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NBSIR 85-3262

The Impact of

Energy Pricing and

Discount Rate Policies on

Energy Conservation in

Federal Buildings

Sieglinde K. Fuller

Rosalie T. Ruegg

U.S. Department of Commerce

National Bureau of Standards

Center for Applied Mathematics

Applied Economics Group

Gaithersburg, MD 20899

Prepared for

U.S. Department of Energy

Office of Conservation and Renewable Energy

Federal Energy Management Programs

November 1985

NATIONAL BUREAU OF STANDARDS

LIBRARY

NBSIR 85-3262

* * THE IMPACT OF

ENERGY PRICING AND

DISCOUNT RATE POLICIES ON

ENERGY CONSERVATION IN

FEDERAL BUILDINGS

Sieglinde K. Fuller

Rosalie T. Ruegg

U S. DEPARTMENT OF COMMERCE

National Bureau of Standards

Center for Applied Mathematics

Applied Economics Group

Gaithersburg, MD 20899

November 1985

Prepared for U.S. Department of Energy

Office of Conservation and Renewable Energy

Federal Energy Management Programs

U.S. DEPARTMENT OF COMMERCE, Malcolm Baldrige, Secretary

NATIONAL BUREAU OF STANDARDS. Ernest Ambler, Director
.
ABSTRACT

The study investigates hew energy conservation projects for federal

buildings would be affected by a change in pricing and discount rate

policies. It focuses on a move from average market prices of energy

to marginal-cost prices and on a change from a 7 percent discount

rate to a 10 percent discount rate. Graphical and numerical

comparisons of hypothetical cases in selected geographical areas

illustrate the expected impact on selection, design and sizing, and

priority of energy-saving projects.

in
TCKNCMjEDGMENTS

The authors are grateful to Dr. Howard Hung, Mr. Stephen Petersen,

Mr. Ralph Schofer, and Dr. Stephen Weber of the National Bureau of

Standards for their review of an earlier draft of this paper and for

their useful suggestions. Appreciation is also due Mr. William

Bethea and Mr. Kelly Devine of the Department of Energy for their

assistance and comments

.

iv
SI CONVERSION

In view of the currently accepted practice of the building industry in

the United States, seme common U. S. units of measurement have been used

in this report. In recognition of the position of the United States as a signatory to the General Conference of Weights and Measures, which gave

official status to the metric SI system of units in 1960, appropriate

conversion factors have been provided in the table belcw. The reader

interested in making further use of the coherent systan of SI units is

referred to:

U. S. Department of Commerce, National Bureau of Standards,

The International Systan of Units (SI), NBS Special Publication

330, 1977 Edition. (Washington, D. C. : U. S. Government Printing

Office, 1977.)

Metric Conversion Factors

Length: 1 inch (in) = 25.4 millimeters (mm)

Energy: 1 British thermal unit (Btu) = 1.05506 kilojoules (kj)

v
TABLE OF CONTENTS

Page

Abstract iii

Acknowledgments iv

SI Conversion v

List of Figures viii

List of Tables ix

Executive Surrmary x

1.0 Introduction 1

1.1 Background 1

1.2 Purpose 2

1.3 Organization 2

2.0 Pricing Policy: Average versus Marginal-cost Pricing 4

2.1 Definitions and Perspective 4

2.2 The Significance of Energy Prices 5

2.3 Marginal-cost Pricing 6

2.4 Issues regarding the Choice of Marginal-cost Prices

versus Average Prices of Electricity 10

2.5 Ccmparison of DoE's Projections of Average Prices

and Preliminary Marginal-aost Prices 13

2.5.1. Ccmparison of Average Prices and Marginal-cost

Prices of Electricity 14

2.5.2

Ccmparison of Electricity Prices with

Distillate Prices 19

vi
3.0 Discount Rate Policy 23

3.1 Background 23

3.2 Impact of Laver versus Higher Discount Rates 23

4.0 Impact Assessment — Case Studies 25

4.1 Criteria 25

4.2 Data and Assumptions 26

4.3 Results 27

4.3.1 Project Acceptance or Rejection 29

4.3.2 Project Design/Sizing 31

4.3.3 Project Priority and Allocation of Total Budget 32

4.4 Impact of the Discount Rate 42

4.5 Combined Effect of Pricing Policy and

Discount Rate Changes 43

5.0 Summary and Conclusions 45

References 47

vii
LIST OF FIGURES

Page

1. Percentage Differences between Marginal-cost Prices

and Average Prices of Electricity - U.S. Average 15

2. Percentage Differences between Marginal-cost Prices and

Average Prices of Commercial Electricity - Selected

Regions 16

3. Average and Marginal-cost Prices in Constant $/MBtu - Electricity and Distillate 18

4. Price Indices - Electricity and Distillate 18

5. Percentage Differences between Electricity and

Distillate Prices 21

6. Savings-to-Investment Ratios of Hypothetical Projects ... 33

7a. Ranking by SIR'S of a Set of Hypothetical Projects - MIDWEST 35

7b. Ranking by SIR'S of a Set of Hypothetical Projects - NORTHWEST 37

7c. Ranking by SIR'S of a Set of Hypothetical Projects -

U.S. AVERAGE 39

8. Comparison of Pricing Policies at Various Discount

Rates 44

vm
LIST OF TABLES

Page

1. Net Savings and SIR'S with Average and Marginal-cost

Prices 28

2a. Energy Savings of a Set of Hypothetical Projects - MIDWEST 36

2b. Energy Savings of a Set of Hypothetical Projects -

NDRfflWEST 38

2c. Energy Savings of a Set of Hypothetical Projects -

U.S. AVERAGE 40

IX
EXECUTIVE SUMMARY

The National Energy Conservation Act of 1978 required the Department

of Energy to incorporate marginal energy prices in its methodology and

procedures for life-cycle cost analyses of energy systems for federal

buildings. In addition, the Energy Security Act of 1980 legislated a

change in the discount rate frcm 10 percent to 7 percent for

energy-related projects.

The purpose of this report is to assess the impact on the selection

of federal energy conservation and renewable energy projects of

1) average prices versus marginal-cost prices, and 2) a 10 percent

discount rate versus a 7 percent discount rate.

The report defines average prices, marginal prices, and discount

rates and states briefly their econcmic meanings in the context of

conservation and renewable energy projects. It discusses the econcmic

efficiency arguments in support of marginal-cost pricing. Graphical and

numerical comparisons show the differences between the average prices and

the preliminary marginal-cost prices estimated by DoE. Unresolved issues

regarding the choice between marginal-cost prices and average prices are

touched upon.

Hypothetical case studies demonstrate the impact of alternative

pricing and discount rate policies on the selection of projects. The

evaluation measures are calculated according to the life-cycle methods

and procedures prescribed by the Code of Federal Regulations under the

x
title "Federal Energy Managenent and Planning Programs". Average prices

and preliminary mrginal-oost prices of energy ccme from the 1984 30-year

price forecasts of the U.S. Department of Energy. The sample projects are

assumed to be located in three DoE energy price regions: the Midwest, the

Northwest, and the average of all DoE price regions. The Midwest shows

the smallest and the Northwest the greatest difference between average

and marginal-cost prices of electricity. The average and marginal-cost

prices of oil, natural gas, and coal were projected by DoE to be

identical

.

The case studies illustrate how energy conservation projects are

affected by the pricing and discount rate policies. They compare the net

savings of projects which save distillate with those which save

electricity at average or marginal-cost prices and show how the design

and size of projects change as prices and discount rates are changed. A

comparison of savings-to- investment ratios shows hew selection among

projects changes as prices and discount rates are changed.

The results show that the decision to accept a given electricity

project is strengthened by marginal-cost pricing, and the decision is

unaffected for projects involving the other types of fuel. Marginal-cost

pricing will tend to increase the size of electricity projects or favor

more costly designs. Additionally, marginal-cost pricing will tend to

increase the priority of electricity-saving projects relative to projects

that conserve other types of energy. With a limited budget, marginalcost pricing of electricity will tend to drive out distillate-saving

projects. In regions where the average price of electricity is

xi
considerably higher than the average price of other fuels, a change to

marginal-cost pricing will increase the existing tendency to favor

electricity-saving projects over distillate-saving projects.

A change fran the currently required 7 percent discount rate for

evaluating federal energy conservation projects to the 10 percent

rate governing most other federal projects would offset in part the

impact of marginal-cost pricing. In reducing the present value of

future energy savings, raising the discount rate tends to make the

choice of energy pricing policies sanewhat less important. Taken

alone, an increase in the discount rate fran 7 percent to 10 percent

would make fewer energy projects cost effective. An increase in

the rate would also mean that a less costly project design or size

must be selected to maintain the same degree of cost effectiveness.

XI

1
1 . 0 Introduction

1 . 1 Background

The National Energy Conservation Policy Act (NECPA) of 1978 directed

the U.S. Department of Energy (DoE) to provide uniform methodology and

procedures for life-cycle cost (ICC) analyses.

^Federal agencies were

directed to use LOG analyses in allocating budgets for conservation and

renewable energy projects (henceforth referred to as energy conservation

projects) in the more than 400,000 buildings owned and operated by the

U.S. Government. The result of this legislation was Subpart A of Part 436

in Title 10 of the Code of Federal Regulations, "Federal Energy

Management and Planning Programs; Methodology and Procedures for Life

Cycle Cost Analyses" (1979).^

The act further directed DoE to develop, as soon as feasible,

estimates of current and future marginal costs of the various types of

energy and to use these as prices in carrying out econcmic evaluations.

In the interim, average market prices were to be used. Frcm 1979 until

the present, DoE has provided average market prices, published annually

as Appendices B and C of Subpart A of 10 CFR Part 436.

A

set of

preliminary marginal fuel costs were developed in 1984, but these were

not incorporated into the methodology. There are unresolved issues

regarding the use of marginal energy costs for making federal

energy-related investments.

1
NE3CPA did not specify the discount rate to be used for evaluating

federal energy conservation projects; therefore, the 10 percent real rate

(i.e., not including inflation) required by the Office of Management and

(4) Budget (CMB), Circular A-94 , automatically applied. The Energy

Security Act of 1980 subsequently specified that federal agencies use a 7

percent real rate in evaluating energy conservation and renewable energy

(5) projects. This meant that non-energy related building projects were

to be evaluated with a 10 percent rate and energy-related projects with a

7 percent rate. This practice also is to be examined.

1 . 2 Purpose

The purpose of this paper is to assess the impact of alternative

pricing and discount rate policies on the selection of energy conservation and renewable energy projects undertaken by the U.S. Government.

Specifically, the effect of two alternatives will be evaluated;

(1) marginal-cost prices versus average market prices (comparing the 1984

projections of average market prices with the 1984 preliminary

marginal-cost prices), and (2) a 10 percent discount rate versus a 7

percent discount rate.

1 . 3 Organization

The remainder of the paper is organized into four sections. Section

2 defines terms and gives perspective to the problen, explains the

significance of alternative pricing policies, and touches on some of the

2
issues related to the choice of pricing policies. It also gives an

account of the differences between DoE-estimated marginal-cost prices and

average market prices of energy for three selected geographical regions.

Section 3 summarizes the basic concepts of discounting and describes the

expected direction of impact of a 10 percent versus a 7 percent discount

rate. Section 4 describes the data and assumptions , the calculation

procedures, and the results of the selected case studies. Section 5

summarizes and concludes the paper.

3
2.0 Pricing Policy: Average Prices versus Marginal-cost Prices

2.1 Definitions and Perspective

As used here "energy price" refers to the value a federal agency is

to assign to a unit of energy for the purpose of evaluating energyrelated investment decisions. To be consistent with DoE nomenclature,

"average price" is used to refer to the average of the market prices of a

designated region, as estimated by DoE and published as part of the LCC

methodology and procedures. "Marginal-cost price" refers to the DoE

estimate of the average of marginal-cost-based prices. The term

"average-oost prices" will refer to prices that are based on average

costs to distinguish than from the DoE projected averages of market

prices

.

Average and marginal costs and prices are central concepts in

economic theory. In the most general sense, "average cost" is the total

cost of a good or service divided by the number of units produced.

"Marginal cost" is the increase in total cost resulting from the

production of a one-unit increment of output. Market prices may reflect

average costs or marginal costs, or may be established by the supplier

according to seme other rule or procedure. If market prices of energy

reflected the marginal cost of supply, DoE could meet the requirements of

NECPA for marginal-cost pricing simply by providing estimates of average

market prices, as they have been doing. But if suppliers do not price

4
according to their marginal costs, DoE, in order to comply with NECPA,

will have to estimate the marginal cost of supply by region and

substitute those estimates for the "average prices" in appendices B & C

of the Methodology for Life Cycle Cost Analysis.

2.2 The Significance of Energy Prices

Energy prices are important for federal investment decisions because

they guide the amount of resources that federal agencies will allocate

both to energy purchases and to efforts to conserve energy and replace

nonrenewable energy with renewable sources. The higher the price of one

energy source relative to another, the greater the effort to substitute

the cheaper source for the more expensive source. The higher the price of

energy, the greater will be the effort to conserve energy or replace it

with renewable sources. A project to conserve higher-priced energy will

receive greater priority than a project to conserve lower-priced energy,

other things being the same. Thus, if market prices of energy differ fran

their marginal costs and if federal agencies are directed to use

estimated marginal-cost prices of energy instead of market prices in

designing, constructing, operating, and maintaining federal buildings,

their decisions regarding the nature, size, and priority of projects will

change

.

5
2 . 3 Marginal-oost Pricing

The interest of Congress in marginal-oost pricing, as expressed in

NECPA, steins fran the widely accepted view in economic theory that

marginal-oost pricing is necessary to elicit an output level that is

socially efficient. Price-equal-to-marginal-oost correctly signals the

cost to society of producing one unit more of a good or the savings to

society of producing one unit less. If the price of a good or service is

set greater than its marginal cost, too little of the good or service

will be demanded. If the price is less than marginal cost, some people

will consume goods and services which cost society more than they are

worth to the consumer and too many scarce resources will be devoted to

producing those items.

In the case of federal investment in energy conservation and

renewable energy, the efficiency argument would hold that if the price of

energy is less than its marginal cost, too much energy will be consumed

and too little will be spent for conservation and renewable energy. By

making its decisions about building design and operation on the basis of

energy prices which are below their marginal cost of supply, the Federal

Government would make socially inefficient investment decisions.

In the textbook case of a perfectly competitive market, the tendency

is towards an equilibrium point at which marginal cost, average cost.

6
and price are all equal: the profit-maximizing firm will expand its

output up to the point where the cost of the last unit (the marginal

unit) equals the per unit price obtainable for the product in the market,

while competitive forces will result in minimum average supply costs. If

a producer earns a return above what is required to stay in business, or

above what the money invested could earn elsewhere at equal risk, other

producers will be induced to enter the market until the price is driven

down by competitive forces to where it equals the cost of a one-unit

increase in production, including a return on the capital invested, i. e.

marginal cost pricing will tend to result naturally.

In the real world, however, there are many forces which may cause a

divergence between marginal cost and price. For example, industries that

are characterized by high fixed costs may exhibit increasing returns to

scale such that average costs decline as production is expanded. This

means that marginal cost will be less than average cost. In this

situation, a producer selling at a price equal to marginal cost will have

unit revenue less than unit cost and total costs will not be covered.

These conditions tend to lead naturally towards monopoly by driving

weaker competitors out of business, and the remaining producers gain the

market power to set prices higher than marginal cost. To protect the

public interest in such cases, the government sometimes intervenes to

regulate industries with strong natural monopolistic tendencies.

Traditionally, electric utilities have exhibited high fixed

7
costs and increasing returns to scale and, therefore, have been subject

to regulation to ensure that pricing policies are "in the public

interest." Regulatory authorities attanpt to set prices so that no

monopoly profits accrue to the utility but that its returns are high

enough to attract capital and to guarantee continued service. Regulated

prices have usually been based on average cost rather than on marginal

cost for the reasons outlined above.

Recent capital shortages, increasing costs of fuel and equipment

,

and declining load factors, however, have caused marginal costs to exceed

average costs in electricity production. These driving forces have led

utility companies, regulatory bodies, and policymakers to examine whether

the pricing of electricity as traditionally practiced might contribute to

an uneconomic growth in demand. They have looked to a pricing structure

based on marginal rather than average cost as a means of helping to

( 6 ) eliminate possible distortions. The Public Utility Regulatory

Policies Act of 1978 (PURPA) under Title I sets standards for the use of

marginal-cost pricing "to encourage conservation of energy by electric

utilities; the optimization of the efficiency of use of facilities and

resources by electric utilities; and equitable rates to electricity

consumers

."

7 * Utility companies are now in the process of developing

alternative pricing policies to reflect their marginal costs of supplying

electricity, but at this time marginal-cost pricing of electricity is not

prevalent

.

Prices not only have the purpose of raising money to pay for the

cost of the system, they also serve as signals to consumers to adjust

8
their demand. Electricity is demanded in a cycle of peak and off-peak

quantities. Since it is to a large extent non-storable, it can be looked

at as two separate products sold at essentially the same regulated price.

The cost of expanding the system to meet peak demand (i.e., the marginal

cost), however, is far greater than the price charged, whereas off-peak

electricity is relatively less expensive to provide than is indicated by

the price charged. When two products with different costs are priced the

same, decisions are made on the basis of incorrect price signals. The

average-cost price of peak-load electricity is lower than the production

cost, so that consumption is increased beyond the point where the costs

of resources and the value of additional consumption are in balance, and

too much electricity is consumed. The average-cost price of off-peak

electricity is too high, so that too little of it is consumed. Thus,

prices based on marginal costs more accurately reflect the cost of

resources and result in an economically efficient load and quantity

demanded.

In contrast to electricity where wide divergences are estimated

between prices now charged and marginal costs of supply, other fuels may

have little or no divergences between their market prices and marginal

costs. For coal and oil, the Energy Information Adminstration (EIA)

estimates identical marginal-cost prices and average market prices,

consistent with the conclusion that no single coal or oil firm has a

market share large enough to influence prices significantly. For natural

gas, as well, marginal-oost prices and average market prices are

predicted by EIA to converge since most of the price ceilings imposed by

9
regulation (Natural Gas Policy Act, 1978) are scheduled to be lifted by

1987. (8)

A difference between marginal-cost prices and average prices of

electricity—estimated marginal-oost prices being significantly higher

than average prices-—has implications for government energy conservation

programs. Before assessing the impacts, let us review certain issues that

have arisen regarding the selection of an energy pricing policy.

2.4 Issues regarding the Choice of Marginal-oost Prices versus Average

Prices of Electricity

Since the marginal-oost price of electricity rather than the average

price reflects the true cost of expanding electricity consumption, the

use of marginal-cost prices rather than average prices for making

decisions about federal energy conservation projects would, in theory,

produce a socially more efficient use of resources. The conditions that

make marginal-cost based prices the better choice are, hcwever, imperfectly realized in practice. Before one can conclude that it is desirable

to base federal energy conservation decisions on marginal-cost pricing of

energy, certain issues need to be resolved.

One issue is that agencies would be faced with the dilenma of having

to make decisions on the basis of prices which—even though they may be

more appropriate fran a social efficiency standpoint—are not those

actually charged by utility companies . As a result, the net savings that

are estimated to accrue in a social sense will not have much relevance

for the agencies' budgetary calculations.

10
The estimation of marginal costs presents another difficulty. When

one tries to calculate actual marginal costs, problems of interpretation

arise as to what is the appropriate marginal cost involved: a) the cost

of the short-term variation in production from hour to hour or season to

season as demand goes up or down, or b) the long-run marginal cost which

includes the cost of an increase in capacity as well as the cost of

additional fuel needed to meet new demand. It is inconceivable that for

long-run projections, prices can be set to follow the true variation in

marginal costs frcm hour to hour or season to season: an average value

must be adopted depending on how the incremental demand for electricity

is added to the existing load requirements.

For calculating the preliminary marginal price projections, DoE

assumes that demand is spread over the entire time spectrum so that the

ratio of peak to average demand regains unchanged. This method of

incrementing demand is consistent with the assumption that new demand

will follow the same load pattern as existing demand, but it may result

in an average marginal price inconsistent with what an individual

electric utility company considers to be its marginal cost.

Another issue is the possible divergence between social and private

marginal costs, such as will arise if the incremental cost to society of

adding one more unit of output does not correspond to the incremental

cost incurred by producers. Pollution costs, for instance, might cause a

divergence if decisionmakers do not include in their marginal costs the

cost of pollution to society.

11
Theoretically/ the divergence between private and social marginal

costs can be corrected by imposing taxes or controls or both. This

"internalizes" the costs of pollution, which will then be taken into

account when decisionmakers determine their level of output. To achieve

an optimal output level, private marginal costs and social marginal costs

must be equal. There are, however, a number of practical problems

associated with determining the optimal levels of pollution and thus of

taxation and control, and there is an ongoing discussion as to how

external costs can properly be internalized.^

The question is whether the energy price estimation procedures

should and can adequately take externalities into account. The DoE

preliminary estimates of marginal-cost prices were the same as average

prices for all energy sources other than electricity. Implicit in this is

the assumption either that existing taxes adequately account for

externalities or that externalities not accounted for by taxes are not to

be included in the marginal-cost prices to be used in making federal

energy-related investments.

See for example, "A Framework for Marginal Cost-based Time-differentiated Pricing in the United States", a report prepared by National

Research Associates, Inc., Nov York, February 1977 (6), and "Equity,

Efficiency, and Sulfur Omissions Reductions," by Carl Pechman in Public

Utilities Fortnightly, Vol. 115, No. 10, May 1985 (9), for contrasting

views about the internalization of pollution costs in the U.S.

12
DoE in the past has addressed the problem of externalities. The

Notices of Proposed Rulemaking to amend Subpart A of Part 436, 10 CFR, on

"Methodology and Procedures for Life-Cycle Cost Analyses" originally

proposed to exclude "the effects of price controls, taxes and subsidies

relating only to energy" frcm the working definition of marginal fuel

costs. Similarly, DoE initially considered an oil import premium which

was to internalize the external costs associated with the importation of

an additional barrel of oil. On further evaluation, however, Doe

implemented neither of these suggested changes.

An additional issue arises frcm the expected consequence of

replacing the DoE average price estimates with DoE estimates of marginal

costs , namely the increased conservation of electricity. As will be shown

in section 4, this effect will likely mean less conservation of oil and

other energy types unless additional total federal funds for conservation

are made available. This is an issue because the original focus of NECPA

was on conserving oil.

2.5 Comparison of DoE's Projections of Average Energy Prices and

Preliminary Marginal-cost Prices

The following comparisons express the differences between

marginal-cost prices and average prices in percentages and in absolute

values to show the magnitude of a change in pricing policy and to provide

a basis for the case studies in section 4. Compared are the prices of

commercial electricity and commercial distillate. Electricity is the only

13
fuel type for which DoE projections show a marked difference between

marginal-cost price and average price. Distillate is an example of a

fuel type for which marginal-cost price and average price are

projected to be the same. The reason for focusing on the distillate

price is that, as a consequence of the 1973 oil shock, legislated

energy conservation programs emphasize oil conservation. The prices

of other fossil fuels (gas, coal) are expected to closely track the

price of distillate and are not graphed separately. To make clear

that the average and the marginal-cost price of distillate are

identical, the price of distillate will be refered to as

"average/marginal price" in the following comparisons and case

studies

.

2.5.1 Comparison of Average Prices and Marginal-cost Prices of Electricity

DoE's projected marginal-cost electricity prices for 1985-86 are on

average across the nation about 30 percent higher than average

electricity prices, and the difference increases about fourfold by early

in the next century. This is evident frcm figure 1 which shows the

percentage difference between marginal-cost prices and average prices of

electricity in the industrial, commercial, and residential sectors, based

on projections by DoE for the country as a whole.

Figure 2 shows the percentage difference between the projected

marginal-cost price of electricity and the corresponding average

price broken out for two regions: the Midwest and the Northwest. For

14
!N30d3d

15

Figure

1.

Percentage

Differences

between

Marginal-cost

Prices

and

Average

Prices

of

Electricity

U.

S.

Average
400

380

360

340

320

300

280

260

240

220

200

180

160

140

120

100

80

60

40

20

0

I

' T I i r

/

// /

T"T III!Ni

i

i

i

i

i

i

i

i

i /

/

/

i

i

i

i

i

i

i

T r TTT;s i i i ^

^

Region 5

(Midwest)

U.S. Average

Region 10

(Northwest)

1 I I I I I—L.-I- .1 I I I I I I I I I I 1 I I I I I I 84 86 88 90 92 94 96 98 00 02 04 06 08 10

YEAR

jure 2. Percentage Differences between Marginal-cost Prices and

Average Prices of Canmercial Electricity - Selected Regions

16
comparison, the percentage difference for the nation as a whole is

also shown in figure 2. For the Midwest region, the percentage

difference is less than for the country as a whole, but nevertheless

is projected to be more than 100 percent by the turn of the century.

The difference increases because, as figure 3a shows, in the Midwest

region the projected average price of electricity (constant $)

decreases frcm about $20 to $14 over the forecasting period, whereas

the projected marginal-cost price increases from about $23 to about

$33 (constant $). A similar relationship exists between projected

U.S. marginal- cost prices and average prices of electricity, as can

be seen frcm figure 3b.

For the Northwest region, the percentage difference is substantially greater than for the country as a whole. Figure 2 shows the

projected marginal-cost price to be 130 to 140 percent greater than

the average price in 1985-86, increasing to almost 400 percent

greater by the mid-1990' s, and maintaining this high percentage

differential into the first decade of the next century. This large

difference is explained by the fact that marginal costs are dominated by the high capital costs of that region's nuclear plants, which

will determine marginal- costs in the late 1980' s, while the average

prices reflect the relatively inexpensive hydroelectric power. As

figure 3c shows, the large gap between projected marginal-cost and

average prices in the Northwest results frcm the large projected rise

in the marginal- cost price rather than frcm any projected decrease ir.

the average price.

17
$

PER

MBTU

$

PER

MBTU

$

PER

MBTU

Midwest

70

60

50

40

30

20

10

0

85 90 95 00 05 10

YEAR

3a

i i i i i t i i f mTTTTTTn n~r i i i

Electricity (marginal price)

Distillate (av/marg price)

Electricity (average price)

i i i i i i i i i i i i i i i

4a

U.S. Average

Northwest

Figure 3. Average and Marginal-cost

Prices in Constant $/MBtu

Electricity and Distillate

18

Figure 4. Price Indices

Electricity and Distillate
2.5.2 Comparison of Electricity Prices with Distillate Prices

Figures 3a to 3c show the average and marginal-cost prices for

electricity and distillate in constant dollars per million Btu.

Figures 4a to 4c show the same prices converted to indices to

facilitate comparison of future trends. There are two curves for

electricity prices but each figure has only one curve for distillate,

since average and marginal-cost prices of distillate are projected to

be the same.

For the Midwest, the average/marginal price of distillate is

projected to triple by the end of the projection period, the average

price of electricity to decline slightly, and the marginal-cost price

of electricity to rise by about 50 percent. As figure 3a shows, the

initial prices of electricity are higher than the initial price of

distillate. DoE projects the price of distillate to increase from

$6.22 to $18.22 over the 25-year period, the average price of

electricity to decline from $19.77 to $14.43, and the marginal-cost

price of electricity to increase from $23.57 to $33.23. The result is

that by the year 2005 the average price of electricity in the Midwest

is projected to be only slightly higher than that of distillate

despite the rapid rise of distillate prices. In contrast, the

marginal-cost price of electricity remains substantially above the

price of distillate throughout the period, favoring electricity

conservation projects over distillate projects.^-

"'‘The price data are based on delivery at the periphery of the building

and are not adjusted for differences in plant or equipment efficiency

which can offset the relative costs of energy consumed. Therefore, tv

price comparisons suggest tendencies for preference of one fuel tyjx- ov--r another but do not indicate precisely which type is most economic for ; given use.

19
Figures 3b and 4b allcw a similar comparison for the U.S. as a

whole. The main difference for the U.S., as ocmpared with the

Midwest, is that the average price of electricity is projected to

increase slightly, rather than decline, while the marginal-cost price

is projected to double. The result is that both average and

marginal-cost prices of electricity ranain above the distillate price

throughout the projection period despite the more rapid rise in the

distillate price; the gap widens between electricity and distillate's

marginal-cost prices and narrows between their average prices.

For the Northwest, figure 4c shows about the same trend in the

distillate price projection as for the Midwest and the U.S. as a

whole, but both average and marginal-cost prices of electricity rise

much more. Figure 3c shows, however, that the initial average

electricity price in the Northwest is about half what it is in the

Midwest and the U.S. as a whole. In the Northwest, the average

electricity price tracks the average/marginal price of distillate

very closely after about 1993. The initial marginal-oost price of

electricity in the Northwest is nearly as high as for the nation as a

whole and its projected rate of increase is even higher. As a result,

the gaps between marginal-oost electricity price and distillate

price, and between marginal-cost electricity price and average

electricity price became greatest in this region.

Figure 5 depicts the difference between electricity prices and

distillate prices for the two pricing policies. It shows the percentage

difference between the average electricity price and the distillate price

(solid lines), and the percentage difference between the marginal-oost

electricity price and the distillate price (dashed lines). The difference

20
440

DC<

cc<

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't^CIWOnOMWCVIWW

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21

Figure

5.

Percentage

Differences

between

Electricity

and

Distillate

Prices
between electricity and distillate prices diminishes for the Midwest

region, as well as for the U.S. as a whole, over the 25-year projection

period, but remains substantial in the case of marginal-aost prices of

electricity versus distillate prices. For the Midwest, the projected

marginal-cost electricity price is more than 300 percent greater than the

price of distillate in 1985-86 and is projected to be about 80 percent

higher than the distillate price by 2010. In contrast, the average

electricity price is about 275 percent greater than the distillate price

in 1985-86, and is projected to be about 25 percent below the distillate

price by 2010.

The corresponding comparison for the U.S. as a whole in figure 5

shows the projected marginal-cost electricity price to be nearly 350

percent higher than the distillate price in 1985-86, and more than 200

percent higher by 2010. The projected average electricity price is about

250 percent higher than the distillate price in 1985-86 and about 25

percent higher by 2010.

For the Northwest, figure 5 shows the percentage difference between

the marginal-cost electricity price and the distillate price to increase

over the projection period, from about three times higher in 1985-86 to

about four times higher by the middle of the next decade. The pattern of

difference between the average electricity price and distillate price is

similar to that for the Midwest and the U.S. as a whole, except that the

differences are muted. The projected average electricity price is about

60 percent greater than the distillate price in 1985-86, falling to near

zero by 1995. This is consistent with the convergence of prices shown in

figure 3c. The comparison of differences in figure 5 suggests that the

greatest impact of marginal-cost pricing would be felt in the Northwest.

22
3.0

Discount Rate Policy

3 . 1 Background

Valid econctnic evaluations and comparisons of investment projects

require that cash flews over time be converted to a time-equivalent

basis, e.g. present values or annual values. The time adjustment, usually

called "discounting," is accomplished through the use of compound

interest formulas, or factors computed frem the formulas. The formulas

and factors incorporate the investor’s opportunity cost in terms of an

interest rate, usually referred to as the "discount rate." It is the rate

that makes the investor indifferent between paying or receiving a dollar

now or at seme future time. With future amounts expressed in constant

dollars, that is, excluding purely inflationary or deflationary changes,

the discount rate should be a real rate, that is, also excluding purely

inflationary or deflationary changes.

3.2 Impact of Lower versus Higher Discount Rates

The discount rate is a critical factor for evaluating capital

investment projects, such as energy conservation and renewable energy

projects, which entail upfront expenditures and future benefits. The

choice of a higher or lower discount rate may make the difference

between acceptance or rejection of a project. A project yielding

positive net benefits at a discount rate of 7 percent may show a loss

23
when evaluated at 10 percent. The choice of discount rate can affect the

proportion of the economy's resources that is used by the public sector

by influencing the number of projects that is accepted or rejected. The

discount rate can also affect the type of project undertaken. A high

discount rate makes durable projects, whose benefits become available in

the more distant future, appear less attractive, other things being

equal.

For evaluating most investments of the federal government, CMB has

specified that a real rate of 10 percent be used (CMB Circular A-94). The

Energy Security Act of 1980 prescribed a different discount rate

specifically for the Federal Energy Managanent Program: a real rate of 7

percent. The lower the discount rate, the higher the present value

equivalent of future amounts. Other things equal, a change frcm a 10

percent discount rate to a 7 percent discount rate can be expected to

increase the net savings and savings- to- investment ratios (and shorten

the payback period) of energy conservation projects, which have their

savings in the future, and, therefore, to encourage federal expenditures

for conserving energy.

24
4.0 Impact Assessment Case Studies

Based on the relationships among investment decisions, energy

prices, and discount rates, the question is what would be the

expected Impact on federal energy conservation of the specific

changes in energy prices and the discount rate described in sections

2 and 3. Case studies serve to illustrate this impact. The approach

. . . . ( 2 ) applies the economic criteria set forth in 10 CFR sec. 436 under

specified conditions to see how the decisions are affected by the use

of marginal-cost versus average energy prices and a 10 percent versus

a 7 percent discount rate. The case studies are based on the energy

(3) price data projected by EIA in 1984 and described in section 2.

Although other conditions and other specific price projections would

yield different numerical results, this approach indicates the

general direction and magnitude of the impact.

4.1 Criteria

The federal LCC Rules specify the following criteria for

(1) accepting a given project, (2) designing or sizing a project, and

(3) assigning priority to a project:

(1) Accept a given project as cost effective,

(a) if the building's life-cycle costs are lower with the project

than without it, or

(b) if the project yields positive net savings, or

25
(c) if the ratio of project savings to costs is greater than one.

(2) Choose the project design or size that

(a) minimizes life-cycle costs of the building, or

(b) maximizes net savings frcm the project.

(3) Assign priority by

ranking cost-effective projects in descending order of their SIR'S

until the budget is exhausted, such that total net savings are

maximized.

These criteria are used in the following case studies to assess the

impact of the alternative energy pricing policies and discount rates.

4.2 Data and Assumptions

The case studies are performed for the hypothetical set of data and

assumptions summarized belcw:

Sample Project: 1” or 2" Insulation of bare hot water pipes in the

(Hypothetical) unused basement of a laboratory complex of a Federal

Science Agency

Locations

DoE Regions Midwest, Northwest, and average of all

U.S. DoE regions

DoE Pricing Policy: Average prices and marginal-cost prices of fuel.

26
for 1" insulation: $2500

for 2" insulation: $4550

Investment Costs:'*'

2 6 Energy Savings: for 1" insulation: 245.8 x 10^ Btu

for 2" insulation: 260.0 x 10

b Btu

Discount Rates: 7% and 10% real rates

Economic Life: 25 Years

4 . 3 Results

Table 1 summarizes the principal evaluation measures, calculated

frcm the data and assumptions of section 4.2, which are needed to apply

the decision criteria listed in section 4.1. Column (1) identifies the

DoE price regions for the hypothetical projects; column (2) shows the

types of energy; column (3) indicates the pricing policy alternatives;

column (4) gives base year prices in 1984 dollars; columns (5), (6), (7),

and (8) list the estimated total energy savings in present value dollars

frcm using 1" or 2" insulation under the alternative pricing policies,

with either a 7 percent or a 10 percent discount rate, over the 25 year

period; columns (9), (10), (11), and (12) give the estimated present

value savings net of investment costs under the same conditions; columns

(13) and (14) list the savings- to- investment ratios for 1" insulation at

a 7 percent and a 10 percent discount rate; columns (15) and (16)

*"The investment costs will be adjusted by a 10 percent investment

cost factor as allcwed by the current ICC Rule. (2)

2

It is assumed that the basanent tanperature is constant among the

locations, such that the quantity of savings is uniform.

27
Table

1.

Net

Savings

and

SIR'S

with

Average

and

Marginal-cost

Prices

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28

U.S.

Distillate

Av./Marg.

Price $

6.33

28,753

30,414

20,989

22,202

26,503

26,319

18,739

18,107

12.78

9.33

.90

.66

Average

Electricity

Average

Price

$20.08

61,103

64,633

47,234

49,963

58,853

60,538

44,984

45,868

27.15

20.99

1.91

1.48

Electricity

Marginal

Price

$27.23

97,185

102,799

72,420

76,604

94,935

98,704

70,170

72,509

43.19

32.19

3.04

2.27
show the incremental savings-to- investment ratio for the difference in

insulation between 1" and 2", under the 7 percent and 10 percent discount

rate assumptions.

Sections 4.3.1 through 4.3.3 deal with the effects of the change in

pricing policy, i.e. , marginal-oost prices versus average prices. To

illustrate the possible switch fran one fuel type to another, the sample

projects are assumed to save either electricity or distillate. Section

4.4 discusses the effect of alternative discount rates, i.e., 10 percent

versus 7 percent. The combined effect is summarized in section 4.5.

4.3.1 Project Acceptance or Rejection

Following the decision criterion of accepting the project if it

yields positive net savings, one can see from columns (9) to (12) of

table 1 that this particular project would be deemed cost effective

regardless of which energy pricing policy or discount rate was used. As

one would expect, however, the cut-off points for investment costs,

beyond which the project would not be cost effective, are affected by the

pricing policy and discount rate and differ for the various cases

depending on their location.

For the Midwest case, project costs for 2" insulation, for example,

could be about seven times greater if, at the 7 percent discount rate,

savings were in electricity at average prices instead of in distillate

(($55,702-25,676) / 4,095 = 7.33). If the savings were in electricity at

marginal prices instead of distillate, costs could be about nine times

29
greater ($63,941-25,676 / 4095 = 9.34) and still be acceptable.

In the Northwest, the same hypothetical example WDuld allcw project

costs to be about the same, if savings were in electricity at average

prices instead of in distillate, but twenty-one times greater if

savings were electricity at marginal prices.

For the U.S. as a whole, if energy savings were based on average

prices of electricity instead of distillate, the 2" insulation project

would be acceptable even if, at a 7 percent discount rate, project costs

were over eight times greater than those assumed. If the net savings

based on marginal electricity prices were compared with those for

distillate, the project cost could be almost eighteen times greater and

still be acceptable.

Thus, the use of the projected marginal rather than average energy

prices increases considerably the existing tendency of electricityconserving projects to be more cost effective than projects to conserve

other types of fuel.

The case studies shew another effect of using marginal-oost prices:

the gap between actual savings (based on the average of market prices)

and theoretical savings (based on marginal-cost prices) can be quite

large. For example, in the Northwest, in the case of 2" insulation, with

a 7 percent discount rate, the estimated present value of energy savings

is $34,657 based on projected average prices of electricity, but it is

$117,234 based on projected marginal-cost prices. The difference of

$82,577 is the present value of savings estimated to accrue to society in

general frcm the investment—not to the agency which must make the

project decision.

30
4.3.2 Project Design/Sizing

If one follows the decision criterion of choosing the design or size

that maximizes net savings, a ccmparison of columns (9) and (10) and

aolunns (11) and (12) shows that the sizing decision is not changed in

the Midwest case examples by the use of rrarginal-cost rather than average

prices. If distillate were the fuel, the decision would be to choose the

smaller level of insulation. If electricity were the fuel, the decision

would be to choose the larger level of insulation regardless of whether

average or marginal-cost prices were used. In the Northwest case

examples, the effect of pricing policy on the sizing decision is shown to

be sensitive to the discount rate. If 10 percent discount rate were

applied, the larger level of insulation would be chosen only if marginal

electricity prices were used. But if a 7 percent rate were used, the

larger level of insulation would be chosen regardless of whether average

or mrginal prices were used.

In general, the impact of using higher energy prices is to increase

the cost-effective design or size of a project, that is, to increase the

size of the expenditure for energy conservation. Raising prices for

electricity relative to other fuel types would, therefore, tend to

increase the expenditure for electricity-conserving projects relative to

other projects. The specific impact, however, is dependent on the

particular circumstances , as demonstrated above.

31
4.3.3 Project Priority and Allocation of Total Budget

The SIR'S for a 1" insulation project, given in columns (13) and

(14) of table 1 and graphed in figure 6, provide guidance on how to

asssign project priority. The higher the SIR, the more likely a project

is to be funded fran limited resources, other things being the same.

Hence, in the Midwest, the electricity project is clearly more likely to

be funded than the distillate project regardless of whether marginal-cost

or average pricing is used, but its priority relative to the distillate

project is boosted if marginal-cost prices are used.

In the Northwest, there is only a small difference between the SIR

for the project saving distillate and the SIR for the project saving

electricity based on average prices (12.73 vs. 14.55 at a 7 percent

discount rate). With average electricity prices, only slightly different

assumptions about project costs and energy savings wculd make the

distillate-saving project preferable to the electricity-saving project.

In contrast, the SIR for the project saving electricity based on

marginal-cost prices is almost four times as high as the SIR for the

project saving distillate (49.26 vs. 12.73 at a 7 percent discount

rate). Therefore, the use of marginal prices would strongly shift project

priority towards the electricity-saving investment.

In the case examples for the U.S. as a whole, the use of marginalcost rather than average prices also significantly raises the relative

priority of electricity- saving projects over distillate-saving projects.

32
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33

Figure

6

.

Savings

-toInvestment

Ratios

of

Hypothetical

Projects
By raising the SIR'S on electricity-saving projects by 50 percent, while

leaving the SIR'S of distillate-saving projects unchanged, the use of

marginal-cost prices could cause electricity-saving projects to displace

distillate-saving projects when agency conservation budgets are limited.

This potential effect is discussed in more detail below.

If one follows the decision criterion to accept cost-effective

projects in descending order of their SIR'S, the following example shows

how a change in pricing policy alters the allocation of limited funds

between electricity projects and distillate projects.

To illustrate the impact, the following procedure was used to

develop sample SIR's: First, a set of ten hypothetical distillate-saving

projects was specified such that, with a 7 percent discount rate, the

energy savings in dollars, when combined with an investment cost of

$2,250, will result in SIR's fran 10 to 1. Second, the quantity of energy

saved in million Btu was derived fran the dollar savings of the ten

initial projects. SIR's for ten counterpart projects saving electricity

at average prices and ten counterpart projects saving electricity at

marginal-cost prices were then computed based on the quantity of energy

saved by the ten distillate projects. In this way, study period, discount

rate, and capital outlays were held constant among the total thirty

projects. This procedure allows the effect of energy pricing on project

priorities to be examined. Distillate- and electricity-saving projects

were then arrayed in descending order of their SIR's. Figures 7a, 7b, and

7c depict the project rankings for the Midwest, Northwest, and the U.S.

as a whole, respectively. Tables 2a, 2b, and 2c, which are paired with

34
SAVINGS

TO

INVESTMENT

RATIO

(SIR)

AVERAGE PRICE MARGINAL-COST PRICE

40

Distillate

30

20

10 A

B

C

D

E

F

G

U

I KJ

Electricity

®

©

Distillate Electricity

i-

©

© ©

Project, distillate-saving

O Project, electricity-saving

Figure 7a. Ranking by SIR'S of a Set of Hypothetical Projects - Ml w.

35
Table 2a. Energy Savings of a Set of Hypothetical Projects - MIEWEST

Project3

rn DistillateLJ saving

Electricity - saving

MBtu

Saved

Energy Savings*3

Average Price Marginal Price

$ $

0

®

196

22,500

45,100

22,500

51,300

m

177

20,250 20,250

® 40,700 46,300

157

18,000 18,000

© 36,200 41,100

137

15,750 15,750

© 31,600 36,000

El

118

13,500 13,500

© 27,100 30,800

m

98

11,250 11,250

© 22,600 25,700

m

79

9,000 9,000

© 18,000 20,600

m

59

6,750 6,750

® 13,500 15,400

m

39

4,500 4,500

© 9,000 10,200

m

20

2,250 2,250

® 4,500 5,100

a The investment cost for each project is $2,250.

, (See text for construct of projects.)

The energy savings are evaluated with a discount rate of 7 percent.

36
SAVINGS

TO

INVESTMENT

RATIO

(SIR)

AVERAGE PRICE MARGINAL-COST PRICE

Distillate Electricity Distillate Electricity

Project, distillate-saving

O Project, electricity-saving

Figure 7b. Ranking by SIR'S of a Set of Hypothetical Projects - NDR’IHWKST

37
on

Table 2b. Energy Savings of a Set of Hypothetical Projects - NORTHWEST

Project3

ps Distillate-

' saving

Electricity- ^

saving

MBtu

Saved

Energy Savings*3

Average Price Marginal Price

$ $

®

193

22,500

25,900

22,500

87,000

m

174

20,250 20,250

(D 23,300 78,300

m

154

18,000 18,000

© 20,800 69,600

m

135

15,750 15,750

® 18,200 60,900

IS

116

13,500 13,500

© 15,600 52,200

m

97

11,250 11,250

© 13,000 43,500

m

77

9,000 9,000

© 10,400 34,800

0

58

6,750 6,750

® 7,800 26,100

m

39

4,500 4,500

® 5,200 17,400

19

2,250 2,250

® 2,600 8,700 a The investment cost for each project is $2,250.

(See text for construct of projects.)

k The energy savings are evaluated with a discount rate of 7 percent.

38
SAVINGS

TO

INVESTMENT

RATIO

(SIR)

AVERAGE PRICE MARGINAL-COST PRICE

40

Distillate

30

20

10

Electricity

©

©

®

CD

®

Distillate Electricity

©

®

®

0

Project, distillate-saving

O Project, electricity-saving

Figure 7c. Ranking by SIR'S of a Set of Hypothetical Projects - U.S. AVKKAQ-:

39
o

Table 2c. Energy Savings of a Set of Hypothetical Projects - U.S. AVERAGE

Project3

Distillatesaving

Electricitysaving

MBtu

Saved

Energy Savingsb

Average Price

$

Marginal Price

$

0 22,500 22,500

®

192

47,800 76,000

M 20,250 20,250

®

173

43,000 68,400

. ei 18,000 18,000

©

154

38,200 60,800

IS 15,750 15,750

®

135

33,500 53,200

11

115

13,500 13,500

© 28,700 45,600

0 11,250 11,250

96

© 23,900 38,000

m

77

9,000 9,000

© 19,100 30,400

e 6,750 6,750

®

58

14,300 22,800

m

38

4,500 4,500

© 9,600 15,200

m

19

2,250 2,250

® 4,800 7,600

The investment cost for each project is $2,250.

(See text for construct of projects.)

The energy savings are evaluated with a discount rate of 7 percent.

40
each of the figures, list the corresponding energy savings in million Btu

and in dollar values for the distillate and electricity projects. The

left-hand side of each figure depicts project rankings based on average

prices; the right-hand side those based on marginal-cost prices. "*"

If it is assumed that the projects are independent and that there is

a floating budget constraint such that only projects with, say, an SIR of

10 or above will be undertaken, a comparison of the SIR'S, based on

average versus marginal-oost prices, suggests the following results:

In the case of the Midwest region, figure 7a shows that the

allocation of funds between electricity projects and distillate projects

would be little affected by pricing policy. In either instance, six

electricity projects and one distillate project appear feasible. If,

instead, a cutoff SIR of 9.00 were selected, the use of marginal-cost

prices would allow acceptance of one additional distillate project and

one additional electricity project, while the use of average prices,

would allow only one additional distillate project.

By contrast, for the Northwest, where the difference between average

and marginal-oost electricity prices is much greater than in the Midwest,

figure 7b shows a much greater impact of pricing policy on the selection

of projects. With a cutoff SIR of 10, only three projects appear acceptable under average pricing: two electricity and one distillate.

^Since all of the thirty projects have SIR's equal to or greater

than one, they all are cost effective and would be justified on economic

grounds if funding permitted.

41
But with marginal-cost pricing, eight electricity projects and one

distillate project appear acceptable. Hence, it is likely that only

electricity-conserving projects would be done.

For the U.S. as a whole, figure 7c shows that with an SIR cutoff of

10, average pricing results in the acceptance of one distillate project

and six electricity projects. A switch to marginal-cost pricing adds two

new electricity projects to the acceptable list, which may eliminate the

distillate project, depending on total funding.

In summary, it is evident frcm figures 7a, 7b, and 7c, that if the

budget is limited, such that not all cost-effective energy projects can

be undertaken, the change in pricing policy frcm average prices to

marginal-oost prices can drive out distillate-saving projects.

4.4 Impact of the Discount Rate

A comparison of net savings in column (9) versus (11) and column

(10) versus (12) of table 1 shows the inverse relationship of net savings

and the discount rate. A lower discount rate will result in more projects

accepted and in up-sizing of projects. Other factors remaining the same,

the projects appear more cost effective with a 7 percent discount rate

than a 10 percent rate, and the larger size of the project is more likely

to be cost effective with a 7 percent rate than a 10 percent rate.

Looking again at table 1 and comparing the difference in net

savings between fuel types in the 7 percent discount column with the

42
difference in net savings in the 10 percent discount column, one can see

that the size of the gap is a function of the discount rate. The

difference in net savings is greater, the lover the discount rate. For

instance, in the Midwest, for 2" insulation, the difference in net

savings between electricity at marginal prices and distillate at

average/marginal prices is $38,265 (38,265=63,941-25,676) with a 7

percent discount rate and $30,318 (30,318=47,923-17,605) with a 10

percent discount rate (cols. 10 and 12). In the Northwest, the difference

in net savings between electricity at marginal-oost prices and distillate

at average/marginal prices is $86,929 (86,929=113,139-26,210) with a 7

percent discount rate and $61,564 (61,564=79,575-18,011) with a 10

percent discount rate.

4.5 Combined Effect of Pricing Policy and Discount Rate Changes

Figure 8 provides a graphic suntnary of the impact of alternative

pricing policies and alternative discount rates on net savings of the

hypothetical projects for each region examined. The graphs show the

widened gap between net savings for a distillate-aonserving project and

an electricity-conserving project when marginal-oost pricing is used. The

graphs also show that the higher the discount rate, the lower the net

savings, and the lcwer the difference in net savings between the fuel

types. Thus, the choice of fuel pricing policy has slightly less impact,

the higher the discount rate.

43
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44
5.0 Summary and Conclusions

This study has investigated how the selection of energy conservation

and renewable energy projects undertaken by the Federal Government will

be affected if benefits and costs are calculated with marginal-cost

prices rather than average prices. In addition, it has compared the

impact on conservation decisions of two discount rates: 7 and 10 percent.

It has also examined the interaction of the pricing and discounting

policies.

Seme general theoretical advantages of marginal-cost pricing were

discussed. A numerical and graphical analysis of a set of hypothetical

retrofit projects provided the basis for a quantitative illustration of

the specific kinds of impacts of the alternative pricing and discounting

policies. DoE 1984 projections of average and marginal-oost prices of

distillate and electricity were used for the comparative analyses. The

focus was on the DoE regions exhibiting the least and the greatest degree

of impact: the Midwest and the Northwest, respectively, and the average

of all DoE regions. All other data and assumptions were held constant in

order to isolate the impact of price and discount rate changes.

The follcwing inferences were drawn frem the hypothetical case

studies

A change fran average prices to marginal-cost prices can be expected

to increase the estimated cost effectiveness of electricity-saving

projects and, hence, their chance of being accepted. The use of marginaloost prices will tend to increase the cost-effective design or size of

45
electricity- saving projects relative to distillate-saving projects.

Marginal-cost prices are likely to raise the relative priority of

electricity-saving projects and, hence, more of them will tend to be

funded out of a limited budget. Depending on the size of the budget,

electricity-saving projects will tend to displace projects saving

distillate.

A discount rate of 10 percent instead of 7 percent reduces slightly

the effect of a change in pricing policies: the higher the discount rate,

the smaller the effect of a higher energy price on net savings and thus

the smaller the shift of priority fran distillate-saving to electricitysaving projects.

46
REFERENCES

(1) The National Energy Conservation Policy Act, P. L. 95-619, 92

STAT 3277, secs. 543-545 (1978).

(2) 10 Code of Federal Regulations, Revised, sec. 436, (1985).

(3)

Appendices A, B, & C of the Methodology for Life Cycle Cost

Analysis Using Average Fuel Costs, DoE/CE-0101, U.S. Dept, of

Energy, Office of Conservation and Renewable Energy, Office of

Federal Energy Management Programs, Washington, D.C., September 1984.

(4)

U. S. Office of Management and Budget, "Discount Rates to be Used

in Evaluating Time-distributed Costs and Benefits," Circular No.

A-94, Revised, (1972).

(5)

Energy Security Act, P. L. 96-294, 94 STAT 611, sec. 405, (1980).

(6)

A Framework for Marginal Cost-Based Time-Differentiated Pricing in

the United States, a report prepared by National Economic Research

Associates, Inc., New York, February 1977.

(7)

Public Utility Regulatory Policies Act, P. L 95-617, 92 STAT

3120, sec. 101, 92 STAT 3144, sec. 210, (1978).

(8) "Appendix D, Forecasting Methodology and Assumptions", Annual

Energy Outlook 1983, DoE/EIA-0383(83) , U.S. Dept, of Energy, Energy

Information Administration, Washington, D.C., May 1984.

(9) Carl Pechman, "Equity, Efficiency, and Sulfur Omissions Reductions," Public Utilities Fortnightly, Vol. 115, No. 10, May 1985.

( 10 ) "Notice of Proposed Life-Cycle Costing Methodology Amendment and

Marginal Cost Prices," 10 CFR Sec. 436, Docket No. CAS-FW-80-124

.

U.S. Dept, of Energy, Office of Conservation and Renewable Energy,

Office of Federal Energy Management Programs, Washington, D.C.,

1984.

47
NBS-114A (REV. 2-80

U.S. DEPT. OF COMM.

4.

BIBLIOGRAPHIC DATA

SHEET (See/nstructions)

1. PUBLICATION OR

REPORT NO. NBSIR-85/3262

2. Performing Organ. Report No. 3.

TITLE AND SUBTITLE

Publication Date NOVEMBER 1985

The Impact of Energy Pricing and Discount Rate Policies on Energy Conservation in

Federal Buildings

5. AUTHOR(S)

Sieglinde K. Fuller and Rosalie T. Ruegg

6. PERFORMING ORGANIZATION (If joint or other than N BS, see instructions)

NATIONAL BUREAU OF STANDARDS

DEPARTMENT OF COMMERCE

WASHINGTON, D.C, 20234

7. Contract/Grant No.

8. Type of Report & Period Covered

Final

9. SPONSORING ORGANIZATION NAME AND COMPLETE ADDRESS (Street. City. State. ZIP)

U.S. Department of Energy

Office of Conservation and Renewable Energy

Federal Energy Management Programs

Washington, DC 20585

10. SUPPLEMENTARY NOTES

Document describes a computer program; SF-185, FIPS Software Summary, is attached.

11. ABSTRACT (A 200-word or less factual summary of most significant information. If document includes a significant

bibliography or literature survey, mention it here)

The study investigates how energy conservation projects for federal buildings would

be affected by a change in energy pricing and discount rate policies. It focuses on

the choice between marginal-cost prices versus average market prices and a 10 percent

discount rate versus a 7 percent discount rate. Graphical and numerical comparisons

of hypothetical cases in selected geographical areas illustrate the expected impact

on selection, design and sizing, and priority of energy-saving projects.

12. KEY WORDS (Six to twelve entries; alphabetical order; capitalize only proper names; and separate key words by semicolon s) applied economics; discount rates; economic impact; energy conservation; life-cycle

cost analysis; marginal-cost pricing.

13. AVAILABILITY 14. NO. OF

fyl Uni imited

| | For Official Distribution, Do Not Release to NTIS

PRINTED PAGES

60

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