Photo: Monia Pavoni

Energy efficiency: a market-based approach for distributed energy resources

by Tiago De Barros Correia

The world’s electricity industry has undergone a period of intense digitalisation and regulatory innovation which set the conditions for the emergence of new business models. Among them, procurement auction and other Market-Based Instruments (MBI) for energy efficiency have grown worldwide. This Topic of the Month focuses on the challenges and opportunities facing the development of the market for energy efficiency as Distributed Energy Resources (DER). In the first post, we will discuss the existence of an energy efficiency gap as well as the market failures and regulatory barriers that need to be addressed to have a functional market for energy efficiency. In the next posts, we will examine how regulators are designing new markets for energy efficiency and the importance to address energy as a DER.

On 28 November, at the Energy Innovation Academy organised by the Florence School of Regulation (FSR), Professor Jean-Michel Glachant presented what he perceives as the intertwined relation between digitalisation and decentralisation. According to the recently published policy brief, digital technologies allow undertakings to manage the growing amount of DER located behind the meter.

Looking more closely at the possibilities of innovation on the demand side, consumers can now actively contribute with the balance between supply and demand of electricity in two ways. Consumers could contribute to distributed generation in their units by managing their loads as a capacity resource, or through investing in a structural change that leads to reductions of electricity consumption using energy efficiency as a resource to address baseload consumption. Therefore, we define DER as any resource or asset, connected to the grid at the distribution level, capable of providing or substituting electricity services, including behind-the-meter renewable and non-renewable generation, energy storage, electric vehicles, energy efficiency and other controlled loads.

In the 2018 Energy Efficiency report, the International Energy Agency (IEA) states that “is becoming increasingly clear that energy efficiency can bring many significant economic and environmental benefits. It is also clear that huge energy efficiency potential remains untapped.” There are several highly cost-effective investment opportunities in energy efficiency, but the global investment in energy efficiency is not on track to achieve the scale required by the Efficient World Scenario (EWS) developed by the IEA World Energy Outlook[1]. On the contrary, the adoption of efficient technologies in the EWS would require average annual investment to double by 2025.

There are differences between the cost-minimising level of energy efficiency and the level of energy efficiency actually realised. This implies that society has forgone cost-effective investments in energy efficiency, even though they could significantly reduce energy consumption at low cost and with attractive return rate.

When referencing the market failure for energy efficiency, the literature usually refers to:

1. Positive externalities of energy efficiency related to climate change, energy security and social impacts, which means that private actors may not receive all the benefits of their actions, and so be less likely to take them;
2. Negative externalities of fossil fuels, including distortion in fuel prices that do not reflect the social and environmental costs associated with fuel production, distribution, and consumption;
3. Incomplete markets, as energy infrastructure requires high levels of coordination;
4. Information failures, including information asymmetry between government and industry, as well as generally poorly informed customers, combined with a significant level of abstraction required in the implementation of measure and verification (M&V), especially for the “baseline” definition;
5. Information gaps. There is often a lack of information on the performance of energy-efficient technologies. Consumers tend not to change their energy consumption behaviour if little information is provided;
6. Misplaced investments and incentives, the principal-agent[3] problem and a lack of life-cycle thinking on costs and savings.
7. Supply infrastructure limitations. The deployment of energy efficiency technologies is highly restricted by factors such as geography, infrastructure, and human resources.

Besides these market failures, the energy efficiency gap may also be explained by regulatory barriers and government fiscal policies. Government policies tend to encourage energy consumption, rather than energy efficiency. For instance, government support has focused more on energy production, and the profit of electric utilities is a function of sales. Other relevant factors that seem to hold the development of the energy efficiency market are the scarcity of sources of financing. Most of Energy Efficiency Measures (EEM) require some up-front investment that must face a discount rate to make trade-offs between the initial capital investment and reduced operating costs. These EEMs also hinder investments in energy-efficiency technologies. Perceived risk of energy-efficiency investments also has a role. Consumers and businesses can be very risk-averse in terms of investing in energy efficiency technologies. The uncertainties of fuel prices and the high discount rate for operating costs have both made energy-efficiency investments even more “risky” for many decision makers.

On the side of the regulation, the core of the EEM is given by mandatory public policies. These include the labelling of manufactured products, setting minimum energy efficiency standards to products and new buildings, putting obligations on utilities, retail sales or end-users to invest in energy efficiency, achieving energy savings, or enforcing mandatory periodical audits of large company’s energy consumption. Most of these policies are designed and defined with a top-down approach, leaving investors and consumers in a passive position.

This non-market-based approach, however, is losing momentum. According to the IEA’s Energy Efficiency 2018 report, most of the overall growth in policy strength occurred in the transport sector, where the standard for commercial and passenger vehicles was tightened in several countries and regions. On the other hand, increasing policy strength in sectors where benefits from more energy efficiency should be clear regardless of mandatory standards, such the buildings and industrial sectors, was minimal. Energy efficiency has often been seen as a regulatory burden rather than as a business opportunity. Thus, the path to the development of energy efficiency potential must go through the transition from policies based on obligations, control, and enforcement to the use of Market-Based Instruments (MBI) and by coupling energy and energy efficiency markets.

This policy aligns with the views of the European Commission. In November 2016, to justify the need of an amendment to Directive 2012/27/EU, it acknowledged that the cheapest, cleanest and most secure energy is energy that is not used at all. Therefore, “energy efficiency needs to be considered as a source of energy in its own right”.

The concept of using energy efficiency as an energy resource is more natural behind the meter. Energy saved with energy efficiency reduces the total cost of electricity consumption without loss of comfort or utility. However, energy efficiency can also be understood as an energy resource at the disposal of the market. The safety and quality of electricity services depend on the existence of potential difference, which may be provided by the addition of power or by the reduction of the load.

This is a very powerful and innovative statement. This means that the markets for energy and for energy efficiency can be coupled. As a result, investments in energy efficiency could have access to a more mature, liquid market, with well-established sources of funding and financing. To do so, it is sufficient to have a reliable method of measurement and verification, which can be provided by the ongoing digitalisation process, and a comprehensive regulatory and contractual basis for the EEM, converted into MWh or MW, to be traded indistinctly as electricity or capacity. In the next post, we will see how regulators and policymakers are designing new markets for energy efficiency and the importance to address energy efficiency as a DER.

International experience with Market-Based Instruments for Energy Efficiency

The December Topic of the Month focuses on the challenges and opportunities facing the development of a market-based approach for Energy Efficiency Measures (EEM). In the first post, we discussed the existence of the energy efficiency gap caused by market failures and regulatory barriers. In this second post, we will see how regulators have designed new markets for energy efficiency and the importance of addressing energy efficiency as Distributed Energy Resources (DER).

Currently, most energy efficiency actions rely on mandatory public policies with a top-down approach, leaving investors and customers in a passive position[1]. This non-market-based approach, however, is losing momentum. According to IEA (2018), regardless of the existence of public policies, the investment in energy efficiency in the building and industrial sectors were minimal. Private agents often see energy efficiency as a regulatory burden rather than a business opportunity. Thus, the path to overcome the energy efficiency gap must transition from policies based on obligations, control, and enforcement to the use of Market-Based Instruments (MBI).

What distinguishes MBIs from other policies is that, by giving market actors the freedom to choose the measures and delivery routes that work best for them, the market as a whole can discover a way to achieve the goals set by policymakers. The international experience with MBIs for electricity efficiency includes:

1. Obligations for utilities to execute standard offers for EEM, providing electricity savings or peak consumption displacement on customers and end-users;
2. Obligations on suppliers or consumers for having a given amount of white certificates attesting emerging energy saving; and
3. Auction and tendering programs, where a government fund or a utility call for EEM projects that can deliver energy efficiency outcomes and the most cost-effective proposals receive a long-term contract or funding support.

Typically, in the standard offer, the obliged party has to buy energy saved, or peak load shifted for various pre-defined technologies (e.g., water heaters, PV rooftops, lighting, and pumps) and pay a fixed price for every MWh saved or MW displaced. It is an MBI to the extent that the government defines the price while the market defines quantities. In practice, quantity ends-up being determined by the funds available (authorised by the regulator) to procure the eligible EEMs. In this sense, the standard offer policy is equivalent to a Feed-in-Tariff for renewables — which has different prices based on entitled technologies.

A Tradable White Certificate (TWC scheme), also called “cap-and-trade” or “target-and-trade” schemes involves the settlement of a mandatory energy-saving target during a given period. Obliged parties then bear this obligation to meet individual energy-saving goals through eligible EEM, and then issue a white certificate as evidence of realised energy savings. The main difference between standard offers and white certificates is that obliged parties can trade the certificates and, therefore, the market clears the certificate’s price. To increase the liquidity of the market, authorities also allow Energy Service Companies (ESCOs) that are entitled to implement measures, to earn and trade TWCs. Independent organisations perform activities related to the measurement and verification (M&V) of energy savings and the management of trading platforms.

An auction is an instrument used to assign rights and reveal prices. A common aspect of auction-like instruments is that they elicit information, in the form of bids, from potential buyers or sellers regarding their willingness to pay, and the outcome — that is, the winner and the price — is determined solely based on the bid information. Brazil (Program of Energy Efficiency — PEE), Portugal (Plan to Promote Efficiency in Electricity Consumption — PPEC), Switzerland (Prokilowatt), Germany (STEP UP!), and United States (Bid4efficiency) have also experimented with auctions as an instrument to foster more competitiveness in energy efficiency markets.

In all these auction schemes, the winners bear the risk related to the costs and performance of the EEM. If the project does not comply with the requirements and standards of the regulation, the amount supported by the program will be reduced or even suspended. On the other hand, the schemes are not clear about the conditions and do not provide penalties for altering the projects for technical or economic reasons. It means that society bears the risk that the winners deliver an alternative project that is good enough to assure some support from the program but that would not be selected in the bidding process[2].

Swiss, German and American schemes do not support EEMs with short payback times. The rationale is that public funding programs should not support investments in assets that are viable without subsidies (the additionality principle). This approach, however, distorts the decision-making process of private agents selecting a new investment by making projects with lower energy and economic efficiency preferable to other options which lack access to the program funding — the agent-principal problem, resulting in a loss of social welfare.

Each of the different MBI categories has advantages and disadvantages. The standard offer has the benefit of simplicity and low transaction costs but relying on prices centrally defined by the government poses a significant risk. If the set price is too small, it will attract the interest only of a few investors and will not deliver the total potential for EEM. If the set price is too high, society may have to overpay, which would not be necessary for an efficient process.

TWC, in its turn, requires a complex set of institutions and regulations to design its market, which typically includes the creation of an independent entity to attest energy efficiency verification and to clear the certificates market which brings relevant transaction costs. On the positive side, TWC enables the creation of an efficient market with greater engagement of obliged parties, customers and ESCO, TWS schemes are usually very effective in facilitating ESCOs to assist often poorly motivated, unknowledgeable and unskilled consumers in undertaking EEM.

Finally, auctions are a very effective and efficient instrument for long-term contracting, especially for procurement of measures still in the project phase. Thus, depending on the adopted scheme, it can carry with it most of the complexity already faced in the TWC[3] and standard offer schemes, including M&V transactional costs and subjectivity in the definition of baselines.

On the other hand, by establishing long-term commitments, even before the start of disbursement, auctions allow for a more comprehensive approach to the distribution of the risks among each party. They also provide financial receivables that serve as collateral for acquiring bank loans. Since auctions have been used as a long-term contracting tool for renewable sources and generation capacity, their use for contracting EEM facilitates the transition to the coupling of energy and energy efficiency markets. Therefore, it is the most natural way to allow the treatment of energy efficiency as a DER. The next post we will discuss the evaluation of the conditions and trade-offs faced in the process to design an auction.

. . .

[1] Except in the case of the labelling policies, which aim to reduce the asymmetry of information so that customers can make better choices, according to their preferences, and the obligations to achieve energy savings, when the regulation allows the obliged parties to procure for their EEMs.

Procuring Energy Efficiency: Regulatory Implications for Auction Design

This Topic of the Month focuses on the challenges and opportunities facing the development of a market-based approach for Energy Efficiency Measures (EEM). We have shown that there is significant space for the market for energy efficiency to grow and that investments in EEMs produce positive externalities that can act as a bridge to a low carbon economy. On the other hand, monitoring energy efficiency investment opportunities indicates the existence of a gap, in the sense that private agents are not adopting EEMs with economic attractiveness.

Public energy efficiency policies commonly adopted by countries, recognising the existence of market failures and regulatory barriers, have focused on command and control solutions. Customers and firms perceive energy efficiency standards more as obligations and regulatory burdens than business opportunities or saving on energy costs. The experiences with Market Based Instruments (MBI) suffer from fragmentation and the adoption of regulatory solutions solve specific problems but cause perverse spillover effects. The fragmentation of several small energy efficiency markets increases the cost of transactions and reduces liquidity and the availability of financing.

An alternative to overcome these issues would be the coupling of energy efficiency and electricity markets. Instead of attempting to provide subsidies and financial incentives to change in consumer attitudes, EEMs would be remunerated for electricity services. Although energy efficiency as an energy resource associated with the demand response was introduced in Directive 2012/27 / EU and was reinforced in the amendment presented in 2016, regulators and policymakers, have not assimilated to the disruptive potential.

Any resource connected to the grid at the distribution level capable of providing or substituting electricity services is a Distributed Energy Resource (DER) and is comprised of supply and demand-side resources. The safety and quality of electricity services depend on the existence of potential difference provided by the addition of power or by the reduction of the load. Usually, demand response is more associated with controllable measures for change or reduction of consumption in peak time. Resources with these characteristics offer great operational flexibility. Nevertheless, it is important to note that, however desirable, operational flexibility and control are not attributes present in all supply-side energy resources and it would be unfair to require them to allow EEMs to enter the electricity market. Energy efficiency meets all requirements to be a demand-side DER since it is a change in the level of electricity consumption in response to price or other forms of financial incentives.

On the other hand, it is necessary to recognise that EEMs have unique characteristics which hinder their direct coupling with electricity markets. EEMs share many features with other DERs, such as the predominance of fixed costs relative to variables and the need for upfront investments that makes project viability loan dependent. Regarding finance dependence, the international experience with auctions for contracting renewable sources can help. Several countries are using procurement auctions that offer contracts or long-term receivables to facilitate credit access through the modality of project finance. Brazil, in particular, has extensive experience in this regard (Araujo et al. 2008 and Moreno et al. 2010). Nevertheless, defining the auction design and the contractual obligations is not trivial. Regulators need to be alert to the structure and maturity of the market to make weighted choices about the risks of the winner’s curse or collusion, for example.

In the case of an immature market, bidders will probably have some degree of value interdependence, since each bidder may learn and therefore be influenced by the valuations of other bidders. The announcement of the victory causes a decrease in the initial estimated value and may represent an overestimated value. Failure to foresee this and take it fully into account when formulating bidding will result in what is known as the winners’ curse.

According to Krishna (2002), the English auction should outperform the second-price sealed auction, which in turn, out-performs the first-price sealed auction and the Dutch auction[1]. Such revenue ranking is a consequence of the different auctions’ forms capability to dissipate the exclusivity of bidders’ information and to mitigate the winners’ curse risk. In the same way, the release of public information in any of the four designs should lead to higher revenues and a lower difference between the expected revenues.

As the auction will procure greenfield EEMs, bidders have to spend considerable time and money only to prepare them and get the required permits and licenses. This means sunk cost, and it can influence bidders’ risk willingness. The higher the sunk cost, the greater the risk aversion of losing the auction and the greater the aggressiveness of the participants. When bidders are averse to the risk of losing the auction, the marginal increment in the payoff associated with a successful, slightly higher bid weight less than the possibility of losing the auction. A risk-averse bidder thinks that it is more important not to risk losing the auction than the small gain that he can make by slightly increasing his bid. Therefore, risk-averse bidders shade their bids less than risk-neutral bidders. Consequently, the auctioneer may expect a greater revenue under the first price auction than under the second price auction, but with the risk of the winner’s curse is also higher in this scenario if there is any degree of interdependence among the bidder’s valuation (Riley and Samuelson, 1981).

Regarding the risk of collusion, Robinson (1985) shows that, assuming a one-time stage game, cartels are stable (i.e., incentive-compatible) in open ascending-bid (English) auctions, but not in first-price sealed auctions. The dominant strategy in the English auction is to keep bidding until reaching valuation. That combined with the assumption that cartels fully share information and the possibility to identify the bidders and retaliate non-compliers (given by open or oral auctions designs), is sufficient to ensure that no other bidder will make profits betraying the cartel. In the sealed-bid, first-price auction, on the other hand, there is an incentive to cheat on the cartel and, therefore, no cartel strategy is a Nash equilibrium in a first-price sealed auction.

On the other hand, the auction to procure for EEMs is not a singular event. A sequence of auctions turns it into a repeated game, where the reputation of the participants becomes relevant in the formulation of dominant bid strategies. In this sense, repeated auctions are more susceptible to cartel activity, by allowing retaliation of participants in subsequent auctions. The difference between the open and the closed auction, therefore, become less relevant.

However, considering the possibility of collusion, it is crucial to include safeguards against a cartel Nash equilibrium in the auction design. Bajari and Yeo (2009) discuss how the U.S. Federal Communications Commission (FCC) introduced rule changes including click box bidding, the presence of large minimum opening bids and anonymous bidding that potentially make collusion more difficult. Click box bidding makes it harder for bidders to signal each other. Large minimum opening bids give bidders fewer rounds for communication via bids to work out a split of the licenses before prices become too high. Anonymous bidding disguises the identity of bidders during the auction, making it difficult, and perhaps impossible, for the cartel to use the bids to monitor and enforce collusive agreements.

Finally, regulators and policymakers typically have multiple objectives and concerns, such as funding sources, cost and benefit sharing, and the principle of additionality whose harmonisation is not simple either. An in-depth regulatory impact assessment together with a broad engagement process with stakeholders is essential to considering alternatives and trade-offs. However, because it is an innovative approach, it is necessary to highlight the relevance of adopting the prototyping and pilots method to facilitate the early identification of risks and failures due to the spillover effect of bad regulation.

[1] The English auction starts with the auctioneer calling out a low price and raising it in small increments as long as there are at least two interested bidders. The auction stops when only one bidder remains active, e.g., when the price is a little higher than the second biggest reservation value, and the last competitor leaves the auction. The winner, therefore, pays the price cleared (pay-as-clear). In a first-price sealed auction, the bids are submitted simultaneously. The winner is the bidder who submitted the highest bid, and the price will be the one in the winning bid (whence the name “first price”). The second-price sealed auction has an identical process for bid submission, the object is also assigned to the highest bid, but the winner pays a sum equal to the second highest bid (whence the name second-price). In a Dutch auction, the auctioneer starts at a high price and then continuously lowers it until one of the bidders submit a bid and stop the auction. This bidder gets the object and pays the exact amount of his offer (pay-as-bid).

References

Araujo, João, Costa, Agnes, Correia, Tiago and Melo Elbia (2008). Reforms of the reforms in Brazil: problems and solutions. In: Sioshansi (Ed.), Competitive Electricity Markets. Design, Implementation, Performance. Elsevier. pp. 543–572

Bajari, Patrick and Yeo, Jungwon. (2009). Auction design and tacit collusion in FCC spectrum auctions. In: Information Economics and Policy, Vol. 21, Issue 2. Pp 90–100

Krishna, Vijay. (2002). Auction Theory. Elsevier.

MacGill, Iain, Healy, Stephen, Passey, Rob. (2013) Trading in Energy efficiency — A Market-Based Solution to market Failure, or just Yet Another Market Failure? In: Sioshansi (Ed.) Energy Efficiency: Towards the End of Demand Growth. pp 563–590.

Moreno, R., Barroso, L.A., Rudnick, H., Mocarquer, S., Bezerra, B. (2010) Auction approaches of long-term contracts to ensure generation investment in electricity markets: Lessons from the Brazilian and Chilean experiences. In: Energy Policy n. 38. pp 5758–5769.

Riley, John, and Samuelson, William (1981). Optimal Auctions. In: The American Economic Review. Vol, 71 n. 3. pp. 381–392

Robinson, Marc. (1985). Collusion and the Choice of Auction. In: Journal of Economics, Vol. 16, n.1. pp. 141–145.

This essay was originally published as a series of fully referenced blog posts on the FSR website which can be read here.