The Economic Fallacies of Demand-Side Management

The Economic Fallacies of Demand-Side Management

Hoffman Study of Electricity Planning
May 01, 1995

Full Document Available in PDF

Recent years have seen the emergence of Demand-Side Management (DSM), a new approach to the electricity utility planning process.  Through DSM programs, utilities endeavor to diminish ratepayer demand to avoid supply costs and capacity expansion.  Such programs typically encourage ratepayers to adopt energy efficient lighting, heating, ventilating and air-conditioning systems, additional heat insulation, and other energy-saving investments, offering partial or total subsidies for purchase and installation.  As an inducement, shareholder-owned utilities are permitted to recover their DSM capital investments and revenue losses by raising their rates.

DSM is premised on the notion that the self-interest of individuals is in conflict with their behavior:  Despite the availability of numerous cost-effective energy efficiency investments, consumers have failed to adopt them.

DMS theory classifies this apparent paradox as a species of “market failure.”  In this view, the market imperfectly disseminates information about the profitability of energy efficiency investments.  However this paradox may result from overestimation of the benefits of energy efficiency investments.  In particular, DSM overestimates the benefits of energy investments by:

·         Only comparing investment options to the exclusion of other relevant choices faced by energy consumers;

·         Neglecting the non-monetary cost components of investments, including transaction costs, measurement and evaluation costs, the risks and uncertainties associated with the investment, its quality of service, and others which often exceed the investment price of the asset significantly; and

·         Ignoring the fact that true costs and benefits cannot be measured, since they are subjectively experienced by individuals and therefore cannot be discerned by external observers.

Thus, the perceived market failure may be more accurately attributed to overestimation of the cost-effectiveness of energy efficiency improvements rather than the failure of energy markets.

The enormous informational obstacles (i.e., the inability to accurately measure costs and benefits) faced by DSM users raises an important question: Why, given such glaring flaws, is it being attempted on such a grand scale?  The answer may be found in the incentives which confront the utilities, their larger commercial and industrial customers, their PUCs, purveyors of energy efficient technologies, environmental activists, and other DSM proponents.

DSM may more properly be seen as an attempt by various interested parties to extract rents from others.  For instance:

  • Energy utilities see DSM as a means to improve their financial condition.
  • The PUC is able to distort its own performance, making it less accountable to those who appoint the commissioners, and ultimately to the public at large.
  • Environmentalists see DSM as a way to connect the economic interest of utilities to the realization of their own ideological goals, which include a dramatic reduction in fossil fuel consumption and the consequent pollution.
  • Large commercial and industrial utility customers are subsidized, which allow them to invest in energy efficiency at the ratepayer’s expense.
  • DSM theorists, consultants and planners have made a cottage industry of DSM planning.  They do not wish to see their jobs eliminated.
  • Producers of energy efficient technologies benefit enormously from the inflated demand for their products.  These are all natural supporters of DSM and other subsidy schemes.

In its current form, DSM would be impossible without the monopoly power of the utility, which allows it to raise rates and cross-subsidize DSM program participants.  In recent years, industrial power consumers are beginning to demand access to the wholesale electricity market, bypassing the monopoly utility.  This process is known as “retail wheeling” and would render most DSM programs impossible.

DSM is flawed in theory and practice.  Its theoretical foundation rests on the discredited theories of central economic planning, which presume that governmental and quasi-governmental institutions have the knowledge and incentives to economize on behalf of individuals.

DSM’s success can be effectively explained with a public choice model that understands if as a “racket,” or a scheme to enable rent-seeking on the part of special interests.  It is largely opposed by commercial and industrial ratepayers, which seek to reduce its cross-subsidization effects that clear the way for competitive electricity markets.  The outcome of that struggle will ultimately determine the fate of DSM, as well as the nature of the electricity industry in the United States.