How have countries linked policy-making related to energy efficiency to regulatory functions?

[Response by Sanford Berg and Achala Acharya, June 2013. Helpful comments from reviewers are gratefully acknowledged. This write-up draws upon a number of resources, including material extracted from Sarkar and Singh’s Energy Policy article on “Financing Energy Efficiency in Developing Countries.” In addition, we draw upon IEA Energy Efficiency Governance Handbook (2010) and the International Confederation of Utility Regulators’ A Description of Current Regulatory Practices for the Promotion of Energy Efficiency (2010).]

A previous FAQ addressed the involvement and mandate of the energy regulator in connection with the promotion of Energy Efficiency. Another FAQ outlined the stages of EE policy development and implementation. This FAQ considers the broader question: how do policy-makers and those implementing policy (regulators) interact to ensure that EE programs are, indeed, cost-effective?

1. Drivers of Public Policy towards Energy Efficiency

While each country has a unique set of factors driving government EE policies, there are usually four key drivers of energy efficiency policies that agencies advising the government and implementing policies need to recognize:

Energy security: Some political leaders perceive their nations as particularly vulnerable to supply cut-offs. Of course, there are great costs to “energy independence,” so these costs need to be factored into political discussions. For example, a goal of reducing imported energy conflicts with the objective of increasing interconnections among nations in a region: trade in electricity can provide lower-cost electricity for importers, increase system reliability, and serve as a source of revenue for suppliers. All this is predicated on an adequate regional transmission grid and load patterns that lead to win-win outcomes. Note further, the goal of reduced fuel imports could force electricity generators to turn to higher cost local sources of inputs. In addition, energy efficiency can reduce energy demand growth, thus limiting imports (and possibly promoting the export of electricity). The sector regulator is in a position to give advice to the government regarding the full implications of focusing on energy security.

Economic development and competitiveness: Another goal relates to how reductions in energy intensity might promote development and improve industrial competitiveness. Deferring or minimizing the need for additional and more expensive generation can keep prices down for customers—assuming that the past investments in transmission and distribution grids have resulted in widespread access to the network. In the case of currently inadequate production and distribution capacity, additional investments in electricity systems is precisely the way to increase industrial competitiveness and reduce the costs of producing consumer and durable goods.

Climate change: Many governments are committed to contributing to global mitigation and adaption efforts, although the track record on delivering on promises is not outstanding. Nevertheless, some nations utilize EE as one way to meet international obligations under the United Nations Framework Convention on Climate Change (UNFCCC). For example, governments may seek to meet supra-national (e.g. EU) accession requirements or directives through energy efficiency policies.

Public health: The reduction of indoor and local pollution is another driver of energy policy. In some nations, pollution has been documented to measurably reduce life expectancy and to contribute to severe health issues for affected communities. Dealing with these indirect costs of electricity generation through energy efficiency and environmental mandates is a cost-effective way to improve national income (correctly measured to take into account such externalities).

Regulatory commissions providing advice to ministries and legislators should be aware of these drivers of public policy.

2. Perceived Barriers to Energy Efficiency

The next issue that regulators need to understand is the rationale behind government intervention to promote energy efficiency. The IEA Handbook provides a listing of barriers that might justify public initiatives to promote EE. Additional observations from other studies are also included to provide supporting detail regarding these perceived barriers. Note, the relative importance of these barriers in deterring EE activity depends on the national context. They are listed here so regulators and utility managers understand the wide range of factors that have led to government intervention in the past.

Market Barriers

Market organization and price distortions prevent customers from appraising the true value of energy efficiency.
Transaction costs (project development costs are high relative to energy savings).
Split incentive problems created when investors cannot capture the benefits of improved efficiency (IEA 2007a).

“Misplaced, or split, incentives are transactions or exchanges where the economic benefits of energy conservation do not accrue to the person who is paying for energy services. The terms have been used to describe certain classes of relationships, primarily in the real estate industry between landlords and tenants with respect to acquisition of energy-efficient equipment for rental property. When the tenant is responsible for the energy/utility bills, it is in the landlord’s interest to provide least-first-cost equipment rather than more efficient equipment for a given level of desired service.”

Financial Barriers

Up-front costs and dispersed benefits discourage investors
Perception of EE investments as complicated and risky, with high transaction costs
Other higher monetary return, lower risk projects are more attractive
Lack of awareness of financial benefits on the part of financial institutions (behavioral biases).

Energy Efficient equipment and technology usually require a high initial capital investment and the benefits gradually accrue over a period of time.Some potential borrowers, for example low-income individuals and small business owners, are frequently unable to borrow at any price due to their economic status or “credit-worthiness.” It is argued that this lack of access to capital inhibits investments in energy efficiency by these classes of consumers.

Information, awareness and ability to pay for End Users

Lack of sufficient information and understanding on the part of consumers can limit their ability to make rational consumption and investment decisions.
Lack of credible data documenting the benefits of EE investments.
Low ability or willingness to pay up front costs.

The lack of information, the high costs of acquiring information, the accuracy of information, and the inability to use or act upon information have been identified as barriers to the adoption of energy efficient appliances and other measures to reduce electricity consumption.

Regulatory and institutional Barriers

Energy tariffs that discourage EE investment (such as declining block prices).
Incentive structures encourage energy providers to sell energy rather than invest in cost-effective energy efficiency.
Institutional bias towards supply-side investments.

Energy markets are often characterized by pricing distortions: price is administratively set by regulatory bodies subject to political pressures. The price of electricity often does not take into account the social opportunity costs of production (the social impacts of emissions, including CO₂). Of course, establishing monetary values for these external costs is difficult. Also, excessively low prices tend to reduce the private benefits from investments in energy efficient technology. In many developing countries, the regulated price of electricity is below the marginal cost of producing and delivering electricity, creating disincentives for residential, commercial, government, and industrial customers’ investments in energy efficiency. Similarly, peak load pricing and interruptible supply (at discounted prices) could reduce electricity consumption in peak periods, but that requires regulatory support for innovative pricing.

Technical

Lack of affordable energy efficiency technologies suitable to local conditions.
Insufficient technical capacity to identify, develop, implement, and maintain EE investments.

One of the potential impediments to the adoption of energy efficient products is the shortage of manpower with expertise in the installation and management of such technologies and their associated products. This limitation could apply to the utility as well as to other organizations, so the implications for intervention are unclear.

3. Energy Efficiency Policies

In addition to the policies most relevant for sector regulators identified in another FAQ, there are sets of policy instruments which are implemented by different government agencies; they are listed here, using the categories presented in Table 3 of the IEA Handbook.

Pricing mechanisms

Variable tariffs where higher consumption levels invoke higher unit prices. Of course, heavy dependence on revenues from usage (as opposed to fixed fees) affects the financial sustainability of the utility.

Regulatory and control mechanisms:

Compulsory activities, such as energy audits and energy management.
Minimum energy performance standards (MEPS) and technology standards.
Energy consumption reduction targets.
EE investment obligations on private companies.

Fiscal measures and tax incentives

Grants, subsidies and tax incentives for energy efficiency investments.
Direct procurement of EE goods and services.

Promotional and market transformation mechanisms

Public information campaigns and promotions.
Inclusion of energy efficiency in school curricula.
Appliance labeling and building certification.

Technology development

Development and demonstration of EE technologies

Commercial development and capacity building

Creation of energy service companies (ESCOs)
Training programs
Development of EE industry

Financial remediation

Revolving funds for EE investments
Project preparation facilities
Contingent financing facilities

The listing provides another cut through the vast array of potential programs that can improve energy efficiency. The circumstances in each country will determine which approaches are cost-effective and consistent with national objectives. Of course, if policy objectives are not prioritized, programs might be implemented that do not have desired consequences. Special interests can be in a position to shape policies in ways that benefit narrow groups, without achieving socially legitimate goals.

4. Key Lessons for Developing and Implementing EE Policy

Sarkar and Singh (2010) provide an overview of EE implementation challenges in developing countries. Project level barriers are linked to the difficulty of scaling projects, since dispersed EE projects must be “organized, packaged, financed and implemented” in a cost-effective manner. Identifying promising projects can be difficult. In addition, Sarkar and Singh (pp. 5562-63) draw attention to systemic barriers:

“Lack of consensus on best practices to promote EE, i.e., (regulation vs. incentives/subsidies vs. market-based schemes vs. awareness/informational issues, the right balance between these mechanisms, and the appropriate role of government;

Project-by-project solutions to address what are inherently larger and more systemic challenges, requiring a more ambitious and concerted engagement at all levels of government and in all sectors;

Overreliance on Western EE program models(e.g., DSM and ESCOs), which can help guide developing countries but need to be significantly adapted to suit local markets and conditions;

Lack of EE data, which is compounded by the lack of internationally recognized indicators to adequately compare countries relative EE levels to take into account their economic structure, climate, geography, population and other factors, and to effectively determine the real potential for improvements;

Poor EE governance among EE and related institutions which can undermine government policy frameworks and initiatives, including inability to enforce or govern EE regulations and coordinate different levels of government, the international community, the private sector and civil society;

Small EE markets, where there is limited demand for high efficiency products, in part due to the limited discretionary income among consumers and lack of awareness, and thus limited domestic supply of EE goods and services;

Energy subsidies which continue to diminish the returns from EE improvements and, even where pricing may be adequate, insufficient or uneven bill collections; and

Lack of institutions and capacities for public agencies to organize, transform, incentivize and develop new and nascent markets for EE goods and services, and for local private sectors to adopt state-of-the-art EE technologies and practices.

Three other key issues in the scale-up dilemma are:

EE Retrofits vs. new systems—while retrofits have been slow to implement, much of the future EE potential can be derived from infrastructure that has to be built yet. The challenge therefore is to accelerate retrofits of existing systems, while concurrently influencing the design of new systems (e.g., new urban areas, factories, buildings, energy and transport systems).

Regulations vs. incentives—regulatory mechanisms can be the least-cost way to transform markets, particularly for new products and systems. However, these require strong and effective local institutions and good governance, which can take years to cultivate. Fostering the right balance between improved regulatory and enforcement regimes and incentives is a challenge.

Global Trade—a majority of the more energy-efficient equipment has been designed and developed in OECD countries, which creates a major disincentive for developing countries to adopt stringent EE standards.”

Thus, the legal system, regulatory capacity, flexibility, extent of public policy collaboration (contributing to the integration of EE and RE goals), and funding mechanisms (including private sector participation) are important features of the enabling environment for policy-makers. Sarkar and Singh (2010, pp. 5568-69) conclude with the following lessons:

“Conduct holistic market assessments, to determine realizable EE potential, public and private capabilities, critical policy and market barriers, misaligned institutional incentives, etc. in order to develop a clear operational strategy to impact the market.
Look to international experiences for common program strategies and approaches, but adapt and tailor models to suit local conditions, including prevailing policy environment, market realities and capacities of institutions to ensure better program effectiveness and local buy-in.
Design programs to be commercially oriented, demand-driven, and flexible in order to help create sustained shifts in the market and adjust based on changing market conditions and implementation realities.
Achieve a strong balance between policy frameworks, institutional arrangements, training, and implementation: policy without program implementation or vice versa has had limited effectiveness. A similar balance is needed between the technical information and assessments and the financial and transaction intermediation.
Focus programs to deliver real energy savings within1–2 years to build program credibility and learn from an early implementation. Programs that have been overly focused on outputs (energy audits, market studies, training, action plans) have generally had minimal impacts.
Provide participating institutions (banks, service providers, end users) with clear incentives to actively participate; stakeholders should share in rewards commensurate with risks borne.
Develop well-designed parallel marketing efforts: such channels can include conventional approaches, such as case studies and workshops as well as more innovative ones that may involve nongovernmental organizations, local schools, etc. In some cases, use of performance-based contracts for marketing contractors (i.e., payments based on positive leads or sales) can help create more focused and effective strategies.
Provide intensive and sustained technical support to address unforeseen and emerging barriers, ongoing skills enhancement, behavioral biases, institutional inertia, etc. and create feedback loops so that early implementation experiences can be incorporated into future training efforts.”

Beyond Bonn (2009) emphasizes four additional lessons based on experiences around the world:

Convey the right message about how energy efficiency contributes to economic prosperity, focusing on important issues other than climate change mitigation.
Shift the emphasis of scaling up energy efficiency from developing technologies to delivering energy savings.
Both regulatory policies and financial incentives are required to promote energy efficiency market transformation; appropriate emphasis and balance between the two will vary from one country to another.
Carbon finance remains largely untapped as a major financial incentive to help scale up energy efficiency markets.

These lessons should assist sector regulators in helping policy-makers evaluate proposed EE activities, incentivize cost-effective programs, and monitor their performance. In the policy arena, the regulatory agency tends to be the advocate for cost-effective initiatives. Particularly when the EE outlays are by the utility, the energy sector regulator needs to monitor outcomes to ensure that the resources are being utilized in ways that are consistent with overarching public policies. Furthermore, interactions of utility initiatives with other EE policies need to be taken into account when evaluating whether the scale and scope of existing utility-based demand-side management programs.

The key challenges facing sector regulators relate to the following:

(1) developing regulatory expertise, so programs can be monitored and evaluated;

(2) having access to information regarding the timing (and incidence) of the costs and benefits of utility-based initiatives;

(3) promoting public participation in regulatory proceedings, to educate and obtain input from key stakeholders;

(4) utilizing transparent processes that create legitimacy for rules that emerge from workshops and regulatory hearings;

(5) avoiding policy shifts and unclear objectives, since both introduce risks that raise the cost of capital to utilities;

(6) developing adjustment mechanisms so programs have predictable funding and programs can be fine-tuned over time (as exit strategies are developed);

(7) creating templates for program bidding and evaluation, so managers collect and report the relevant data, programs can be compared across program-types and utilities, and bidding processes ensure that political cronyism does not drive the selection of contractors;

(8) limiting inter-agency conflicts, so regulatory incentives and rules have broad political support (and so the process gives clear decision-authority to specific institutions);

(9) promoting evidence-based benefit-cost analyses, including determining which benefit-cost test is appropriate for evaluating utility-based EE programs; and

(10) avoiding capture by special interests that back specific programs (in order to create a coherent set of EE programs.

Achieving consistency across utility-based EE initiatives and EE programs implemented by other groups is no easy task. Given the many burdens of (and small budgets for) newly established regulatory commissions, simplicity and scaling up over time are probably the two key words that characterize best-practice. Nations have a wide range of options for addressing EE issues. It is up to the regulator to provide input into the policy-making process and then to implement national policies in ways that improve sector performance.