TODAY’S STUDY: Rates To Align the Interests of Utilities and their Customers
Energy Efficiency and Ratemaking: Aligning the Interest of Utilities and their Customers Robert King, Steve Isser, and Jess Totten, March 2016 (Southcentral Partnership for Energy Efficiency as a Resource)
While many states have taken actions to encourage energy efficiency, standard ratemaking practices for regulated electric utilities in the United States result in incentives for utilities to encourage their customers to increase consumption, rather than to reduce it. A number of rate-making innovations, however, have evolved over the last few decades to align the interests of utilities and their customers, and minimize conflicts with government mandates, such as energy efficiency. We find the utility regulatory strategy that has the greatest likelihood of fostering energy efficiency combines a clear state policy goal with a ratemaking framework that addresses the legitimate concerns of the utility. Despite a dizzying array of possible approaches to accomplish the second part of that formula, there are three fundamental components: procedures for timely recovery of energy efficiency program costs by utilities administering the programs, for reducing the lost revenue risk through decoupling, and providing opportunities for increased earnings from effective management of energy efficiency programs that create net benefits for society.
Electric utilities, and transmission and distribution utilities in particular, have a high level of fixed costs, but recover most of their costs through volumetric rates, that is, rates that are charged on a dollar per unit of consumption basis. The incentive to encourage consumption occurs in several ways.
First, because the primary rate recovery mechanism is through a volumetric rate, revenue rises and falls in direct proportion to customers’ consumption. Second, the standard rate formula compensates a utility for its reasonable expenses and provides a regulated rate of return on its investment in capital assets. To the extent that additional consumption results in the need for new infrastructure to serve customers, the utility is able to increase its return. Simply stated, increased consumption leads to increased investment, which leads to increased profits.
Finally, the cost and time required to conduct a rate case at a regulatory commission results in lengthy intervals between rate changes. To the extent that increased consumption occurs in these intervals, and utility revenue growth exceeds increases in the utility’s cost of supplying the additional demand, the utility benefits from the regulatory lag.
Thus, traditional rate regulation inevitably gives rise to conflicting objectives for the managers of an electric utility. For example, managers have an incentive to invest in capital assets, because such investments are a major source of utility profits, but they also must demonstrate to regulators that any investments are prudent and the assets are “used and useful” in providing service to customers. Government energy policies that are administered by utilities, such as requirements to conduct programs to improve customers’ energy efficiency, may conflict with the managers’ objective to increase sales and revenue.
Various alternative ratemaking approaches have been adopted in a majority of states to counteract the inherent incentive for utilities to work for increased consumption in traditional ratemaking regimes. Many of these alternative approaches attempt to incentivize regulated utilities to improve customer service, reliability, operational efficiency, and more efficient use of energy and capacity; in the absence of a regulatory driver, a utility has little financial motivation to improve outcomes in any of those areas.1 Performance based ratemaking (PBR) mechanisms or other innovative ratemaking approaches have been developed by regulatory commissions to address these conflicts.
The approaches include:
• Revenue regulation, which “decouples” the allowed revenue collected by the regulated utility from the sales volume, thereby eliminating the disincentive to conduct customer energy efficiency programs.
• Lost revenue adjustment mechanisms that allow a utility to recover reductions in revenues due to energy efficiency programs.
• Performance targets, in which rewards and penalties are established for identified areas of utility performance.
• Rate freezes coupled with performance targets, which provide a utility an incentive to control costs during a period in which it may enjoy the benefits of regulatory lag, if it meets performance standards in identified areas.
Absent some innovative rate approach, adopting an energy efficiency program results in increased costs and reductions in customers’ demand and, accordingly, adverse financial consequences for a utility. There are three aspects of energy efficiency programs that have ratemaking implications: (1) the utility incurs costs to conduct the program; (2) the utility loses revenue as a result of reductions in sales due to improved energy efficiency; and, (3) in general, utilities have no financial incentive to develop the expertise to manage a program to encourage customers to improve their energy efficiency.
Traditional ratemaking may address cost recovery, subject to regulatory lag, but it does not address the remaining issues.
In an era of small budgets for energy efficiency programs and gradual impacts from building codes, appliance standards, and emerging technologies, failing to address these issues may have had minimal financial impact on the utility. Today, however, many utilities operate in an environment of large and growing energy efficiency programs and massive impacts from codes, standards, and new technologies (e.g., LEDs, solar PV, etc.) that are having a material detrimental impact on utility sales and revenues. Some utilities are also operating in an environment of economic stagnation, which results in declining sales. In the recent past, as energy efficiency and other demand side measures substantially reduce electricity consumption in some regions, state regulators began addressing rate issues in innovative ways. While the approaches vary, the goal is similar: give utilities an incentive to accelerate energy efficiency and emerging technologies rather than work against them—and do so in a way that also improves customer satisfaction and lowers overall costs to consumers.
A comprehensive approach to cost recovery for energy efficiency programs would include at least three regulatory aspects:
(1) A decoupling mechanism designed so that the “throughput incentive” no longer remains;
(2) Timely cost recovery, through a special rate or rider for efficiency program costs; and
(3) A performance-based incentive which would allow the utility to share the net benefits of the energy efficiency program or to include a portion of the program costs in rate base. Regulators, particularly in states with large energy efficiency programs, have begun to address the issue of full cost recovery for program costs and lost revenues. However, utility management typically has other legitimate concerns. Why would a utility embrace a large state-mandated program that requires significant expertise and thoughtful management but does not contribute to its profitability? It may be necessary to adopt incentive mechanisms that make increased energy efficiency a “profit center” for the utility. The optimal regulatory strategy may be a clear state energy efficiency policy, a procedure for timely recovery of energy efficiency program costs, reducing the lost revenue risk through decoupling, and creating opportunities for increased earnings from effective management of energy efficiency programs that create net benefits for consumers…
Utility management has a fiduciary obligation to protect the interests of utility shareholders and to seek maximum returns on their behalf. Thus, management would be expected to be concerned about cost recovery and the potential for lost earnings associated with customer energy efficiency programs. Moreover, regulators have a legal obligation to afford a utility the opportunity to recover its reasonable costs and a reasonable rate of return on investment. In an environment of large or growing energy efficiency programs, part of the cost that should be addressed is the lost revenue that results from a successful energy efficiency program. Regulators across the country have begun to address the issue of full cost recovery. However, utility management may still have legitimate concerns beyond recovery of program costs and lost revenue. Will utilities fully embrace a large state-mandated program that requires significant expertise and thoughtful management but does not contribute to profitability? It may not be sufficient to merely protect the utility from lost revenues due to energy efficiency.
Rather, incentive mechanisms that make increased energy efficiency a “profit center” for the utility may also be required. The optimal regulatory strategy for energy efficiency may include some combination of a clear state policy goal, and procedures for timely recovery of energy efficiency program costs, reducing the lost revenue risk through decoupling, and providing opportunities for increased earnings from effective management of energy efficiency programs that create net benefits for society.