the new technologies need to be kept down and the grid needs to remain reliable. Several revisions to the draft plan were made specifically to provide time and flexibility to ensure the lights stay on while more clean energy sources join the grid. An important accommodation is carefully phasing in targets.

Much of the US and many countries rely on wholesale markets to help manage electric grids. It’s a good strategy. Well-designed markets can maintain reliability while also keeping costs down. However, policymakers and regulators are faced with a bewildering number of choices to ensure these markets function well.

Fortunately, the US can look to Germany. In Germany, wind and solar already represent 43% of installed generating capacity. While the US is at a modest 7%, some regions are approaching 20% (see graph). The Energy Information Administration projects that under the Clean Power Plan, US-wide wind and solar penetration could reach an overall average of 22% by 2030. Again, though, this masks significant regional variation.

SOURCE: Energy Information Administration (EIA) Electric Power Monthly, June 2015; EIA, Analysis of the Impacts of the Clean Power Plan (2015); Fraunhofer.

SOURCE: Energy Information Administration (EIA) Electric Power Monthly, June 2015; EIA, Analysis of the Impacts of the Clean Power Plan (2015); Fraunhofer.

As Max discussed in a recent blog, Germany is also phasing out nuclear energy and accelerating coal’s exit.

German policymakers need to know that with these changes its market will work harmoniously into the future — maintaining reliability and keeping costs reasonable. Fossil fuel power plant owners see problems on the horizon. German energy policies are pushing down wholesale energy prices and could potentially cause fossil fuel power plants to go out of business. As a result, the country could experience shortages and blackouts, say the fossil fuel plant owners.

Concerns about the future have prompted the Germans to review their wholesale markets. American and German policymakers shared their perspectives on this important topic at a recent joint US-Germany Electricity Market Design Workshop held in Berlin, Germany. With support from the US Department of State, I attended the event, which was co-hosted by the German Ministry of Economic Affairs and Energy and the U.S. Departments of State and Energy.

Germany’s electricity market is currently structured as what’s referred to as an “energy-only “ market. In an energy-only market, power plants earn revenues primarily by selling energy. The German government is evaluating whether they should create an additional market, referred to as a “capacity market”.

Power market concepts can be a bit peculiar, so let me try to describe the capacity market concept with an analogy.

Think about milk before the era of affordable refrigeration. Buying energy is like buying milk. You buy it when you need it, perhaps by getting daily deliveries from the milkman. Buying capacity is like buying a cow. When you want milk, your cow can provide it. Except the cow’s milk production doesn’t exactly line up with your needs. You need to buy enough cows to make sure everyone in your family has enough milk for their breakfast cereal. When you have extra milk, hopefully you can find someone to sell it to. Otherwise it spoils. If all your neighbors are selling milk at the same time, you won’t get much for it.

A power market that compensates power plants for energy and capacity is like having consumers pay for milk and also pay an extra amount to sustain the herd of cows. They aren’t your cows, but you happily pay knowing the cows are out there somewhere. When you or anyone else needs milk, these herds of cows are supposed to make it.

SOURCE: "Wb deichh drei kuhs" by Dirk Ingo Franke - Own work. Licensed under CC BY-SA 2.0 de via Wikimedia Commons - https://commons.wikimedia.org/wiki/File:Wb_deichh_drei_kuhs.jpg#/media/File:Wb_deichh_drei_kuhs.jpg

SOURCE: “Wb deichh drei kuhs” by Dirk Ingo Franke – Own work. Licensed under CC BY-SA 2.0 de via Wikimedia Commons – https://commons.wikimedia.org/wiki/File:Wb_deichh_drei_kuhs.jpg#/media/File:Wb_deichh_drei_kuhs.jpg

On July 3rd the German Ministry of Economic Affairs and Energy completed its deliberations with the release of its White Paper. So far the paper has only been released in German, but an English-language summary is here and the predecessor Green Paper is here.

The Ministry has concluded that a slightly reformed energy-only market—what they are calling electricity market 2.0—will serve the country into the future. The new market reforms will enter legislation in the Fall and reforms will be implemented in 2016.

The Ministry does not buy into the narrative that fossil fuel plants need to be compensated through a capacity market to ensure grid reliability. The Ministry sees other ways to ensure reliability, such as by increasing links to neighboring countries. This would allow Germany and its neighbors to benefit from differences in demand and supply between countries.

The Ministry is also recommitting to not impose explicit or implicit price caps in the energy markets. Flexible power plants can earn revenues by selling energy if prices spike as wind and solar ramp up and down.

How will we know if the Germans made the “right” choice? Ideally, we could run an experiment with multiple Germanys, implement a capacity market in one Germany, but not the other. Maybe we should designate the recently discovered earth-like Kepler-452b for economics experiments like this!

Until NASA takes up my proposal, we’re stuck in the world of observation, theory, and conjecture.

As the German experience unfolds, policymakers in markets such as the US should take a hard look at their own markets. Should capacity market structures be introduced, as was recently debated in Texas? Or should price caps continue to be raised, as the US Federal Energy Regulatory Commission has been urging? Should markets be kept local as in Texas or better integrated with their neighbors, as is beginning to happen in California?

We should continue to keep an eye on Germany.

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Membership has its Co-benefits

Last week marked the first “informal ministerial consultations” in the run up to the UN climate talks in December. The objective of these informal meetings before The Meeting is to provide the opportunity to find common ground and an organizing framework for what the UN Climate Chief is ominously calling the “last chance for a meaningful agreement”.

Two decades worth of efforts to broker a binding global climate change treaty from the top down have largely failed. But hope springs eternal, and there is belief that a more “bottom up” approach which allows countries to define their own contributions will break the impasse.  Each country has been asked to submit a self-determined national “intention” to curb its greenhouse gas emissions. These pledges will provide the foundation for any climate deal reached in Paris.

tree

Every time a country registers a pledge, this UNFCC tree sprouts a new green leaf  linked to the plan. As of today, 20 pledges have been submitted.

The prospects for free-riding make this process particularly daunting.  As Gernot Wagner and Marty Weitzman note in their recent book:

“Why act, if your actions cost you more than they benefit you personally? Total benefits of your actions may outweigh costs. Yet the benefits get spread across seven billion others, while you incur the full costs. The same logic holds for everybody else. Too few are going to do what is in the common interest. Everyone else free-rides.”

In other words, why would a country voluntarily commit to making significant, costly reductions in domestic greenhouse gas emissions (GHGs)?

Last week, I saw a paper presented by Ian Parry at a summer gathering of environmental economists that suggests this free riding problem might not be quite as dire as it appears. The jumping off point is that reducing the use of GHG producing fuels can generate domestic co-benefits for the countries that undertake them (such as improvements in local air quality or reduced traffic congestion). These authors set out to quantify these environmental co-benefits by country and evaluate the possible implications for GHG emissions. In my mind, the paper’s findings strengthen the pragmatic case for the new “bottom up” approach to global climate change mitigation.

Climate change policy from the bottom up

At the heart of the new approach to climate change negotiations is a new climate change acronym:  Intended Nationally Determined Contributions (INDCs). These national pledges describe steps that countries intend to take to reduce their GHG emissions. Countries have tremendous flexibility in drafting these plans.  They can pledge to cut emissions by a lot – or a little. Commitments can be binding – or voluntary.  The idea is to let countries decide what they are willing and able to contribute to this global effort and take it from there.

The figure below, taken from a special IEA report on climate change, projects the emissions associated with the climate pledges countries have already declared. This INDC trajectory (in blue) is contrasted with a “450 scenario” (in green) that would achieve the widely accepted target of limiting global warming to 2 degrees Celsius, or 450 parts per million of CO2 equivalent in the atmosphere.

INDC

The gap between the blue and green line is downright depressing. Although the INDC scenario could improve as more countries sign on, even Al Gore acknowledges that these INDC pledges will fall short of the critical target.

But the glass half full (or at least not empty) view is that these initial pledges are the sign of meaningful global cooperation taking hold.  Ultimately, the success of an approach that relies on voluntary contributions will depend on whether countries find the political will to engage in this global effort and pursue significant GHG emissions reductions. Co-benefits could provide a leg up in this regard.

Membership (in the global climate change mitigation club) has its co-benefits

When a country takes steps to reduce GHG emissions benefits beyond climate change mitigation often result.  Domestic “co-benefits” of GHG reductions include, for example, reductions in the number of deaths caused by air pollutants that are emitted along with CO2 when fossil fuels are burned, and reductions in congestion, accidents, and other externalities from motor vehicle use.

The paper I saw last week calculates the domestic co-benefits of pricing of carbon dioxide emissions for the top twenty emitting countries that are responsible for about 80 percent of global CO2 emissions.  Using country-level estimates of (non-CO2) environmental damages by fossil fuel from this study, together with fuel price data and fuel tax/subsidy information,  the researchers derive efficient CO2 prices that reflect domestic (non-internalized) environmental benefits and costs:

tax

The figure summarizes the nationally efficient carbon prices that reflect domestic co-benefits excluding climate benefits.  The average (emissions weighted) price is remarkably high: $57/ton CO2. This exceeds the current, mid-range estimates of global climate-change damages per ton CO2.

The graph also shows how prices vary dramatically across countries. Some of this variation reflects differences in the extent to which fuels are subsidized/taxed across countries.  The extremely high prices in Saudi Arabia and Iran, for example, are largely due to large subsidies on transportation fuels and natural gas. The analysis assumes that these subsidies remain, and that the carbon tax works to offset the subsidy. The negative tax in Brazil reflects the fact that the existing fuel taxes exceed the author’s calculations of non-carbon external costs per unit of fuel use.

To put these tax estimates in perspective, the authors ask: How would CO2 emissions change if these nationally efficient carbon taxes were implemented?  The figure below summarizes emissions reductions estimates for each country (relative to the 2010 emissions that were actually observed).

emi

Across all 20 countries, the authors estimate a 14 percent reduction in 2010 emissions. The majority of emissions reductions come from reduction in coal consumption. In  countries where the tax effectively offsets transportation fuel subsidies, reductions in diesel and gasoline play a larger role.

These numerical results are, of course, sensitive to some of the underlying (and sometimes uncertain) assumptions that are documented in the paper.  Qualitatively, the take away is that domestic co-benefits from climate change mitigation appear to be significant on average and highly variable across countries.

Boosting local motivation for global cooperation

The mere existence of co-benefits need not imply that countries will implement climate policies to pursue them. There are political constraints, distributional concerns, and other considerations that help explain why most countries have neglected to address domestic externality problems and other distortions in the first place.  These constraints will presumably limit a government’s ability to reduce greenhouse gas emissions via a carbon tax or other means

But large co-benefits can make it easier for countries to drum up support for pursuing reductions in domestic GHGs among a wide range of domestic actors, not all of whom are motivated by the spirit of global cooperation or the will to lead. Here at home, President Obama introduced the proposed Clean Power Plan, the centerpiece of his Climate Action Plan, in the asthma ward of a Children’s hospital.  Health co-benefits from reductions in local air pollution, including avoided asthma attacks, were estimated to yield approximately 60 percent of the gross benefits under the proposed Clean Power Plan. China offers another example of a country where concerns about air pollution are accelerating action on climate change (and vice versa).

Many economists will cringe at the thought of using climate change policies to address other unpriced externality problems. This is not the ideal, first-best path forward. Climate change policy is an indirect tool for addressing related but different problems of air pollution, traffic congestion, etc.  However, until efficient corrective policies are implemented, countries can and should consider these co-benefits in the design and implementation of climate change policy. This will help to mitigate domestic damages associated with the burning of fossil fuels at home while greasing the wheels of the global response to climate change in Paris and beyond.

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Are Clean Energy Tax Credits Equitable?

A new Energy Institute working paper finds that income tax credits for weatherization, solar panels, hybrids, and electric cars go predominantly to higher-income households.

Over the last decade, U.S. households have received more than $18 billion in federal income tax credits for weatherizing their homes, installing solar panels, buying electric vehicles, and other clean energy investments. In a new EI@Haas working paper, available here, Severin Borenstein and I use tax return data from the IRS to examine the socioeconomic characteristics of filers who receive these credits.

1040

We first examine a set of income tax credits aimed at residential investments in energy-efficiency and renewables. Between 2006 and 2012 the largest categories of investments were energy-efficient windows ($4.0 billion), qualified furnaces ($2.4 billion), qualified air conditioners and water heaters ($2.4 billion), ceiling and wall insulation ($2.0 billion), and solar photovoltaic systems ($1.8 billion).

The figure below shows how use of these credits varies across income levels. We divided tax filers into six categories based on their Adjusted Gross Income (AGI). The first five categories are approximately quintiles, and then the last category ($200,000+) includes about 3% of returns.

Income Tax Credits for Clean Energy Residential Investments
Average Credit per Tax Return, By Income Level

recs

The figure shows a strong positive correlation with income. Filers with less than $40,000 in AGI receive less than $10 in credits on average per tax return. The average credit amount more than doubles for filers with $40,000-$75,000 and then doubles again for filers with $75,000-$200,000 in AGI. Finally credits reach $80 per return for filers with AGI above $200,000. The figure above also plots 95 percent confidence intervals, though they are barely visible except for in the highest income category.

Another significant tax credit is the Alternative Motor Vehicle Credit, which provided a credit for hybrid vehicles until 2010 and continues to provide credits for natural gas, hydrogen, and fuel cell vehicles. As the figure below shows, this credit exhibits the same strong positive correlation with income. The bottom three income quintiles receive about 10% of all credits, while the fourth and fifth quintiles receive about 30% and 60%, respectively.

Alternative Motor Vehicle Credit
Average Credit per Tax Return, By Income Level

amv

Finally, we looked at the Qualified Plug-in Electric Drive Motor Vehicle Credit, an income tax credit for electric and plug-in hybrid vehicles. The size of this credit ranges from $2,500 to $7,500 depending on the battery capacity of the vehicle. For example, the Toyota Prius plug-in hybrid qualifies for a $2,500 credit whereas the Chevrolet Volt qualifies for a $7,500 credit.

We find that this credit is considerably more concentrated in the highest income categories. As shown in the figure below, filers with less than $75,000 in AGI rarely claim the electric vehicle credit. The average credit amount jumps considerably in the $75,000-$200,000 category and then soars in the top AGI category ($200,000+).

Electric Vehicle Credit
Average Credit per Tax Return, By Income Level

ev

Thus overall, we find that filers with AGI in excess of $75,000 receive about 60% of the tax credits aimed at energy-efficiency, residential solar, and hybrid vehicles, and about 90% of the tax credit aimed at electric cars.

We find that tax credits are less attractive on distributional grounds than pricing GHGs directly. Previous studies (here and here) have examined how a carbon tax or cap-and-trade program would impact households with different income levels. Whereas tax credits go disproportionately to high-income households, a carbon tax would be paid disproportionately by high-income households. It would seem difficult, therefore, to argue for tax credits on distributional grounds.

Our data come from individual income tax returns, so they miss tax credits received for electric vehicles and solar panels that are leased. Leasing has grown more common in both markets, though especially in the solar market with the well-documented move toward third-party ownership. However, previous research finds that the decision to lease is uncorrelated or even slightly positively correlated with income, so leasing is unlikely to undo the pronounced positive correlation between credits and income.

solarpic

Why are these tax credits so concentrated among the higher income categories?

Part of the explanation is that all of these credits are non-refundable. You can use these credits to offset your tax bill, but you cannot go negative and receive a net payment from the IRS like you can with the Earned Income Tax Credit and many other tax credits. This is a significant distinction because a large fraction of filers do not have positive tax liability. In 2012, for example, more than one-third of U.S. tax returns had zero tax liability. These filers without tax liability tend to be lower-income, so this helps explain the low take-up in lower income categories. Making these credits non-refundable doesn’t make much sense. After all, what is the real difference between a filer who owes $0 in tax and another who owes $1000?  Both reduce carbon emissions when they install an energy-efficient window. Both stimulate innovation when they purchase an electric vehicle. So it seems odd to treat these filers so differently in our tax code.

Another issue is that renters are ineligible for most of these credits. Over 40 million American households are renters, and thus cannot take advantage of any of the credits aimed at weatherization, energy-efficiency, or solar PV. Addressing renters is challenging because of imperfect information and split incentives, but excluding this sector altogether misses a large share of the housing stock. The proportion of households that own a home increases steadily across income quintiles from 0.49 to 0.91 (here),  so excluding renters disproportionally impacts lower-income households.

With the electric vehicle credit there are also a couple of additional potential explanations. It may simply be that, for the moment, electric vehicles are only affordable for relatively high-income households. Even after the credit, electric and plug-in electric vehicles are expensive compared to equivalently-sized gasoline-powered vehicles. Finally, another possible explanation is that in California, electric vehicles owners are allowed to drive in high-occupancy vehicle lanes. The value of time is highly correlated with income so this could help explain why this credit is so highly concentrated in the highest income categories.

window

So what? Should we scrap these tax credits? Should we expand them to include more Americans? Ultimately, in evaluating tax credits or any public policy it makes sense to think about both equity and efficiency. Our new paper is mostly about equity, and the results imply that it probably does not make sense to argue for these tax credits on distributional grounds.

What about efficiency?  Although tax credits may initially seem like a good idea, they are actually quite a poor substitute for first-best policies like a carbon tax or cap-and-trade program.  Probably the single biggest limitation of a tax credit is that it cannot achieve the efficient level of usage. Take energy-efficient windows as an example.  A tax credit can encourage households to install better windows, but it cannot get households to use less heating and air-conditioning. A carbon tax, in contrast, would encourage households both to install better windows and to use less heating and air-conditioning.

Tax credits are also extremely coarse instruments. The social benefits from clean energy investments vary enormously by geography. For example, a new paper by Stephen Holland, Erin Mansur, Nick Muller and Andrew Yates finds that the environmental benefits from electric cars varies from $3000 in California (where most electricity comes from natural gas and renewables) to -$4700 in North Dakota (where most electricity comes from coal). Tax credits ignore this heterogeneity completely, whereas price-based policies would incorporate these differences.

In the end, it is hard not to be somewhat disappointed. The more we have studied these tax credits, the more we realize their limitations.  There are large potential social benefits from clean energy investments, but income tax credits are an inefficient instrument for realizing changes in behavior. Moreover, the distributional impacts are a real concern. Through several key features of the tax code, we have set up these credits in a way which excludes millions of Americans from participating, and higher-income households receive the lion’s share of total credit dollars.

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Hawai’i – The Next Frontier

hawaiian sunset

Aloha, dear readers. It’s quiet at the Energy Institute as most of us are out in the field. I just got to spend some time with a number of the world’s smartest economists on Oahu and some vacation time on Maui. Hawai’i is an awesome place. Not only because of its pristine beaches, balmy waters and glorious sunsets, but because of the energy challenges and opportunities it faces.

If you have ever flown to Hawai’i, you know it is far away from anywhere and does not have any significant local energy resources. Hence most inputs to electricity production are imported. This means mostly oil. Hawaiian Electric Industries Inc. (known as HECO) is the largest supplier of electricity, counting over 95% of Hawai’i’s population as its customers, with subsidiaries on all the major islands, with the exception of beautiful Kauai, which is served by a cooperative. And all the islands are separate grids; no transmission lines between them.

While I have pondered before what a world without coal would look like, Hawai’i provides an interesting case study.  HECO serves 300,000 customers just on Oahu, where most of the population of Hawai’i lives. Coal accounts for 9% of generating capacity, rooftop solar for 10% and oil for 65%. On Maui, Moloka’i and Lana’i, HECO serves 70,000 customers with zero coal, 29% of renewable generating capacity and the remainder coming from oil. On the big island, it serves 82,000 customers with a bigger share of wind and geothermal which results in 48% of renewable generating capacity.

Generating electricity with oil is expensive, which is why Hawai’i is leading the scoreboard for most expensive electricity in the country. The EIA quotes an average price per kWh of 31 cents! That is almost thrice the price of California’s fancy average kWh sold.

So why do I get all giddy when thinking about Hawai’i? Yes, Mai-Tai’s on the beach at sunset; but even more importantly, this is a set of islands, each of which has ample sunshine, plentiful wind, and potentially significant geothermal resources. Each island has a significant share of commercial (think hotels and restaurants) and residential customers. And electricity is already expensive. What we have here ladies and gentlemen is a unique opportunity to study smart integration of renewables on the supply side and demand side programs that go hand in hand with the rapidly growing share of renewables.

At the Energy Institute we have an impressive array of demand side studies underway in collaboration with the investor-owned and municipal utilities in California, which are integrated into the Western grid. While Jerry Brown is looking for collaboration with China, I would like to see us pay attention to what is happening half-way to Beijing!

In California we have some of the most innovative utilities in the country (I am looking at you SMUD!). The islands of Hawai’i provide us with a setting that would allow us to push our understanding of renewables integration and pricing further in a field setting. Plus, the thought of field work in Hawai’i is an appealing idea!

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Do Residential Energy Efficiency Investments Deliver?

Today’s post is co-authored by Michael Greenstone (University of Chicago) and Catherine Wolfram

We recently released a paper presenting the findings of a first-of-its kind, randomized controlled evaluation of the returns to some common residential energy efficiency investments. The study’ s context is the nation’s largest residential energy efficiency program, the Weatherization Assistance Program (WAP). You can read media coverage of the paper here, here, here, and here.

For those who haven’t read about the paper, between 2011 and 2014, we administered a randomized controlled trial (RCT)—considered the gold standard in evidence—on a sample of more than 30,000 WAP-eligible households in the state of Michigan in order to shed some light on a critical question: Do investments in important residential energy efficiency measures (improved insulation, air sealing, weather-stripping, window replacement, furnace replacement, etc.) deliver the energy savings they promise?

The research revealed five main results: (1) The energy efficiency measures undertaken by households in the study reduced their energy consumption by between 10 and 20 percent on average; (2) However, these savings were just 39 percent of the average savings predicted by engineering models; (3) There is no evidence that the shortfall in savings is the result of rebound—households did not turn up their thermostats after the investments were made; (4) While the investments cost roughly $4,580 on average, our best estimate of the energy savings was about half of these costs[1]; and (5) The costs also greatly exceeded the benefits when the monetary value of pollution reductions are added to the energy savings to calculate benefits. While the WAP program has a number of goals, when measured by the energy savings and emissions benefits, these efficiency upgrades were not a good investment.

Infographic

The urgency of the climate challenge means that it is critical to identify cost-effective strategies that will deliver real greenhouse gas emissions reductions. Energy efficiency is a crucial component of most climate change mitigation plans, underscoring the importance of developing a body of credible evidence on the real-world—versus projected—returns on energy efficiency investments in the residential sector and beyond.

Such a process will undoubtedly uncover some gems, but in some instances it will also be necessary to update our beliefs. When seemingly inconvenient evidence comes to light that challenges our beliefs—as we have uncovered with this analysis—that data should not be undermined and ignored.  Instead, it should be used to inform our strategy to confront climate change. The magnitude of the climate challenge requires that we ruthlessly pursue the most cost effective mitigation options.

Our paper has generated some strong reactions and important questions, some the result of misconceptions about what exactly we evaluated and how the evaluation was conducted. In the remainder of this blog, we respond to the most common criticisms of our study and its findings.

*              *              *

Reaction 1: This is just one study and scores of other studies have opposite findings.

Some critics have cited prior evaluations showing that residential energy efficiency programs are good investments and that our study is an anomaly. Many of these evaluations, however, are based on savings projections that- as we found- can significantly overestimate the savings when applied in the real world. Other studies use real- world data, but analyze these data using methods that can confuse the effects of energy efficiency improvements with other factors that drive changes in energy consumption.

Our study is different. It represents a first-of-its-kind evaluation using a randomized controlled trial, the gold standard for rigorous evaluation. Society routinely relies on this methodology to assess the efficacy of new drugs, treatments, and other interventions. This approach is increasingly used in the social sciences, including criminology, education, development economics, and energy economics. In many instances, the application of randomized control trials has changed the conventional wisdom. Our application of this approach to residential energy efficiency measures is therefore an important departure from, and improvement upon, previous analyses.

Reaction 2: The study unfairly paints WAP as an ineffective program.

WAP has multiple goals and improving the living standards of its recipients is clearly a central and worthy one.  Our study does not claim to provide a comprehensive evaluation of WAP, nor would it be appropriate to do so.

Rather, the study’s purpose is to measure the real-world energy savings resulting from WAP-funded energy efficiency improvements.  We then compare them to both the investment costs and the projected energy savings generated from detailed energy audits.

In interpreting the results, it is important to bear in mind that for a measure to be implemented under WAP, federal regulations require that it pass a cost-benefit analysis—that is, the projected cumulative energy savings must be greater than the investment costs. This cost-benefit analysis is based on an in-home energy audit conducted using an engineering model, in this case the National Energy Audit Tool (NEAT).

For the households we studied, NEAT-driven audits projected that the WAP measures would reduce annual energy consumption by 43.7 million British thermal units (MMBtu). Yet, when we observed the energy bills of households that received WAP measures, the actual energy savings were just 17.2 MMBtu. In other words, the model systematically over-predicted energy savings by a factor of 2.5.

This is an important finding. The investments in efficiency in our study underperformed relative to projected values and in a way that the program was expressly designed to avoid. Homeowners, program managers, and taxpayers only received 39 percent of the projected savings. According to the Department of Energy, the NEAT model is used by approximately 700 state and local Weatherization Assistance Program subgrantees in more than 30 states.

Broader program objectives notwithstanding, WAP is a compelling setting to learn about the returns to energy efficiency investments. WAP is the nation’s largest residential energy efficiency program. According to the Department of Energy, which administers the program, more than 7 million homes have participated in the program since its inception in 1976. If one is attempting to assess the performance of commonplace residential energy efficiency investments on a large scale, there may be no better option.

Reaction 3: The study’s calculations of costs and benefits are inaccurate.

Here again, it is important to note that we recognize WAP has benefits beyond saving energy. But, the intent of our study was focused solely on evaluating the energy-related (and associated emissions) costs and benefits. We never claim to evaluate the other benefits of these upgrades, as that is beyond the scope of our study. It is also important to note that, no matter how one decides to evaluate monetary costs and benefits, a central finding of our analysis remains unaffected: efficiency upgrades delivered just 39 percent of the energy savings they promised. It is therefore challenging to find a set of assumptions (e.g., about lifespans and discount rates) that would cause these efficiency investments to have energy savings and emissions benefits that exceed their costs.

To drill down a bit more, here are some of the criticisms of our calculation of the costs and benefits and our responses:

Costs

Some have argued that it is inappropriate to factor in costs that don’t directly lead to energy savings.  As anyone who has done home repairs knows, once you start down the path to do something like lay new insulation, additional costs are necessarily incurred. For example, weatherization can reduce indoor air quality by tightly sealing a house, so additional costs may be required to maintain indoor air quality. Separating what’s required to lay the insulation from what’s completely separate is not easy. The average household in our sample received approximately $4,600 in energy efficiency upgrades, which includes roughly $800 in costs required to make installation of the weatherization measures safe and functional, such as wiring upgrades. Our judgment is that the most reasonable assumption is to include all of these installation and materials costs. It is worth noting, however, that if we take the polar opposite view and exclude all costs that do not directly result in energy savings, the average cost per household still significantly exceeds our central estimate energy savings.

Moreover, there are other costs associated with these retrofits that are not reflected in our cost-benefit comparison. For example, we do not include any program overhead or administrative costs. Nor do we account for the hassle and effort that households expend to implement a weatherization retrofit, even one with zero out of pocket costs. An earlier blog makes the point that these process costs can be large (we found that it cost $1,050 per weatherized household to encourage take up of these measures). Accounting for these additional expenses would of course widen the gap between costs and savings.

Benefits

We measure benefits by calculating the net present value of annual energy savings using a range of discount rates (3, 6, and 10 percent) and investment lifespans (10, 16, and 20 years). Our estimate of the benefits also includes an estimated upper bound on the benefits households derive from increased warmth (based on our analysis of “rebound” in demand for heat in the winter). In no case does the present value of energy savings reach parity with actual costs, even if we ignore the indirect efficiency-related improvements.

In calculating program benefits, we used real 2013 residential energy prices for electricity and natural gas in Michigan and assumed that these figures would increase at the rate of inflation over the lifetime of the investments. While some have criticized this as too conservative, it is standard to  use current energy prices as a predictor of future energy prices.

Reaction 4: The results cannot be generalized because they only relate to one part of Michigan, to one program, and to one subset of the population.

We study a subset of low income households in Michigan undertaking a particular set of residential efficiency measures recommended by NEAT. However, minimizing the significance of our findings on account of this context ignores the ubiquity of the measures we analyze and of the reliance on audit tools like NEAT.

As noted above, the households in the sample we studied were subjected to the same measurement tool that is used by residential weatherization programs throughout the country to gauge which upgrades are the most cost effective; and all implemented measures had to pass the same cost-benefit analysis. The types of upgrades installed at the WAP households in our sample (e.g., furnace upgrades, improved insulation, and weather stripping) are commonplace for home retrofits for all income groups.

Drawing implications from a study is not an all-or-nothing proposition.   For example, the results of a randomized controlled trial studying the effectiveness of a given drug or treatment on middle-aged men will in some instances tell us everything we need to know about its effectiveness on young women.  Of course, in other instances, less decisive conclusions are warranted until further research is conducted.

Our study tells us that a common set of efficiency measures installed in the low-income households we studied in Michigan did not deliver the expected energy savings, and that investment costs significantly exceeded these savings. Given similarities between the setting we evaluate and other efficiency applications, these findings likely generalize to a broader set of residential efficiency investments. There is logic behind this implication, while also acknowledging the need for  further experiments on the returns to energy efficiency investments  in other contexts  (Indeed, we have already begun to do them and, in at least one case, our preliminary results are qualitatively similar).

Reaction 5: The study period covered a time when the program experienced a significant increase in funding that led to poor results (e.g., inexperienced contractors).

The time period we studied included an unprecedented number of weatherizations because the American Recovery and Reinvestment Act (ARRA) increased the amount of money allocated to the program dramatically. As a result, some say new, inexperienced contractors were called in to do weatherizations and their work may not represent the norm.

To investigate this possibility, we compared savings at homes where the contractors were experienced to homes where the contractors weren’t experienced and found no difference in the average energy savings. Consequently, we find no evidence that inexperience during the time period played a role in explaining the lower-than-expected savings.

[1] This blog focuses on a subset of the numbers and results reported in the paper. Here we emphasize our preferred estimates from the randomized controlled trial that estimates average impacts for the subset of households whose participation in weatherization was the result of random assignment to our experimental intervention.  These households are associated with somewhat lower average costs ($4,580) as compared to the larger sample of recipient households from whom we collected data for our quasi-experimental analysis ($5,150).

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Winners and Losers from Flattening Tiered Electricity Prices

The California Public Utilities Commission is moving closer to major changes in the steeply increasing-block residential electricity rates that the state has had since the 2000-01 California electricity crisis.  This Friday the Commissioners may decide to significantly flatten the tiered rate structure.  In a blog post last fall, I discussed the inefficiency of charging tiered prices that don’t reflect cost and the unfairness of charging different customers different prices for the same good – a kilowatt-hour (kWh) of electricity.

In that blog, I also addressed the three standard arguments that defenders of such steeply tiered pricing commonly put forward.  The first is that increasing-block pricing yields conservation.  While in theory this could happen, the best empirical work on this subject, by (my former student) Professor Koichiro Ito shows that it is likely to have about zero effect on overall consumption.  It does encourage high-consumers to consume less, but it also encourages lower-using households to consume more.  Professor Ito shows that the net effect is no reduction in overall consumption.

The second argument is that supplying electricity to high-use households is more expensive per kWh on average, because they consume more at peak times.  My own research has shown the difference is so small that it would justify less than a one-cent differential in price between high-use and low-use customers.

The third argument carries the most weight, that higher-use customers are on average higher-income customers.  That’s true, as I showed in research published in 2012, using household consumption data from 2006.  However, like most states, California has a separate tariff for the lowest-income customers: households up to 200% of poverty-level income are eligible for the CARE program and pay much lower rates.  With the CARE program now covering about 30% of all residential customers, is tiered pricing in the standard residential rate an effective way to help lower-income households?

My 2012 paper just showed the average bill change for households in each income bracket, not the distribution of changes within each bracket.  There is another issue of equity if a program designed to transfer wealth from high-income to low-income households actually does a poor job of targeting either group, harming many low-income and/or benefitting many high-income customers.  This week I went back to the usage data from 2006 to see how great of a concern that should be.

Using PG&E data, I applied my earlier work on usage and household income to current electricity rates and the flatter tariff that a CPUC administrative law judge has proposed.  I estimated the range of impacts the proposed change would have on households across the income spectrum.

PGETariffChange

The figure above shows Pacific Gas & Electric’s current residential rate and an alternative rate that would raise the same revenue, but would have only two tiers with a 20% increase between them, as the ALJ has proposed.[1]  The first thing to note is that the new rate would be higher for consumption out to what is currently the third tier, the point where the two lines cross at 130% of baseline quantity.  In order to be a “structural” winner with the flatter rate – that is, paying less without changing consumption at all — the household would have to be consuming out beyond the crossing point in order to offset the higher marginal prices for the lower kWhs.

In this case, the breakeven point is at 216% of baseline quantity.  The median household consumes about 130% of baseline quantity, so that means most households would pay more.  By my calculation about 21% of households would save, while about 79% would see a bill increase if no one changed consumption.   This reflects the fact that since the electricity crisis the great majority of price increases have been placed on the highest-use customers, resulting in the steep tiers.

Using census data and applying a statistical matching method I developed in the 2012 research, I estimated into which of 5 income bracket each household falls.   I focused on the customers who are not on CARE, because CARE households are on a separate tariff.   The 5 income brackets are based on census categories that are roughly equal parts of the entire population.  As the table shows, however, in this analysis the bottom two brackets are smaller due to the substantial participation in CARE.

Income Bracket 1 2 3 4 5
Income ($2015) Under $27,400 $27,400-$54,800 $54,800-$82,200 $82,200-$137,000 Over $137,000
Share of non-CARE customers 2% 16% 23% 31% 28%
Average change in Monthly Bill with 2-tier tariff $5.84 $4.59 $2.40 $0.70 -$5.78
Percent Structural Winners 5% 12% 18% 22% 32%

Next, I calculated how much the average monthly bill of each household would change if the rate were changed to the two-tiered structure in the figure above (and the household did not change its consumption).  The third row of the table above shows the average bill change for households in each income bracket.  Not surprisingly, because lower income households consume less on average, they are more likely to see their bills go up with the change.  But even in the highest income bracket more than two-thirds of customers would see bill increases.

What was particularly surprising to me is the figure below, which shows the distribution of the change in bills for each of the income brackets.  The impacts across brackets are more similar than I expected.     In every income bracket two-thirds or more of the customers see their bills rise between $0 and $20 per month, even in the highest-income bracket.  Are these high-income households that don’t use much electricity super-conservers?  Maybe, but I bet many of them are households with only one or two people, who work and travel a lot, and don’t spend much time at home.

PGETariffWinnerAndLosers

About 4% of households are the biggest winners with bills dropping by at least $50 per month under the proposed tariff.  Are these “energy hogs”? Maybe, but I bet some of them are big families and people who are home all day, because they are retired or have small children.   Among these biggest winners, I estimate that slightly less than half are in the highest-income bracket.

Undoing the steeply tiered rates that were created during California’s electricity crisis will on average cause lower-income households to pay more.  If there were no other consequences of the steep tiering, I could see keeping it on that basis.  But there are other impacts on both efficiency and fairness, not the least of which is the monthly harm to higher-consuming, middle- and lower-income households that is caused by a rate structure that has no basis in costs.

Some opponents of the two-tiered rate proposal have presented it as a simple shift of payments from poor to rich.  This analysis shows that the story is not that simple.  Both winners and losers are present at every income level.  The two-tier proposal makes bills more cost-based and more proportional to usage, as they were before 2000.  And as they are in nearly all other states, and in the parts of California served by municipal utilities.

I’m still tweeting energy news articles and new research papers @BorensteinS 

[1] All of these calculations assume no consumption response to the tariff change.  As I show in my 2012 paper, accounting for the small elasticity that has been estimated for response to a change in increasing-block pricing makes very little difference to these calculations.

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