Daniel Englander
A Funny Thing Happened on the Way to the Emissions Auction June 24, 2008 at 3:34 AM
New Jersey’s Public Service Electric & Gas Company, an investor owned utility, has filed a proposal with the state’s Board of Public Utilities to launch a $45.9 million demand side management program. Demand side management (DSM) is a method utilities use to reduce consumer demand for electricity and gas through the introduction of efficiency measures and technologies. In regulatory environments where utilities are constrained by the amount of electricity they are allowed to produce, typically through mechanisms that determine ratemaking as a function of fixed asset investment alone and not through a combination of fixed asset investment and commodity sales, demand side management is used to curb consumer demand. Under the former regulatory mechanism, known commonly as decoupling, utilities are punished for exceeding their planned electricity production schedule. On the flip side, consumers - the ratepayers - are punished if utilities under produce and are unable to make a sufficient rate of return on their fixed asset investment. Such a regulatory mechanism requires a balance between consumer demand and utility supply, which can be accomplished through a combination of demand side management and integrated resource planning (IRP).
DSM is the easier and less expensive of the two. While IRP may require the introduction of renewable generation capacity, DSM typically involves utilities helping consumers insulate home heating systems, passing out CFL bulbs, conducting home energy audits, or upgrading consumers to programmable thermostats. In other words, it targets the lowest of the low hanging fruit. And this is exactly what PSE&G is doing. What’s interesting here is that New Jersey’s utilities are regulated under the traditional regulatory design scheme, which was described in the early 1960s in a paper by Harvey Averch and Leland Johnson. The Averch-Johnson Hypothesis describes how utilities tend to overcapitalize due to incentives inherent in traditional rate of return regulation. Briefly, overcapitalization maximizes profits under rate of return regulation because the return on capital investment is linked to the amount of the commodity - electricity - that is produced and sold. More electricity requires more power plants. In unregulated environments, as any first year B-school could tell you, utilities would invest in and produce only what the market demanded. In other words, rate of return regulation distorts the supply market by encouraging over production. As a result, consumers tend to use more electricity than they would otherwise. Regulators encourage this activity by mandating rates remain low.
So why would a utility in such a regulatory environment intentionally shoot its balance sheet in the foot? New Jersey is one of the signatories to the Regional Greenhouse Gas Initiative, a multi-state agreement that calls for a 10 percent reduction in greenhouse gas emissions below 1990 levels by 2018 for 10 New England and Mid Atlantic states. RGGI, at least initially, is targeted specifically at power utilities. To attain this goal, RGGI has introduced a cap-and-trade system that will have its first emissions permit auction in September 2008. While PSE&G has neglected to mention the motivation behind the DSM proposal, it is likely they are undertaking the program as a way of reducing its exposure to what may be a fairly pricey emissions trading market. By encouraging conservation and energy efficiency among its consumers, PSE&G will be able to produce less electricity, thus reducing their rate of carbon emissions and the number of permits they will need to buy. This effect is similar to what occurred in the early 1990s with the introduction of a cap-and-trade scheme aimed at mitigating acid rain, except those changes occurred on the supply side. Twenty years ago, utilities began using SOX and NOX scrubbing technology because it was cheaper than buying emissions permits. This is also the same, though again on the supply side, as the European utilities that have invested billions of euros in wind capacity.
This leads to an interesting, though fairly obvious, conclusion. Utilities would rather make adjustments now that they know to be both cheaper and more controllable to their electricity production and greenhouse gas emissions rates than subject themselves later to a volatile and less certain market mechanism that they will be forced to compete in. Or at least introduce measures to hedge against potential future exposure. Though PSE&G’s DSM proposal is fairly small scale it helps put in context actions undertaken by larger utilities - XCel’s Smart Grid City in Colorado and Duke Energy’s $100 million residential solar plan are both good examples, though these may also be viewed partly as measures aimed at complying with state-based renewable portfolio standards.
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Just wanted to say HI. I found your blog a few days ago on Technorati and have been reading it over the past few days.