Societal benefits of smart grid – an economics perspective
In response to the Energy Policy Act 2005 (EPAct) Section 1252 many utilities have undertaken aggressive initiatives to drive a “Smart Grid” program. Almost a necessary part of undertaking this exercise is developing a business case to capture the benefits of Smart Grid capabilities, which typically consist of everything needed to support a) advanced metering; b) AMI communications networks; c) home or personal area networks; d) distribution automation sensors and nodes; and e) data systems and interfaces to legacy applications.
Business cases for Smart Grid are developed to compare the benefits, often incrementally, with the costs of multiple technology options to evaluate and determine the options that provide the greatest economic value. In almost all cases, the onus of developing the business case is on the utilities, For utilities, the principal benefits only account for the sum total of what accrues from providing electricity to consumers, i.e., purely from a producer of goods standpoint. Utilities then compare these benefits with the cost of implementing the technical solutions available. To date, the costs for these these solutions are almost entirely borne by the utility[1].
Typically, the assessment of cost/benefits does not result in a fair comparison. While utilities, as producers, bear almost the entire cost of a Smart Grid implementation, the total economic surplus (or, social surplus) due to a Smart Grid implementation go beyond those accrued to utilities alone. From an economist’s viewpoint, substantial benefits accrue to consumers and, more interestingly, to third parties because of positive externalities created from a Smart Grid implementation. Therefore, while the costs are almost entirely borne by the utility at the onset, there are benefits that are not accounted for by the utilities.
This article, presents some of these third-party benefits of “Smart Grid” to highlight why it is important, especially for regulators, to recognize these benefits when considering rate cases. This article also attempts to shed some some light on why it may be good economic policy in some cases for the government to induce support for Smart Grid initiatives through some form of subsidy. Such an approach might help utilities overcome some of the challenges faced in justifying Smart Grid investments, thus benefiting society overall.
What are societal benefits?
What should be included in the term “societal benefits” is subject to interpretation. In KEMA’s experience, we have found that the implementation of a Smart Grid provides direct benefits to the end consumers of the electricity. However, these types of benefits accrue to society in general and are not just limited to the end consumers. Therefore, it is important to make a distinction between “consumer” benefits and “third party societal benefits”.
An example of a consumer benefit would be the economic loss a consumer can prevent with better outage management provided by the Smart Grid. In other words, outages may cause consumers to dispose of food in the refrigerator because it gets spoiled due to the electricity outage. If a Smart Grid helps in reducing the frequency and/or duration of the outage, then the avoided economic loss (food costs in this example) is termed as a consumer benefit of the Smart Grid. By comparison, an example of a “third party societal benefit” would be a decrease in environmental degradation because of better electric demand management that results from a Smart Grid. Note that the societal benefits impact everybody[2] regardless of whether an entity is a direct customer of the utility.
Smart grid societal benefits
Now that we have distinguished “societal” benefits from “customer” benefits, the challenge is how to identify them. Identifying and quantifying societal benefits in any economic valuation is not a trivial exercise. This is because, by definition, valuation of societal benefits relates to what economists call a “social analysis” that relates to human welfare and how livelihoods of different communities are affected. This, in turn, impacts economic performance. The nature of these benefits are difficult to forecast and can very easily be wrongly valued.
Smart Grid is no exception from this standpoint. While there are some obvious social benefits, their relevance and valuation are very specific to the deployment areas and the conditions present within those areas. Utilities typically are not concerned about accounting for these benefits because they do not realize them and hence these benefits do not get reflected in their financial statements. Again, based on KEMA’s experience, we list here some of the societal benefits that are relevant in most Smart Grid deployments. It is important to recognize the caveat that—just like Tolstoy’s, “…happy families are all alike, but every unhappy family is unhappy in its own way”—every Smart Grid deployment will have its own unique list of societal benefits and requires rigorous understanding of community welfare effects in the deployment areas to recognize the value. With that said, here is a sample of typical societal benefits that many utilities will ultimately include in their business cases:
Decreased electric demand and load that would improve environmental conditions. Smart Grids provide the infrastructure to facilitate load reduction and demand management programs. Each participating customer in this program creates a positive consumption externality that helps in reducing peak loads coincident with the utility’s system peak. Utilities can take advantage of this condition to displace generating units’ run-time, thereby decreasing the amount of pollutants discharged by peaking units. In addition, by automating certain field operations, manual field trips can be avoided, further reducing tailpipe emissions associated with these vehicular trips. Of course, reductions of pollutants have many other benefits that include health benefits and reduced cost. To what extent these additional health benefits and reduced costs ultimately go into a valuation depends on how defensible the assumptions and quantitative data are in providing credible dollar equivalents.
Benefits that accrue from enabling the efficient and flexible connection of distributed energy resources (DER) devices to lower voltage distribution grids. DER devices include renewable energy (low or zero carbon impact) generation such as wind and photo-voltaic cells and also bulk electricity storage devices that are now becoming available. DER devices break the pattern of ‘economy of scale’ that for 50 years has led to generation connections migrating to central power plants connected to high-voltage transmission grids. Many DER sources are of a scale that makes it economic to connect to distribution grids directly at the distribution voltage level, provided that the existing grids are upgraded to Smart Grids to accept these energy infeeds, collect intelligent information, and handle their variability. The challenge to traditional grid design is most evident where it needs to accommodate microgeneration with its power quality and revenue metering challenges. This aspect is likely to be a key determinant for governments in which carbon reduction targets have been set. Conversely, traditional grids are potentially a significant barrier to achieving such targets if they are not converted to smart operation.
Benefits that accrue from enabling large-scale DER devices (such as off-shore wind farms, marine energy, and storage systems) to connect and operate efficiency and securely. Large scale DER may connect to transmission grids, but in many circumstances it may be economically and technically attractive to connect them to grids located in coastal areas[3]. This, however, places a new duty on distribution grids, requiring them to operate more like transmission systems with new requirements for power flow control, voltage management, and automatic control actions. Smart Grids architectures and technology solutions are likely to be important enablers here.
Benefits that accrue from enabling plug-in electric vehicles. A Smart Grid infrastructure will be required to support a fully operational practical implementation of plug-in electric vehicles[4] in the near future. Most of these initiatives are presently in the “concept stage” but many automobile companies are becoming increasingly aggressive in their development activities. The principal idea behind plug-in vehicles is to view an automobile as an electric appliance. To make the concept of plug-in vehicles a pervasive, commercially viable, and operationally practical, requires the development of effective markets and a broader access to these vehicles At this point, the anticipated benefits are plug-in vehicles are enormous, especially when the reduction oil consumption , decreased dependence of foreign oil, and the ensuing national security concerns and environmental ramifications are included in the equation.
The above benefits provide a sense of the type of societal benefits that are possible in a Smart Grid program. In addition to these above benefits, there are other, not-so-easily quantifiable benefits. These includes benefits like social perception of the utility and the goodwill created in the marketplace. This not only can serve as source of competitive advantage with other utilities, but also impacts seeking corporate funding in equity and credit markets. Typically such benefits create a “bandwagon” effect in the industry that forces other utilities to undertake programs that also create significant economic welfare for the society.
Valuation of societal benefits in smart grid
Once the applicable benefits for a Smart Grid deployment are identified, the challenge is to value these in dollar terms. It is a known fact in economic analysis that an important consequence of externalities is that, when left unattended, they lead to inefficient resource allocations. Utilities conduct financial valuations of Smart Grid investments based on competitive market allocations such that the investments made are exceeded by the returns, taking into consideration time value of money[5] and cost of capital. However, this allocation may not be optimal for the society at large due to third-party societal benefits. Therefore, when measuring social benefits, we must take into account all the effects that a society experiences from production and consumption of electricity in a Smart Grid deployment, and not only the effects experienced by the utilities that produce electricity and their registered consumers who consume electricity.
As highlighted earlier, there are positive externalities that, if not considered in the valuation exercise, will under-value the benefits of a Smart Grid deployment to the overall society. To value these benefits, oftentimes we encounter enormous quantification challenges that may require complex statistical studies of demographics, health effects, value of life, etc. These quantifications are subject to vast diversity of assumptions that are usually extremely difficult to validate and verify. The encouraging aspect, however, is that there are huge opportunities to leverage from work that is being done in other industries. For example, it might be of interest to an automobile industry to quantify the societal benefits of a fully electric car that would include valuation of reduction of pollution and greenhouse gases. In addition, a public health organization may conduct studies to quantify dollar impacts of quality of health improvement that come from reduced pollution. Data obtained from these industries can be a useful resource in bringing more rigor and accuracy to the quantification exercise and conducting such valuations effectively.
Subsidy considerations
So far this article had addressed some of the ways to identify and value societal benefits. In reality, the valuation of societal benefits is of no consequence to the utilities unless there are incentives placed to take credit for these benefits. In other words, the next challenge is how to implement a policy that is consistent with the valuation of societal benefits. More generally, societal benefits left to electricity-producing utilities will only leave behind a void of an appropriate “market for the positive externalities” that a Smart Grid deployment creates. The absence of such a “market for positive externalities” creates a problem. For example, if there was a market for clean air inside a city, a car driver could be rewarded (through market prices) for polluting less and could potentially be induced into consuming a socially optimal level of gasoline. In such a hypothetical market, marginal social costs of polluting would be equated to marginal social benefits of driving, and social efficiency would be restored. We can apply a similar mindset to think about achieving optimal allocation of resources expended by utilities in Smart Grid programs.
Based on the characteristics of societal benefits that are imminent in a Smart Grid deployment, and the positive externalities mentioned above, we believe that the situation is not very different from the conditions where government support becomes necessary to leverage the full benefits of the Smart Grid. Similar to the market for clear air inside the city that rewards the less polluting car driver, we can think about ways in which a market for utilities that took Smart Grid initiatives would also reward utilities with market prices for creating all the additional societal benefits. Such a scheme would be a more accurate pricing representation of the socially optimal benefits of a Smart Grid deployment. For example, in such an ideal market environment, utilities might receive money for each extra unit of electricity that it pushes through the Smart Grid infrastructure.
While creation of such an “ideal” market is very rarely practical due to high transaction and verification costs, another alternative that is possible is government grant subsidies through policies – both monetary and/or otherwise to utilities to recover part of the costs that relate to societal benefits. A subsidy can serve as a good approximation of the “ideal” market conditions and provide decent incentives for utilities to initiate Smart Grid programs.
Conclusion
This article has presented some of the societal benefits that are obtained through a Smart Grid deployment. While in most cases, it is difficult to accurately quantify societal benefits, depending on the specific deployment conditions these benefits may be significant in dollar terms. The lack of a market that rewards such benefits to those who produce – typically utilities that invest in Smart Grid initiatives and the consumers, who consume the electricity from these deployments—may inhibit deployments that are socially beneficial to all. As such, if regulators do nothing to reward utilities for their Smart Grid efforts, many utilities will continually find it difficult to obtain positive returns from Smart Grid deployments. One way regulators and government at large can promote Smart Grid deployments is through a subsidy policy for Smart Grid investments. Such a policy would provide a more realistic valuation to Smart Grid deployments accounting for all the benefits emerging out of the positive externalities, and hence setting the right incentives for Smart Grid investments.
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[1] Which eventually wholly or partially get rolled into the rate case that needs to be approved by the local regulators.
[2] Similar to the characteristics of a public good.
[3] Some of the issues in offshore wind power are documented in http://www.ocean.udel.edu/windpower
[4] See GM Chevy Volt, http://www.chevrolet.com/electriccar/
[5] Usually a form of Discounted Cash Flow is performed.