FSR Topic of the Month
Energy efficiency: a market-based approach for distributed energy resources
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:
- Obligations for utilities to execute standard offers for EEM, providing electricity savings or peak consumption displacement on customers and end-users;
- Obligations on suppliers or consumers for having a given amount of white certificates attesting emerging energy saving; and
- 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 risks distribution 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.
[2] These remarks are part of an ongoing research conducted by me Gabriel Moreira Pinto and Vitor Hugo dancing Silva Oliveira.
[3] Except by the need of an exclusive market entity.
