the transfer loss is all transfer, no loss

Is There a Transfer Loss in Utility DSM?

Looking for Winners - and No Losers

In our May 1993 issue we were pleased to publish a provocative article by Eric

Bhltlk-‘” Minimizing Non-Participant DSM Bate Impacts - Without Harm-

ing Program Participation.” The article addressed one of the most nettlesome

problems facing utilities and customers interested in the design of useful de-

mand-side management programs - i.e., programs that give customers who

participate an appropriate incentive to do so, without causing economic harm to

those customers who may choose not to particpate.

Blank’s article, which takes gfrom the wiaUy d@rent implicit discount rates

of electric utilities on the one hand and their customers on the other, was pro-

vocative indeed. It has already prompted a critical letter from Messrs. Man&is

and P@@nberger which we published in our June issue and an article fim Paul

Chernick and hmathan Wallach, which begins on this page.

Immediately following, on page 41, Eric Blank responds to both sets of critics.

Paul Chernick and Jon Wallach are, respectively, president and research di-

rector of Resource Insight, a Boston-based wnsultingfirm.

Eric Blank is a staffattorney and economist@ the Land and Water Fund qf

the Rockies.

The Transfm Loss Is All Transfm, No Loss

By Paul Get-nick and Jonathan Wallach

n I ‘Minimizing Non-Participant DSM Rate Impacts -Without

Harming Program Participa- tion,“’ Eric Blank presents two es- sentially independent ideas. The second part of the paper presents the ploposal that is central to Blank’s concerns: Blank suggests that utilities impose energy service charges on D!3M program participants to rninimk rate effects, and then make bonus payments to overcome customer reluctance to participate in DSM programs with energy service charges.

As discussed below, we do not believe that the bonus payment approach will be widely useful be cause such payments will increase program transaction and marketing costs without removing aiti- cal market barriers. However, the concept offers another program design concept that might be considered in some circumstances.

It is the first part of Blank’s paper that is more troublesome. To justify his bonus proposal, Blank purports to develop a theoretical basis for counting lost revenues as a cost of DSM programs, and pos- its a “transfer loss” due to DSM. While Blank asserts that “this transfer ‘loss’ has no role in determining msource cost effective ness,“2 he treats it as a real cost which can be added to other costs and benefits; other analysts might

34 The Electricity @xal

use Blank’s line of reasoning to conclude that his “transfer loss” is a real cost.

In fact, the “transfer loss” problem that Blank hypothesizes does not exist. It is an artifact of his treatment of implicit discount

rates as if they were actual discount rates, &k33ing time prefer- ences for costs and benefits. The derivation of the “transfer loss” also depends on acceptance of the idea that the same customer ap- plies different discount rates to equivalent cash flow streams.

I. Theory of the Transfer Loss

A. Blank’s Approach

Blank starts by attempting to demonstrate that conventional DSM programs - even those that pass the total resource cost (TRC) test - can impose a “transfer loss” on society. The “transfer loss” is the supposed difference between the benefits of bill xeduc- tions to the participants and the bill increases to non-participants due to lost revenues?

This “transfer loss” results from the assumption that each participant in a DSM program has a real discount rate of 25% for his bill savings from that program, but that all customers (including participants in other programs, other participants in the same program, and even the same participant) have a 10% real discount rate for the bill increases due to DSM.4 Blank assumes that the measures installed through the DSM pm- gram will last for 15 years. Thus,

every annual dollar of bill reduction has a present value of $4.50 to the participant, while the customers as a whole who absorb the lost revenues from the program as- sign a present value of $9.86 to each dollar of additional bills.

Blank does not explicitly claim that customers are composed of two distinct groups, participants and non-participants, who have different discount rates for utility bills? Instead, Blank effectively assumes that each customer ap- plies two different discount rates, a high one for bill effects from its own DSM and a low one for biIl

The “transfer loss” problem that Blank hypothesizes does not exist.

effects due to other customers’ DSM. This assumption leads to some bizarre outcomes.

Suppose that every customer is a DSM participant, and that every participant’s consumption falls by 2000 kWh, each unit of which is now priced at lOc/kWh. This would produce a participant bill reduction of $200 annually which Blank would discount at 25% and value at $900 over the life of the measure. If the avoided costs are 5c/kWh, or $lOO/year, rates will be increased enough to recover another $lOO/year of net lost reve-

nues from each customer Blank would discount the $lOO/year in lost revenues over 15 years at lo%, for a present value cost of $986. Hence, even though every customer gets a $100 annual bill reduction, the model would still conclude that the program made each customer worse off by $986 - $!300=$86.

B. Is the Wmsfer Loss” a Cost?

Blank is aware that the “transfer loss” makes no sense if it is interpreted as a cost:

It is important to n?cognize that this transfer “loss” has nothing to do with economic efficiency or the overall societal benefit/cost analysis. Thus, it has no role in d&xmining nzsource cost e&c- tiveness. Rather, it is intended to roughly quantify one of the sources of the non-participant rate impact problem6

We agree with Blank that the “transfer loss” has nothing to do with costs, benefits, or efficiency

Nonetheless, Blank’s computa- tions add the “transfer loss” to TRC costs to derive a “net rate benefit,” which certainly sounds like a measure of cost effectiveness. Indeed, if Blank were cor- rect that DSM incentives reduce the discount rate applied to future costs, the resulting increase in discount rates would almost certainly be a cost.

Adding a “transfer loss” to the TRC test results in a variant of the Rate Impact Measure (RIM); lost revenues are treated as costs, but less than half of the participant’s

July 2993 35

bill reduction is included as a benefit.7 The transfer-loss variant is a little better than the classic RIM, in that it counts participant costs and counts at least some of the participant benefits! None- theless, this calculation of “net rate benefits” is the most mislead- ing result of the “transfer loss” analysis. Although not his intent, our concern is that Blank’s treatment of transfer losses will be interpreted as support of the use of the RIM (in its variant form). More critically, this treatment could be interpreted as support- ing the RIM as a measure of economic efficiency, rather than as a more limited measure of equity or the fairness of DSM programs.

C. Market Barriers and Discount Rates

Blank derives the “transfer loss” by confusing the handy illustra- tive concept of implicit discount rates with the financial concept of actual discount rates. The empiri- cal evidence indicates that customers do not invest in energy efficiency that appears to be cost-effective by utility investment standards; utilities invest in supply options with paybacks of 15 years or more, while many customers will not invest in efficiency options unless they pay back the investment within a year or two. This payback gap might, in principle, result from any of a number of customer charac- teristics: l Short time horizon (e.g., valu-

ing only costs and benefits within two years),

0 High tune values of money, and willingness to pay much more later rather than spending a little now (e.g., a 25% real discount rate), l Under-valuation of electric

rates (e.g., treating an &/kWh rate as if it were 2u/kWh)p or l Attribution of higher costs to

DSM than assumed in utility analyses (e.g., marking up all DSM costs by 400%).

Any of these explanations can be useful in understanding the magnitude of the payback gap.

Our concern is that Blank3 treatment of

transfer losses will be interpreted as support of

the use of the RIM.

While the discount rate model has oftenbeenusedindescribingthe magnitude of the difference between customer and utility behav- ior, the literature has long recog- nizedthatthisissimplya convention for expressing the impact of multiple market barriers.

As has been noted, “The payback gap is not necessarily di- rectly caused by differences in customer-required returns, and the gap may also be treated explicitly as a markup by the customer over the utility’s cost of implementing the efficiency measum.“1o

Blank attributes the high discount rate for DSM savings to risk and uncertainty in the customer’s benefits, including “the life of the DSM measures installed, the performance of the measures, the impact of the measures on ongoing processes, the likelihood of re- mainingatthe current location and the future cost of electricity”11 and also to “institutional factors” (for which he offers only the example of tenant-landlord split incentives), lack of capital, “transaction costs” (by which Blank appears to mean disruption due to installation), and time commitments or “hassle.”

I ndeed, most of these and other identified market barn-

ers do not increase the time value of money (the discount rate) to customers; they increase the costs of acquiring DSM. This is true for personal time commitments to ac- quire and understand technical information, find equipment and contractors, supervise and inspect work, and deal with disputes and problems; institutional barriers to raising capital (which can be very severe even for managers of well- financed companies); the incon- venience and discomfort of nego- tiating and supervisingj the split in incentives between tenants and landlords, builders and owners, architects and developers; the risk of affecting “ongoing processes”; and the uncertainty in initial measure performance.

We can identify only four time- dependent market barriers. One that Blank does not list is the cost of capital to customers; for exam-

36 The Electricity Journal

ple, low-income households whose swing source of capital is a charge account at 20% interest will have high discount rates. However, these customers will have high discount rates for all bills, not just for DSM benefits. The “transfer loss” disappears if customers apply the same discount rate (high or low) to DSM benefits and costs.

S econd, customers who ex- pect to move may not value

DSM bill savings that occur after their tenure in the building.” This consideration certainly reduces the benefits of D!3M for the transient participant, but since the benefits will generally continue for the next occupant of the building, relocation does not reduce the social benefit of the D!3M measure. If Blank wanted to in- clude this factor in his analysis of social costs, he would have to in- clude three classes of customers: non-participants, curlentpartici- pants, and successors to participants. The benefits to participants and their successors of any revenue transfer should equal the costs of that transfer to non-participants.

Third, the uncertainty in electricity prices over time may make customers reluctant to invest in energy efficiency since falling prices would mnder their investments not cost-effective. This is a concern about regret, rather than risk, since locking in energy services at the DSM cost reduces the risk of future rate volatility. The potential for price regret may be an important market barrier for

an employee (or a spouse) who may be blamed for “wasting” money after the fact.

Fourth, some DSM measums may be subject to uncertainties in their performance over time. large, uncertain, and non-diversi- fiable expected benefits may actu- ally be discounted at a higher rate than small and diversified costs.

D!3M programs that combine aggressive financial and nonfinancial strategies can reduce or elimi- nate most market barriers, .

whether time-related or not, low- ering the customer’s implied dis-

Blank’s fundamental error follows from confusion of a model with realty

count rate on bill savings. Yet Blank assumes that market barriers and transaction costs are the same regardless of program design, thereby treating the implied discount rate as immutable. A more realistic analysis would fo- cus on market barriers, transaction costs, and markup, rather than treating customer resistance to efficiency improvements as be- ing driven by a schizophmnic ap preach to the value of utility bills over time.

In short, Blank’s fundamental error follows from confusion of a

model with reality compounded by a willingness to believe that thesamecashflowhasdiffemm values to the same customers, de- pending on whether it results fromachangeinkWhpur&ases or a change in rates per kWh.

II. The Effects of the Energy Service Charge with Bonus Payment

Jn the second part of his paper, Blankrecommendsatwo- pronged approach to overcome its transfer loss problem. First, he proposes that program costs and some portion of lost revenues be recovered from participants through an energy service charge. Thisenergyservicechargere- duces transfer losses to the point where programbenefits exceed program costs plus transfer losses; the energy service charge thus ensures that plograms will be “costsffective” under Blank’s modified version of the RIM.

Second, Blank proposes that participants be paid a bonus payment in addition to thefiZZ incre- mental cost #the eficient equipment. Recognizing that many market barriers to efficiency will not be overcome by simply financing conservation investments through energy service charges,i3 Blank recommends that customers be compensated for the burdens associated with the adoption of efficiency measures with an up-front bonus payment.

This proposed mechanism is un- necessarily costly and ineffective. The energy service charge in-

July 2993 37

creases transaction and marketing costs without reducing barriers to efficiency Moreover, the bonus payment approach forgoes viable nonfinancial strategies for reducing market barriers in favor of monetary inducements for customers to endure the hassles and uncertainty that give rise to these barriers. Instead of removing barriers, Blank attempts to push customers through them.

A. Increasing Program Costs

In comparing the combination of the energy service charge and bonus with “traditional” program designs,‘* Blank assumes that measure and program costs are unaffected by program design. This is unlikely to be true for sev- eral reasons.

The energy service charge imposes additional administrative costs. Contracts must be signed, monthly charges must be com- puted and added to the participant’s bill, and those charges must be explained to customers. Participants are likely to complain that they are still paying for measures that no longer appear to have any effect on their bills. When participants move, the utility will either have to pursue recovery of unamortized balances,i5 or write off the balances. Blank suggests that the new occupant of a building could be forced to repay the bonus given to the earlier occupant;16 a legal means for enforcing repayment may be developed, but the administrative costs (customer relations, legal services) are apt to be high.”

The energy service charge also imposes higher marketing and fixed costs per kWh saved. Since the programs will be less attrac- tive to customers, they will require more aggressive marketing and more inquiries, site visits and audits per installation.

Finally the bonus payments themselves will increase costs in two ways. First, the payments provide real incentives for fraud, which will require additional

monitoring to reduce payments for sham installations. This is particularly true for customers who may move or go out of business before the bonus has been mcov- ered. In order to make the system work, the utility may need to con- duct expensive credit checks, require co-signers, and otherwise complicate the application pmc- ess. This will tend both to increase costs and decrease participation.

B. Bonuses and Market Barriers

The combination of energy service charge and bonus will not do much to overcome most market barriers. The energy service charge leaves the participant at risk for the performance of the DSM measure. The participant’s transaction costs (information, hassle, time, embarrassment) are nearly the same as without any utility program, since the participant will need to much more closely understand the D!SM measure and supervise the DSM installation. The direct cost of bearing the undiversified risks of performance (both initial and over time) are also not reduced by the energy service charge and bonus.l*

T he important market barriers created by split incen-

tives will also not be reduced much by the charge-and-bonus approach. Blank does not discuss the practical problems with implementing his model for water heater replacement, air condi- tioner replacement, residential new construction, or commercial new construction. We do not see how a utility could implement the energy service charge for equip ment and buildings selected or de- signed by persons other than the ultimate customers. Would the utility pay the plumber or builder for measure costs, and then force the customer to pay for the program costs and lost revenues?

Even within the conceptual framework laid out in the tirst

38 The EletiityJouml

part of Blank’s paper, the bonus approach would not be expected to overcome customer reluctance to lock themselves into the energy service charge. Blank’s basic assumption is that customers discount “low-risk” general utility costs at 10% and “high-risk” DSM savings at 25%. However, he in- correctly assumes that the energy service charge would be discounted at 25%. The energy service charge would be a very “low- risk” cost: The customer would have to pay the energy service charge loan regardless of his energy usage, whether the DSM con- tinued to function, whether the customer moved, whether the house burned down etc. Dis- counting the energy service charge at lo%, rather than 25%, eliminates the viability of energy service charges, at least in Blank’s examples. This is shown in Table 1.

E SCOs have been unable to move the efficiency market

because they must impose energy service charges to cover direct program costs. If utilities apply

Blanks approach, they would need to recover both direct pro gram costs and lost revenues.19 The weak incentive of bonuses is unlikely to allow utilities to out- perform lower-cost PSCOs in marketing DSM services.

C. DSM Program Design and Cost Recovery

Blank’s analysis of lost reve nues, transfers, and rate effects does not consider the overall con- text of DSM portfolio design and cost recovery The acceptability and desirability of specific rate effects can only be judged as part of the overall DSM portfolio. It is pointless to worry about decreas- ing revenue transfers until we know whether the transfers repro- sent a problem, an advantage, or a non-issue. DeWmining whether rate effects am excessive, and determining which customer groups, programs, measures, and time periods produce the problem, requires careful modelling of annual rates and bills for each rate class, and for major groups of interest within a rate class20

Table 1: Participant Perspective with Bonus and Energy Service Charge: Correction of Blank’s Ems

BkF Proper Disalunting !L Energy rAceCharge

Transaction Costs -100 -100

Bill Savings discounted @ 25% 563 563 Energy Service Charge

discounted at 10% 423 discounted at 25% -422

Bonus Payment 302 302

Net Benefits 343 -158

If and whensome real problem

related to revenue transfers has been identified, the utility shouId attempt to reduce that problem in the manner that does the least damage to DSM benefits. The hi- erarchy of solutions should start with changes in cost recovery - over time (e.g., amortization ver- sus expensing), between classes, or within classes. If cost recovery changes are insufficient, theprob lem may be solved by accelera- tion of programs for disadvan- taged groups, or reduction of supply-side costs. If, as a last re- sort, changes in program design must be considered to avoid unto- ward rate effects, the changes should

0 Capture lost-opportonity le- sources. Energy service charges will be particularly ineffective at overcoming the split incentives that dominate new construction and much equipment replacement, and the reduced participation cannot be recaptured later.

0 Reduce only expenditures that contribute to the problem. Blank treats all programs in the same manner. l Avoid cream skimming. En-

ergy service charges will reduce the penetration of aggressive measures more than widely applied measures. l FbCOglliZ&Wdiffe~~be-

tweenmarket segments. One size of program will not fit all classes

equal.@ Energy service charges maybe

feasible in some discretionary mt- refit segments, especially for large, well-understood DSM in-

July 1993 39

vestments for knowledgeable customers. With large savings per custom, the utility may be able to measure and guarantee savings, overcoming a range of barriers otherwise posed by the energy servicecharge. Energyservice chaqeswillalsoburdenD!SM participation less if the customer understands and is confident in the DSM technology; even within a program, charges may be feasible for some measures and not others. For programs with smaller savings per customer, the admini&rative costs of savings guarantees are likely to be prohibi- tive; less sophisticated participants face high information and hassle costs for any EM whose costs they must repay.

In short, energy service charges defeat the efforts of DSM pro-

grams to ovetcome many of the market barriers to efficierq split incentives, undiversified risk, E- gret, information requirements, hassles. Thus, energy service charges should only be applied in very limited circumstances. Bo- nus payments are unlikely to sig- nificantly reduce the problems associated with energy service charges, but might be used experi- mentally where energy service charges cannot be avoided. n

Endnotes:

1. E. Blank, Minimizing Non-Partici- pant DSM Rafe Impacts - Wifhouf Harming Program Participation, ELEC. J., May 1993, at 32. A longer version of the same proposal is contained in E. BLANK, PAYING FOR UTILITY DSM PRO- GRAMS (LAW Fund, Feb. 1993).

2. Id. at 41, n. 18.

Afree rider contemplates his ill-gotten gain.

3. Blank assumes that the “non-par- ticipating” customers share the utility’s discount rate. He does not explain why this should be the case.

4. Blank assumes that the utility has a 10% discount rate and that customers (except when they are acting as program participants) have the same discount rate as the utility

5. Dividing customers into distinct groups of participants and non-participants is impossible, since Blank’s “non-participant” perspective in- cludes all customers, even if they are participants in other programs, in the same program in other years, and even in the same program in the same year. If Blank intended to assume two distinct groups, he would have to model (at a high discount rate) the share of DSM costs collected in the rates paid by the participants and ad- just the share of non-participants downward over time as cumulative participation rises.

6. Note 2, supra.

7. The transformation of the TRC into a mock-RIM test is also apparent in re- cent work by George Sterzinger. See direct testimony of G. J. Sterzinger, Case No. U 10102, Application of the Detroit Edison Co. for Authority to Amend its Rate Schedule, before the Michigan Service Comm’n.

8. The share of revenue losses counted as a benefit to the participant falls with the length of the life of the measure.

9. This explanation would be consis- tent with Blank’s observation that customers “place a low value on future electricity bill savings” (Blank, at 33). He does not explain how he concludes that “in other words, they use ex- tremely high implicit discount rates to discount future bill savings.”

10. J. Plunkett and R Chemick, The Role of Revenue Losses in Evaluating De- mand-side Resources, ACEEE 1988 SUM- MER SNDY PROCRAM ON ENERGY

EFFICIENCY IN BUILDINGS 8.199 (1988).

11. Blank, supra note 1, at 34.

40 l-he Electric&j Journal

12. Building owners may not be confident that they will receive the unamortized balance in the sale price, and tenants generally have no prospect of recovering their investment after -they leave leased space.

13. In fact, relative to direct utility payment for efficiency measures, financing through energy service charges may enhance market barriers by additionally burdening customers with long-term contractual arrange- ments.

14. The designation of third-genera- tion DSM programs as “traditional” is something of a misnomer. Tradition- ally, energy efficiency has been the customer’s responsibility; if aggressive utility-sponsored DSM programs were traditional, we would not be here to- day to discuss strategies for getting utilities and regulators to adopt them.

15. Blank suggests this approach for portable equipment, suggesting that the utility would impose credit checks, deposits, liens, and other expensive and burdensome requirements.

16. Blank, supru note 1, at 41, n. 24.

17. Requiring a lien on the building will likely discourage participation.

18. Blank describes this feature as an asset, noting that customers who re- move DSM equipment (presumably because it is not working properly, or provides poor service quality)wili have to pay the surcharge even though they receive no benefits.

19. Blank minimizes this problem in his example by assuming that rates are below avoided costs. If rates are above avoided costs, Blank’s insis- tence on not raising rates requires that the energy service charge recover all programs costs, plus the excess of rates over avoided costs.

20. Blank acknowledges that rate impact problems are inherently short- term in nature (at 32), but measures rate effects with long-term present value. This is not a useful approach.

Bonus Payments Solve a Real Problem= Responding to Critics

By Eric Blank

I appreciate the opportunity to

respond to the comments of Chernick and Wallach (“C&W”) on page 34 of this issue and Mani- atis and Pfeifenberger (“M&P”) (TEJ, June ‘93, at 3) on their criti- cisms of my article, “Minimizing Non-Participant DSM Pate Im- pacts -Without Harming Partici-

pation” (TEJ, May ‘93). I will ad- dress both the theoretical and im- plementation concerns raised in the comments.

I. Theory of the Bonus Payment Approach

A. The Role of DSM Cost-Effectiveness Tests

C&WseemtothinkthatIam endorsing the RlM test by putting forward the Transfer Loss construct. This is incorrect.

The bonus Payment approach to DSM program design should

not change DSM cost-effective l-less analysis. Regardless of lXM programdesign,Irejecttheuseof the RlM test to determine DSM cost-effectiveness. similarly I will continue to advocate for the TRC and societal tests in a variety of regulatory contexts. Moreover, I would oppose any attempt to in- clude the Transfer Loss as part of a modified TRC test.

Nevertheless, I recognize that there are a number of interests, many of them politically power- ful, that am concerned about non- participant rate impacts. As an advocate interested in obtaining the economic and environmental benefits associated with energy efficiency I want to find a way to mitigate these non-participant impacts. Such efforts to find a mid- dle ground will likely be important in ensuring that a substantial portion of the cost-effective DSM resource gets implemerkL1 Thus, the Transfer Loss construct was developed to better understand what causes non-participant rate impacts and to help find an acceptable way of mitigating this concern. The alternative, de- nying that a problem exists,2 is not likely to further the debate and, over the long run, may prove to be counter-productive.

B. Time-Dependent Market Barriers

The bonus Payment approach and the construct of the Transfer Loss are based on the idea that utility customers use high implicit discount rates to evaluate the costs and benefits of energy effi-

July 1993 41

the transfer loss is all transfer, no loss

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