Historical baseline allocations can increase acceptance of emergency policies, or lock in unfair resource allocations.
The price of a good may rise because inputs to making it become more expensive, or there is a supply shortage (real or artificial), or society realizes the good is harmful to the environment and imposes a pollution tax or new regulations. Regardless of the cause, the high price means that consumers who use a lot of the good take the biggest hit. The standard economist’s response to this impact is a shoulder shrug. When it comes to equity, the job of the government is to help those who are disadvantaged, not to buffer everyone from changes in market prices.
But that view is not shared universally. Some argue that departure from the status quo makes the change intrinsically unfair. Such a notion of “status quo equity” – that a change is inequitable because it makes a group of market participants worse off – carries remarkable weight, no matter how unjust the status quo was, or the process that led to it.
Thus, there is a perennial search for a way to compensate policy losers, while still creating better incentives for using a good that is scarce, costly, or damaging to the environment. One appealing approach is the historical baseline: give customers the right to continue consuming the quantity they bought at the old price level (their historical baseline quantity), but expose them to the higher (or sometimes lower) true market price for any change from that quantity.
If energy is your thing, “historical baseline” probably conjures up paying customers to reduce electricity consumption in peak hours. But the approach is used for everything from water allocation, to airport landing slots, to pollution emissions rights. The entire Paris agreement is premised on historical baselines.
2005 per-capita GHG emissions (Source)
In the purest implementation, the customer pays the market price for any increases from their historical baseline quantity but is compensated at that price for any decreases from baseline. That way – economists point out – the customer faces the true cost for their incremental consumption decisions (up or down) but is still protected from big price changes on their historical usage.
Of course, if historical baseline quantities are themselves the result of inequitable history – such as greater water use by those who could afford sprawling estates due to inherited privilege – then locking in that preferential treatment may not be very fair. Still, if the political realities mean the alternative is deadlock or even worse new policies, then allocations based on historical quantities might still have much appeal.
Should this home receive a high water usage baseline? (Source)
But there are also practical issues associated with implementing policies based on historical baselines. For one thing, many (most?) customers will feel that their baseline understates their needs going forward. History is never a perfect indicator of future need: one household finds its electricity demand rising as it welcomes new additions to the family, while another sees it falling as the kids go off to college. I still remember suggesting such a baseline-anchored approach to a group of Silicon Valley companies during the California electricity crisis in late 2000 (also the time of the dot-com bust) and having most of those attending respond that the idea made sense except their business is growing by leaps and bounds. Hmmmmm…..
Another important practical concern is baseline manipulation, and here lies an interesting challenge. If a baseline-anchored allocation is used very infrequently and only during unforecastable crises, then customers won’t have much incentive to increase their usage in order to boost their baseline. But if it is implemented on a regular basis, they will.
Let’s say that an unexpected, once-in-a-generation world event suddenly makes natural gas (and electricity) drastically more scarce and expensive. The government realizes that high prices will help incentivize customers to conserve, but the punishing effect of levying those charges on all consumption would be devastating to low- and middle-income customers, and could bring on a steep macroeconomic slide. You might think that historical baseline allocation of moderately-priced gas might be an imperfect, but least-bad, policy. Yet, there seems to be little talk of this approach in Western Europe today, which instead is hurtling towards price controls on virtually all consumption, an approach that will discourage conservation and increase the risk of real shortages.
Natural gas price in Europe (euro/MWh)
On the other hand, if the event (and the baseline setting) occurs regularly, strategic responses to historical baseline allocation are much more likely. If you have lived in California for long, probably the first example that comes to mind is water allocation. When the state gets into severe drought, water restrictions based on historical usage are on the first page of the policy playbook. Anyone who thinks about it for long, however, realizes that means that in years when water is less scarce, there is a baseline-reducing downside to conserving.
Then consider the electricity customer who is paid to reduce consumption when the grid is strained, which occurs multiple times each summer. Typically, the baseline for measuring that reduction is their consumption in the prior few days. Sophisticated customers – who are most of the load on these programs – will design consumption algorithms that account for the value of establishing the higher baseline for future compensation. (Just ask the consultants who advise large customers on this “optimization”.) The result is payments to reduce usage that wasn’t going to happen in the first place.
The good news is that since these events occur regularly, it would not be difficult to establish a market where customers could purchase their baselines (known as a forward contract) at normal prices before anyone knows when a heat wave will hit. That approach would also be resistant to manipulation, because the customer is actually paying the fair price for that higher baseline that reflects the expected cost of providing the power.
Yet, electricity markets are mired in the paradigm of paying for demand reductions from easily-manipulated baselines. It’s actually worse than that, because these programs typically just pay for going below the baseline without charging higher prices for being above the baseline, so they get less demand reduction bang for their bucks. And just as with water allocations, the incentive to invest in conservation technologies is reduced when it also cuts usage during the times that set the baseline.
Historical baselines are one tool that in some cases can help an economy manage scarcity in an equitable and efficient way, but they can also lock in unjust allocations of valuable resources. The goal for policymakers should be infrequent, targeted use when historical baselines are likely to do the most good, while not allowing them to be captured by powerful private interests who achieve maximum payments with minimum effort. I was hoping by the end of this post I would understand why the actual application of historical baselines seems to be the mirror image of when it would be most valuable, but I still don’t. Maybe your comments can fill that in.
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Suggested citation: Borenstein, Severin, “A Right to Keep Consuming?”, Energy Institute Blog, UC Berkeley, November 7, 2022, https://energyathaas.wordpress.com/2022/11/07/a-right-to-keep-consuming/
Severin Borenstein is Professor of the Graduate School in the Economic Analysis and Policy Group at the Haas School of Business and Faculty Director of the Energy Institute at Haas. He received his A.B. from U.C. Berkeley and Ph.D. in Economics from M.I.T. His research focuses on the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. Borenstein is also a research associate of the National Bureau of Economic Research in Cambridge, MA. He served on the Board of Governors of the California Power Exchange from 1997 to 2003. During 1999-2000, he was a member of the California Attorney General's Gasoline Price Task Force. In 2012-13, he served on the Emissions Market Assessment Committee, which advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. In 2014, he was appointed to the California Energy Commission’s Petroleum Market Advisory Committee, which he chaired from 2015 until the Committee was dissolved in 2017. From 2015-2020, he served on the Advisory Council of the Bay Area Air Quality Management District. Since 2019, he has been a member of the Governing Board of the California Independent System Operator.