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

FSR Topic of the Month

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[2]:

  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 behavior 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 the 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[4].

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.

[1] This scenario is based on the premise that all available energy efficiency measures were implemented until 2040. All these measures, according to the IEA, use technologies that are readily available and are cost-effective, with three times payback on average, based on energy savings alone.

[2] 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, Academic Press

[3] The agent-principal problem occurs when the agent, that will make decisions on behalf of the principal, has an incentive to act in their own best interests, which are diverse to those of their principal.

[4] 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 own preferences.