Avoided CostEdit

Avoided cost is the economic value assigned to the energy, capacity, and ancillary services that would have to be produced or procured if a particular resource, policy, or project were not available. In power-system planning and regulation, it serves as the yardstick by which alternatives—such as solar panels on rooftops, energy-efficiency programs, or new gas-fired plants—are judged for cost-effectiveness. The core idea is straightforward: if a resource replaces or defers a supply option, the costs that are avoided should mount into the basis for a decision. Proponents of market-based policy argue that avoided-cost calculations, when done transparently and conservatively, promote efficiency, protect ratepayers, and keep the price signals that drive private investment clear and honest. Critics, meanwhile, contend that the way avoided cost is estimated can tilt decisions toward or away from certain technologies depending on regulatory design, political incentives, or optimistic assumptions about future prices and reliability.

To understand its practical relevance, it helps to connect avoided cost to the broader toolkit of energy planning and policy. Avoided cost figures feed into least-cost planning and integrated resource planning, where utilities and regulators compare the economics of generation, transmission, and demand-side resources on a common financial footing. They intersect with concepts such as the levelized cost of energy Levelized Cost of Energy and the valuation of capacity Capacity Value to form a comprehensive view of the value a resource adds or saves over time. In many jurisdictions, avoided-cost calculations influence payment rates for distributed generation, energy-efficiency programs, and other grid resources, affecting how resources compete in the market Electricity market and how regulators structure incentives Subsidy.

Concept and economic rationale

What counts as an avoided cost: the marginal savings from not having to produce, import, or purchase electricity, plus the avoided or deferred investments in generation, transmission, and distribution assets. This can include fuel costs, operation and maintenance, capital costs, and, in some formulations, avoided environmental or health damages that would otherwise be borne by society.
Distinguishing energy and capacity: avoided cost typically aims to quantify both the energy value (kWh) and the capacity value (kW) of the resource being considered. A resource that provides reliable capacity at peak times may have a higher avoided-cost value than one that only lowers energy consumption, and vice versa.
Time horizon and structure: the estimate depends on assumptions about fuel prices, technology costs, load growth, and how the grid evolves. Short-run avoided costs may look different from long-run values as the mix of generation changes and new investments occur.
Relationship to market prices: in a competitive setting, avoided cost should reflect the actual prices utilities must pay to meet demand, not arbitrary benchmarks. When avoided costs diverge from real market signals, there is a risk that policy and procurement decisions misallocate resources and shift risk onto ratepayers.

Measurement and components

Energy value: the saved cost of generating or purchasing one more unit of electricity, typically measured as the avoided fuel and operating costs for the marginal unit that would otherwise be used.
Capacity value: the value of the resource in reducing the need to run expensive peaking plants or to build new capacity for reliability, especially during periods of high demand.
Transmission and distribution implications: avoided cost may incorporate the avoided investment in new lines or upgrades, but there is debate over how fully to credit such savings given the need for system reinforcements that may accompany higher penetrations of certain resources.
Externalities and non-market effects: some calculations try to include emissions, water use, or other external costs, though this is contested and varies by jurisdiction and policy preference.
Methodological pitfalls: choices about discount rates, time horizons, treatment of price volatility, and the treatment of federal tax incentives or subsidies can materially change avoided-cost estimates. Critics warn that aggressive assumptions can inflate the apparent value of certain resources, while conservative assumptions may undervalue beneficial options.

Links to related concepts: Discount rate, Fuel price, Grid reliability, Externalities.

Applications in energy policy

Procurement decisions: avoided cost helps determine what price the utility should offer for power from rooftop solar, energy efficiency programs, or other distributed resources, placing them on a comparable footing with central-generation options Distributed generation.
Rate design and incentives: regulators may use avoided-cost calculations to justify or challenge tariffs, net metering policies, and performance-based incentives.
Regulatory debate: supporters argue avoided cost aligns policy with real-world resource costs, while critics warn that imperfect calculations can privilege incumbents or certain technologies under political pressure. The debate often centers on how much weight to give reliability, system costs, and future price uncertainty.
International and regional practice: approaches vary by country and region, reflecting different regulatory philosophies, market structures, and policy objectives. See Public Utilities Commission or Regulation for more on how agencies translate avoided-cost reasoning into policy.

Links to related concepts: Regulation, Net metering, Energy efficiency, Distributed generation.

Controversies and debates

Reliability versus price signals: a frequent critique is that avoided-cost calculations focused narrowly on short-run fuel costs or immediate dispatch costs can understate the value of reliability and overstate savings from intermittent resources. Proponents of a more market-based approach argue that transparent, competitive bidding and direct price signals deliver better reliability outcomes than policy-driven incentives.
Integration costs: as penetrations of wind and solar rise, grid integration costs—-balancing, reserves, and flexibility—can be substantial. Critics say avoided-cost analyses sometimes omit or understate these costs, leading to an overvaluation of certain resources (or underestimation of needed investments elsewhere).
Subsidy design and political incentives: when avoided costs are used to justify long-term contracts or subsidies, there is a risk that political considerations or special interests skew the math. Advocates of a more market-oriented framework stress that subsidies distort price discovery, raise rates for all users, and crowd out other efficient investments.
Time horizon and risk: future fuel prices and technology costs are inherently uncertain. Relying on optimistic assumptions about future avoided costs can create moral hazard, while overly conservative estimates can retard beneficial innovations. The right balance, in a market-leaning view, is to let competition and open transparency determine value over a clear horizon, with risk-sharing mechanisms that do not socialize costs through regulation.
Equity and ratepayer protection: some observers worry that avoided-cost frameworks can be used to push expensive options onto ratepayers under the banner of “avoided costs,” even when the broader economic case is weak. A conservative, private-market perspective emphasizes that ratepayers should not bear undue risk or hidden subsidies, and that competition should guide investment decisions.

Links to related concepts: Reliability, Grid integration costs, Carbon pricing, Subsidy.

Practical outlook and policy prescriptions

Transparency and conservative assumptions: to keep avoided-cost calculations credible, practitioners favor clear methodologies, public disclosures, and sensitivity analyses that show how results change with reasonable variations in fuel prices, technology costs, and demand.
Market-based procurement: where feasible, letting competitive auctions determine the value of distributed resources tends to align payments with true market value, reducing the possibility that ratepayers subsidize preferred industries.
Focus on real-world performance: avoided-cost assessment should reflect actual system benefits, including reliability and resilience, rather than relying on theoretical savings that may not materialize under stress conditions.
Balanced handling of externalities: while some external costs are important, a disciplined approach weighs them against direct procurement costs and certainty for ratepayers, avoiding overreliance on policy instruments that distort investment decisions.

Links to related concepts: Policy incentives, Auction, Natural gas.