Energy Efficiency Under Alternative Carbon Policies: Incentives, Measurement, and Interregional Effects

In this report, we review how alternative policies, namely tradable mass-based policies and tradable rate-based policies create different incentives for energy efficiency investments. We show that rate-based policies, as a result of the output subsidy they create, reduce the incentive for investment in energy efficiency measures relative to an optimally designed mass-policy or equivalent carbon tax. We then show that this reduced incentive can be partially corrected by modifying the rate-policy such that electricity savings from energy efficiency measures are treated as a source of zero-carbon generation within the denominator of the intensity fraction or equivalently by assigning avoided emissions credit to electricity savings in the numerator of the intensity fraction at the rate of the intensity target. This approach results in an extension of the output subsidy to efficiency measures and eliminates the distortion between supply-side and demand-side options for efficiency, but does not eliminate the electricity price distortions resulting from the output subsidy. Furthermore, we demonstrate that alternative approaches to crediting efficiency measures in the numerator of the intensity fraction fail to correct the distortion. Finally, we identify a number of challenges that arise in implementing a rate-based policy with efficiency crediting, including the requirement to develop robust estimates of electricity savings in order to assess compliance, and the requirement to track the regionality of the generation impacts of electricity savings in order to account for inter-state effects of efficiency measures. tax. We then show that this reduced incentive can be partially corrected by modifying the rate-policy such that electricity savings from energy efficiency measures are treated as a source of zero-carbon generation within the denominator of the intensity fraction or equivalently by assigning avoided emissions credit to electricity savings in the numerator of the intensity fraction at the rate of the intensity target. This approach results in an extension of the output subsidy to efficiency measures and eliminates the distortion between supply-side and demand-side options for efficiency, but does not eliminate the electricity price distortions resulting from the output subsidy. Furthermore, we demonstrate that alternative approaches to crediting efficiency measures in the numerator of the intensity fraction fail to correct the distortion. Finally, we identify a number of challenges that arise in implementing a rate-based policy with efficiency crediting, including the requirement to develop robust estimates of electricity savings in order to assess compliance, and the requirement to track the regionality of the generation impacts of electricity savings in order to account for inter-state effects of efficiency measures. tax. We then show that this reduced incentive can be partially corrected by modifying the rate-policy such that electricity savings from energy efficiency measures are treated as a source of zero-carbon generation within the denominator of the intensity fraction or equivalently by assigning avoided emissions credit to electricity savings in the numerator of the intensity fraction at the rate of the intensity target. This approach results in an extension of the output subsidy to efficiency measures and eliminates the distortion between supply-side and demand-side options for efficiency, but does not eliminate the electricity price distortions resulting from the output subsidy. Furthermore, we demonstrate that alternative approaches to crediting efficiency measures in the numerator of the intensity fraction fail to correct the distortion. Finally, we identify a number of challenges that arise in implementing a rate-based policy with efficiency crediting, including the requirement to develop robust estimates of electricity savings in order to assess compliance, and the requirement to track the regionality of the generation impacts of electricity savings in order to account for inter-state effects of efficiency measures.