CHAPTER 8
PRICING POLICY AND DEMAND FOR ELECTRICITY

(Chapter 8 was written by Alfred Kahn under the general supervision of the committee, which reviewed the work at several stages and suggested modifications that have been incorporated. While every committee member has not necessarily read and agreed to every detailed statement contained within, the committee believes that the material is of sufficient merit and relevance to be included in this report.)

EFFICIENT PRICING AND CONSERVATION

One important means of achieving the broad goals of our national energy policy (i.e., reduced dependence on foreign crude oil and minimization of damage to the environment consistent with economic welfare) is to promote conservation or, put another way, avoid waste in our consumption of energy. Referring to our mandate in this chapter, one important way of minimizing damages to health and the environment from the use of coal to produce electric power is to limit the consumption of electricity or reduce its rate of growth.

There are various definitions of “conservation” and “waste.” But whatever the disagreements over the choice of definitions, there can be no disagreement that we want to eliminate inefficient uses in the economic sense, which means, most broadly, uses whose benefits are less than the costs they impose on society. There is wide social consensus that our principal mechanism for assessing these



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Air Quality and Stationary Source Emission Control CHAPTER 8 PRICING POLICY AND DEMAND FOR ELECTRICITY (Chapter 8 was written by Alfred Kahn under the general supervision of the committee, which reviewed the work at several stages and suggested modifications that have been incorporated. While every committee member has not necessarily read and agreed to every detailed statement contained within, the committee believes that the material is of sufficient merit and relevance to be included in this report.) EFFICIENT PRICING AND CONSERVATION One important means of achieving the broad goals of our national energy policy (i.e., reduced dependence on foreign crude oil and minimization of damage to the environment consistent with economic welfare) is to promote conservation or, put another way, avoid waste in our consumption of energy. Referring to our mandate in this chapter, one important way of minimizing damages to health and the environment from the use of coal to produce electric power is to limit the consumption of electricity or reduce its rate of growth. There are various definitions of “conservation” and “waste.” But whatever the disagreements over the choice of definitions, there can be no disagreement that we want to eliminate inefficient uses in the economic sense, which means, most broadly, uses whose benefits are less than the costs they impose on society. There is wide social consensus that our principal mechanism for assessing these

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Air Quality and Stationary Source Emission Control benefits and costs should be the competitive market system in which ultimate choices are made by the “sovereign” consumer. If this system is to work efficiently, the prices of all the competing costs and services that buyers confront, and on the basis of which they make their choices, must accurately reflect the respective costs to society of providing them. More precisely, the price of each product must equal its marginal cost, the cost of producing a little bit more, or the cost that would be avoided if buyers consumed a little bit less. The reason for this is that the demand for all goods and services is, in some degree, elastic—if price goes up, buyers will typically take a little bit less, if price goes down, they will typically, take a little more. If then, buyers are to make their individual choices in such a way that they will, as a group, get the maximum total satisfaction from our limited total productive capacity, the prices by which they are guided must reflect the cost to society of producing a little bit more, or its savings from producing a little bit less. Only then will consumers know what sacrifices they are imposing on society (and therefore on themselves as a body) by behaving correspondingly, and (according to this idealized conception) consume just the right amount of each good and service—neither too much (carrying their consumption beyond the point where incremental costs exceed incremental benefits) nor too little (refraining from consumption whose incremental benefits exceed the incremental costs to society). By this reasoning, one prerequisite for achieving the proper degree of conservation, or economizing, in the use of energy, is that its price be equated to its marginal social cost of production. In fact, our pricing of electricity falls far short of this requirement in many ways, of which we can mention only the most prominent. Electric utilities are in most jurisdictions regulated on an original, or historic, cost basis. This means that their capital costs (depreciation, return on investment, income taxes), which bulk extraordinarily large in this industry compared with most others, are measured

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Air Quality and Stationary Source Emission Control by, and as a return on, the cost historically incurred. But the only measure of marginal cost that has any economic significance is current costs, or, as one sets rates for the future, the cost that will be incurred or saved during the period when those rates are in effect. In times of rapid inflation, those marginal costs tend, naturally, to rise relative to average company revenue requirements, when the latter are based heavily on historic costs. For example, the current cost of a kilowatt of additional base load generating capacity may range between $300 and $800; the average book cost, on the basis of which we fix the depreciation and return component of electric rates, is on the order of $150 to $200. This means that the prices that purchasers confront (to which they will, if they are rational, equate the benefits of additional consumption) understate the additional sacrifices imposed on society by their consumption or the savings that society would realize if they consumed somewhat less. In this way, such prices encouage wasteful consumption. Operating in the same direction is the failure of electricity rates typically to reflect peak responsibility principles. The demand for electricity varies widely from one hour of the day and one season of the year to another. Since the current itself cannot be stored, the only way demand can be satisfied when it is at its highest levels of the day or year is by having the required capacity available at those times. The required level of investment in generating and transmitting capacity thus depends specifically on the level of demand at the times of system peak consumption. If the economically proper amount of capacity is to be constructed, therefore, it is that particular consumption, i.e., consumption at the time of peak utilization, that must be charged the full marginal costs of making that capacity available: only purchases at the peak are marginally responsible for the industry’s incurring the costs of providing that capacity; every kilowatt hour by which consumption might be reduced on peak would save society the cost of providing that much additional capacity. In

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Air Quality and Stationary Source Emission Control contrast, consumption truly and inalterably off peak should not pay any capacity costs: the inustry would have to be adding to capacity to meet peak demand regardless of whether consumption off peak continued or ceased. There is not time here to discuss all the problems that would be involved in administering such a pricing system. It is clear, generally, that the failure of most electric utility pricing to reflect these peak responsibility principles, as well as to measure capacity costs in current rather than historical terms, gives rise to a greater demand for electricity and a consequent greater construction of plant than would otherwise occur. The embodiment of these principles in electric rates would be expected to both restrict total consumption and shift some of it from peak to off-peak times. The latter shift by itself, incidentally, would in the first instance conserve mainly construction of capacity, rather than the consumption of energy. And yet both energy and environmental conservation would nevertheless be served by such a shift in consumption, even in the absence of a decline in the total kilowatt hours, for several reasons. First, the construction of capacity itself uses energy, in producing the materials that go into the generating and transmission plant, and in the construction process itself, energy that would be saved to the extent that the same total of consumption could be supplied by fuller utilization of a smaller plant. Second, the plant used for peaking purposes is typically highly energy-intensive. Consumption for relatively short peaks is most economically served by plant, such as gas turbines, involving relatively low capital and high fuel costs: it does not pay to incur the much higher capital costs of, say, nuclear capacity for plant that will operate for only a small fraction of the year. In terms of energy utilization, peaking capacity is therefore extremely inefficient. To the extent that consumption is, therefore, shifted from peak to off-peak, kilowatt hours will be supplied at

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Air Quality and Stationary Source Emission Control energy costs of only a few mills instead of several cents per kilowatt hour. Third, in important measure impairment of the environment is a function of the amount of capacity constructed. The construction of economically unnecessary generating and transmission plant involves unncessary additional injury to the environment, even though the total amount of electricity generated is unchanged. Fourth, to some extent the injury to the environment from the generation of electricity is an increasing function of the amount generated at any particular time. Air and water can, within limits, handle a given infusion of pollutants with little injury; but it seems likely that increasing that total load on the environment at any given time involves rapidly mounting external costs. Anything therefore that levels out the generation of energy, reducing its amount at times of peak utilization, even though increasing it correspondingly at off-peak times, is likely to result in a net diminution in environmental costs. For all these reasons, more efficient pricing that has the effect only of leveling out the consumption of electricity, without changing its total, will in itself be promotive of conservation. In addition, however, it may confidently be expected that efficient pricing will diminish total consumption, as well, and thus contribute further to the same end. DEMAND PROJECTIONS AND ELASTICITY One important part of our national energy policy must be a strenuous effort to encourage conservation to the extent that this is consistent with economic welfare. There are many justifications for such a policy; one benefit that is directly pertinent to our inquiry is that one way to limit sulfur dioxide emissions from electricity generation is to decrease the need for so much electricity in the first place. Conservation thus becomes part of a national

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Air Quality and Stationary Source Emission Control policy to control these emissions. We suggest elsewhere in Part Two several ways of encouraging this result, including that of pricing electricity, in so far as practicable, at its long-run marginal cost and on the basis of peak responsibility (see the discussion of pricing below.) It is not part of our task here to predict the effects of such efforts, or to supply estimates of the rate at which the demand for electricity is likely to grow in the next several years or the level it is likely to reach in 1980 or 1985. These estimates and the methods of making them vary widely, largely because of the enormous uncertainties that have been introduced into our energy equations by the dramatic events of 1974, and partly because of the difficulty of predicting the consequences of national energy policies that are still in process of formulation. The electric companies themselves have tended to use an essential eclectic method of projecting demand as the basis for their long-range planning. There is a popular assumption that most of them have, until recently, relied essentially on naive extrapolations of past trends, and many of them may have done so. Others have relied on projections of such factors as demographic trends, market saturation rates for various appliances, predictions of general economic conditions, the prospects for certain key industries in their market areas, and the market shares of electricity as compared to other sources of energy in their various submarkets. These techniques have often produced the same kind of results as simple extrapolations on the assumption of constant growth rates, and have proved reasonably reliable during the last several decades because most of the determining economic factors have in fact grown at reasonably stable rates from the late 1940s to the early 1970s. The validity of these methods and their projections of essentially unchanged growth rates have been subjected to intense criticism during the last few years, under the gradual impact of environmentalist and conservationist objections to perpetuation of the 7 percent growth rate of

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Air Quality and Stationary Source Emission Control the last two decades, and especially in the wake of the energy problems that have emerged since the 1973–74 boycott by the oil exporting countries. The critics have argued that the industry clings unrealistically to the basic assumption that, apart from the loss of a year’s growth because of the shortages and unusual conservation efforts of 1974, growth may be expected to resume in 1975 at something like its former rate. The critics contend, instead, that the altered consumption habits manifested in 1974, and particularly the drastic increases that have occurred in the price of energy in the recent past and may be expected to occur in the future, are likely to have a permanent dampening effect on the rate of demand growth. Using the 1973 demand of 1.85 trillion kilowatt-hours as a base, the 1980 demand at various growth rates would be as follows: rate (%/yr) 1980 demand (1012 kwh) 0 1.85 2 2.12 4 2.43 6 2.78 8 3.17 In calling into question the need for constructing additional electric generating plants, these observers have tended to insist on the application of more sophisticated and formal statistical techniques for estimating future demand than the electric companies have traditionally employed. These techniques involve a formal effort to identify the major external determinants of electricity consumption—such economic factors as income, the price of electricity, the prices of substitute fuels, as well as demographic factors—and, on the basis of an analysis of past experience, to specify mathematically the relationship between each of these external determining (or exogenous) factors and the variable to be estimated—electricity consumption in this case. These various competing methods of making electricity demand projections have produced a wide range of differences in result. The most recent forecast of total electricity (net)

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Air Quality and Stationary Source Emission Control generation in 1980 made by the National Electric Reliability Council (NERC) for the current National Power Survey is 3.07 trillion kWh, as compared with an actual level of 1.85 trillion in 1973. In contrast, Chapman et al. have produced an econometric model that emerged with a forecast of 2.21 kWh in 1980, obviously projecting a growth rate only a fraction of that implied by the NERC estimate. The major reason for the difference between these two results is that Chapman et al. estimate an elasticity of demand for electricity in the range of −1.00 to −1.22 for the three classes of customers (residential, commercial, and industrial). This implies that a 10 percent increase in price (measured in constant dollars) would eventually lead to sales of 10 to 12.2 percent below the levels which would result if price had not increased. This comparatively high estimated elasticity of demand has an important effect on the ultimate level of consumption projected, because the authors assume an increase of 5 percent per year in the real price of electricity from 1972 to 1980. Other statistical analyses have produced results implying a considerably lesser elasticity of demand for electricity, and, in consequence, estimate a considerably more rapid rate of growth in the demand for electricity than the rate forecast by Chapman. The Data Resources Inc. model, for example, projects the consumption of electricity will grow by more than 5 percent per year by 1985, which correspons to a generation level of 2.59 trillion kWh in 1980, as compared with the 3.07 the NERC forecast and the 2.21 by Chapman. The estimate by the Project Independence Blueprint of the Federal Energy Administration is roughly consistent with the NERC forecast for 1980. Moreover, whatever the elasticity of the demand for electricity, it will be greater in the long than in the short run. It takes time for consumption patterns to change in response to alterations in price, not only because habits are always slow to change, but because, even more important, the kinds of energy employed and the efficiency with which they are employed is determined preponderantly by the characteristics

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Air Quality and Stationary Source Emission Control of the existing stock of appliances, buildings, industrial and transportation equipment, which can change only as that population is replaced; and finally, because altered price relations can induce adaptations in the technology of utilization only over time. For all these reasons, the full response of demand to recent price changes is unlikely to be achieved in the 1975–1980 period. For our purposes, it suffices to observe that the demand for electricity must certainly have some price elasticity, and that the prospective increase in the price of electricity may confidently be expected to exert some dampening effect on the growth of consumption; but that, on the other hand, the sharply increasing price of alternative sources of energy, the drying up of supplies of natural gas, and the uncertainties on the part of consumers about the continued availability of oil imports, after the experience of the Arab boycott, will all tend to work in the other direction—that is to say, inducing a shift from those alternative sources of energy to electricity. We conclude that electricity demand will continue to grow, that it will have to be supplied in increasing proportions from coal as well as nuclear power, and that the problem of reducing sulfur dioxide emissions cannot therefore be exorcised by the comfortable assumption that additional generating capacity will be unnecessary.