3. Background

The need to update avoided cost calculations and to coordinate the development of input assumptions and methodologies across Commission proceedings has been articulated in several Commission decisions over the past year, including D.04-01-050, D.03-12-062 and D.03-04-055. In D.03-04-055, our energy efficiency rulemaking (Rulemaking (R.) 01-08-028), we initiated an avoided cost updating process to "assess externalities to reflect the societal costs of energy."²⁰ A draft report on this issue, dated January 8, 2004, prepared by Energy and Environmental Economics, Inc. under the direction of our Energy Division staff, is now available on the Commission's Website.²¹

This report, entitled "A Forecast of Cost Effectiveness Avoided Costs and Externality Adders," was developed in order to: (1) update the current cost-effectiveness inputs used in evaluating energy efficiency programs to more accurately reflect current conditions, and (2) provide the Commission with a method and model for updating cost-effectiveness inputs on an ongoing basis. Among other things, this report develops a forecast for the years 2004-2023 on avoided costs for use in quantifying the benefits of demand-reduction programs. The report proposes a time dependent valuation method to calculate avoided costs that are location-specific and vary by hour of day, day of week and time of year. The report also establishes a forecast of externality adders for use in quantifying demand side resource program benefits, namely, an environmental externality adder, a transmission and distribution adder, a system reliability adder, and a price elasticity of demand adder.

In D.03-12-062 and D.04-01-050, in our procurement rulemaking (R.01-01-024), we also articulated the need for a complete review of QF pricing policies relating to SRACs:

" . . . [I]n our view, there is a pressing need to revisit the SRAC pricing system, which will accurately and fairly set utility avoided cost prices both under current and expected future market conditions and with an eye toward diverse utility resource portfolios.

"As the foregoing discussion demonstrates, the SRAC energy pricing formula is now out-of-date. The capacity pricing component of the SRAC formula is also problematic, because the QFs receive capacity payments in addition to energy payments. With SRAC energy prices that can now be above market prices, the additional capacity payments that QFs receive could compound any inequity to the utilities and their ratepayers of the current SRAC pricing formula.

"We have a two-year window until most existing QF contracts begin to expire, and we should craft a remedy in the new OIR that better matches QF contracts with the actual needs and economic alternatives of the IOUs. Because it is so important that the current methodologies to establish SRAC be modified, we are directing the Commission staff to immediately begin work on a draft Order Instituting Rulemaking (OIR) that will examine and propose appropriate modifications to the SRAC methodology."²²

The need for consistency in assumptions regarding resource benefits was also recognized in D.03-06-071, our most recent decision on RPS implementation. Under the bid review process established for that program, utilities are obligated to assess those bids "on consistent assumptions," and apply "transparent criteria" in evaluating claimed project attributes, including environmental benefits.²³

More recently, in our new rulemaking proceeding on distributed generation and distributed energy resources, we recognized the need to develop a common methodology for assessing avoided costs in order to evaluate resource options for utility planning and procurement:

"In future iterations of our proceedings addressing efficiency, demand response, and electrical storage (when and if storage technologies become a cost-effective resource option [footnote omitted]), we will introduce the concept of DER [Distributed Energy Resources] and seek to develop and employ a uniform cost-benefit test in judging the suitability of these options for utility planning and procurement. This standard framework will in turn influence our consideration of incentives for utilities and their customers.

"This standardized cost-benefit test ultimately involves the calculation of avoided costs over some time frame, typically the short run (SRAC) or the long run (LRAC). This exercise is currently underway in a number of forums before the Commission: in the energy efficiency proceeding, in the implementation of the Renewable Portfolio Standard, in the treatment of QF resources . . . , in our previous distributed generation proceeding, and now here.

"These efforts are essentially technology-specific attempts to answer a common question: what is the value of deferring an IOU investment in traditional generation resources? The answer to this question is the foundation of the benefits side of the cost-benefit analysis, to which consideration of externality avoidance and other technology-specific attributes should be added.

"The Commission intends to develop a common methodology for assessing avoided costs across the full range of supply- and demand-side technologies, to be employed as a fundamental component of integrated IOU planning for the short and long term."²⁴

Finally, in our rulemaking to promote coordination and integration in electric utility resource planning, R.04-04-003, we adopted a case management approach to the development of avoided costs, as a vehicle for coordinating the ongoing record- building on this issue in our resource-related proceedings.²⁵