NRRI 18-02 Electrification – The Link

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The focus of this briefing paper is on consumer behavior and its relationship to public policy on electrification in the U.S. and other developed countries. Although electrification in less developed countries usually means something different ̶ namely, the introduction of electricity in rural and other remote areas ̶ the policy principles discussed in this paper are applicable to that context.

Electrification involves energy consumers choosing electricity over natural gas and other fossil fuels in satisfying their demands for energy services. Because energy consumption affects the environment and climate change, any discussion on electrification should encompass a broader societal perspective.

In their decision-making, energy consumers must invest in an appliance or other technology combined with a particular form of energy to “produce” an energy service. These services include transportation, space heating, water heating, cooking, clothes drying, and agricultural pumping. Energy-choice decisions are complex, involving myriad factors that are both customer-specific and site-specific.

This paper centers on natural gas and electricity for households, and electric vehicles, as these fall under the influence of state utility regulation. It defines policymakers as any out-of-market governmental entity that tries to manage the pace of electrification. They typically specify an objective for their actions, which presumably intend to advance society’s interest. Policymakers can include federal, state or even local officials, including state utility regulators. Whether consumers make choices that on their own are socially optimal determines the proper role of out-of-market intervention.

Why the interest in electrification?

With deepening concerns over climate change, policymakers, electric utilities, environmentalists and others are increasingly championing the idea of “electrification,” notably for the replacement of fossil fuels with electricity for direct end uses like transportation and space heating. Electric vehicles and heat pumps are the “electrification” technologies that have received the most attention up to now. Other than power plants, the two largest sources of carbon emissions are cars and light trucks, and buildings. Within buildings, the two largest emitting sources of carbon are for space heating and water heating.

Environmental groups and others contend that stringent climate goals are out of reach as long as there continues to be widespread use of fossil fuels in home appliances and vehicles. That is, the numbers just do not add up for deep carbonization if fossil fuels remain a major source of energy for transportation and buildings.

The electric industry sees electrification as an opportunity for revitalizing sales and revenues. A growing number of utilities now view electrification as an integral part of their future business plan. With smart dispatching, utilities see the added benefit of optimizing their load shape from electrification of transportation and water heating.

Electrification represents one of the four major pillars of energy-sector transformation in meeting stringent climate goals; for example, curtailing carbon by 80 percent by 2050, or the so-called “80 by 50” scenario. The other three are energy efficiency (reduce energy use per capita), decarbonization of electricity (reduce carbon emissions per kWh), and decarbonization of fuels (liquid and natural gas) with biofuels or synthetic decarbonized fuels.

Supporters of electrification contend that it has to occur sooner than later, preferably over the next two or three decades, and the most likely way to achieve that is through subsidies and other governmental inducements, in addition to accelerated research and development activities (especially for the industrial sector). Some advocate for mandated electrification as indispensable for avoiding climate catastrophe. Others point to the less lofty goal of revitalizing the electric industry. A third group has argued that electrification for certain end uses is already economical and others will be before too long.

The Electric Power Research Institute is doing its part by undertaking innovative research on electrification on behalf of the electric utility industry through its Integrated Energy Network. (Electric Power Research Institute, The Integrated Energy Network: Connecting Customers to Reliable, Safe, Affordable, and Cleaner Energy, February 2017) It is actively engaged in disseminating information and educating stakeholders on the benefits of electrification.

Overall, presently electrification has a strong tailwind, at least in public discussion. This paper addresses whether the current push for electrification merits serious consideration or specific actions by policymakers.

The core question for policymakers

This paper starts with the question: Have markets, consumer-behavioral, or regulatory barriers prevented or discouraged socially beneficial electrification? Gas-to-electric switching fundamentally involves consumers choosing among different energy sources for meeting their heating, transportation, cooling and other energy-service needs. Policymakers should begin by asking whether market and consumer-behavioral obstacles and flaws or governmental barriers have prevented socially beneficial electrification. Another way to say this is whether an “electrification gap” exists where the present use of electricity for different end uses is less than the socially optimal level.

A first-order area of inquiry is identifying what market and consumer-behavioral problems might exist, what effect they would have on consumer behavior and whether “outside” actions could rectify them cost-effectively. This translates into actions by the policymaker that address market and behavioral problems head-on. If end use markets for electricity and other energy sources, on the other hand, are functioning well enough in the interest of customers and society at large, then less rationale exists for out-of-market intervention. One reason for intervention is energy consumers optimizing from their perspective, but not from a broader societal perspective.

In almost all U.S. sectors, whether energy or non-energy, the market is the primary institutional arrangement for consumer decision-making. An energy consumer’s major consideration is the required capital and energy costs for providing, for example, the level of heating comfort and other benefits that the consumer desires. Non-price factors such as comfort, reliability and the carbon footprint also play into consumers’ decisions. Another relevant consideration is the high cost of conversion from natural gas to electricity for space and water heating, which can erect a nontrivial barrier to consumers switching energy sources.

Overall, whether energy consumers rely on fossil fuels or electricity for their transportation or home energy needs comes down to a rational choice of what source of energy would best satisfy those needs. In most instances consumers express their choices and make the best decisions for themselves, given the market within they participate. But for various reasons, markets sometimes fail to operate the way they should and consumers err in maximizing their well-being, justifying consideration of outside intervention.

Conditions for out-of-market intervention

The premise is that at some point in the future non-fossil energy will be the primary source of electricity production and the argument for electrification becomes more defensible. The question then becomes: Should markets alone drive this technological evolution or should public policy “push” it along to hasten its penetration in the marketplace? In other words, should we hurry electrification through governmental actions with incentives and subsidies, or instead, allow the market by itself to determine the speed and magnitude of electrification?

The latter posture is more tenable with a carbon tax or an equivalent cap-and-trade program that would convey proper price signals to consumers in making energy choices. A well-designed tax would include the societal cost of carbon emissions in the prices of competing energy sources. It would mitigate, but not necessarily eliminate, the discourse over the role of out-of-market policies over electrification. Policymakers would still be able to justify outside intervention in the presence of market and consumer-behavioral problems.

Without a carbon tax, however, policymakers must depend more on second-best and other inferior policies to place clean electricity on a level playing field with fossil fuels. These actions include a mixture of standards and incentives, which up to now has become the most prominent policy mechanism for mitigating climate change. We have seen many of these policies, however, to be seriously flawed, especially in violating basic economic principles.

Diffusion of new technologies like electric vehicles, advanced heat pumps and water heaters normally follows a gradual, dynamic process, rather than a process where a new technology is adopted en masse: The process typically begins with few early adopters, followed by a more rapid period of adoption, and then by a more moderate adoption rate once most potential users have purchased the technology. Often times, consumers will stay with their current technology, even though a new technology appears superior in performance and cost. A key question for policymaking is whether the actual diffusion rate is a product of rational actors facing dissimilar incentives and other conditions or a consequence of market inefficiencies and undue barriers.

As a prime consideration, rational public-policy intervention in consumer markets should pass a broad-based cost-benefit test. This requires evidence of serious market and behavioral problems; for example, consumers making poor choices for themselves or market prices that exclude external costs. Otherwise, government involvement to promote electrification could make matters worse; namely, the societal costs would exceed the societal benefits. The tough task for policymakers is to identify and quantify the appropriate benefits and costs.

Public-policy actions to address market and consumer-behavioral problems should strive to mitigate or eliminate any defects that directly hamper electrification. That is, a core principle for intervention is that any action or policy should redress any market or behavioral problem as directly as possible. The first step should be to identify features of a well-functioning market and determine whether energy end use markets lack any of those features. Tailoring subsequent intervention to a particular market or consumer-behavioral defect would have the best chance of steering public policy toward increased societal welfare. Policymakers must therefore exercise prudence to ensure that any action targets the core problem and does so cost-effectively.

Most markets confront barriers themselves by expending resources and finding ways to overcome barriers to an industry’s technologies. If heat pumps and electric vehicles need further improvements to become more marketable, then suppliers should have the incentive to make this happen. In fact, we do observe manufactures presently striving to improve the efficiency and recovery rate of heat pumps to make them cost-competitive, even in cold climates.

Rationale for governmental intervention must rest with evidence of the social desirability of technologies to penetrate the marketplace more intensively and quickly than what would occur under private-market incentives. This is ostensibly the core argument for governmental intervention to accelerate the marketability of electric appliances and cars. This sentiment reflects the view that electrification, which would lessen the building of new fossil-fuel infrastructure with long operating lives, must evolve as promptly as possible for the U.S. to achieve stringent climate-change goals. As this paper emphasizes, whether these goals merit out-of-market action comes down to a cost-benefit question.

Following the previous discussion, a micro perspective in rationalizing market intervention is superior to using macro data. Macro studies are not able to accurately calculate the benefits and costs for individual customers located in a particular area. That is, policymakers should rely on market characteristics and performance rather than on simplistic economic analysis at a fifty thousand-foot level, as the trigger for action.

Looking ahead

Although it is not yet prime time for electrification, it is more imminent for transportation (light duty vehicles and short-range heavy duty vehicles) than for space and water heating. The potential for reducing carbon is greatest in the transportation sector. Industry and heavy transport can also switch to electricity but face bigger challenges and barriers.

If electrification is to have a profound change on climate change, however, electric generation will increasingly have to rely on clean energy. It is seemingly premature to believe that electrification (outside of transport) would have a major effect on reducing carbon in the next few or even several years.

That said, technological advancements are moving in a direction that favors electrification with its emphasis on digitization and clean energy. If these developments continue to evolve, it is highly likely that we will see a more electrified economy with less dependency on fossil fuels to meet future direct-energy demands. Instead of “artificially” promoting electrification, one alternative path is to wait to see where the technology takes us. Technology will determine the ultimate success of electrification ̶ not subsidies and other governmental policies that could distort the diffusion of electric appliances and vehicles, and even obstruct their long-term presence in the marketplace.

State utility regulators should ask themselves several questions about electrification. They include:
1. Do end use markets for energy operate well and in the interest of customers and society at large?
2. Have market, consumer-behavioral or regulatory obstacles prevented or discouraged socially beneficial electrification? Which of them requires governmental/regulatory intervention?
3. Do regulatory practices and policies distort customer behavior decisions?
4. What benefit-cost test is applicable for evaluating regulatory options to promote electrification?
5. What are the direct and indirect costs associated with executing regulatory actions to encourage electrification? Who should bear those costs?
6. Will the benefits of regulatory intervention exceed its costs? What are the risks associated with the proposed actions? What parties should shoulder those risks?

Artificially promoting electrification with subsidies and other monetary inducements can be a win-win for electric utilities and the environmentalists, but questionable for the rest of society. The problem of new electric technologies funded by utility customers and taxpayers with only a distinct minority benefitting is hard to avoid. Electrification, overall, could have a regressive effect by disproportionately benefiting higher-income households, while being funded by all income groups. Artificially promoting electrification can also have a negative effect on
economic efficiency, especially when it misaligns public policies with actual market or behavioral problems.

Policymakers need to do more homework before they extol the wonders of electrification. In the meantime, they can capture the low-hanging fruit by identifying any undue obstacles to socially-beneficial electrification. This would achieve the objective of placing different energy sources on a level playing field.

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