Making Efficiency Pay

Aging coal plants are closing across the nation, along with a growing number of nuclear units, and utility planners are increasingly concerned about how best to replace this shuttered generation capacity. While improving energy efficiency has proven an effective and affordable alternative to building new power plants, this approach has its own cost in lower returns to investor-owned utilities. Now, an innovative approach to rate-setting is helping to spur energy efficiency, and it is earning praise from the utility industry in the process.


Getting energy-efficiency advocates and electric-utility executives to agree on anything related to rates has long been a struggle. The groups are often opponents during state-level ratemaking battles, with the former arguing for more efficiency incentives, and the latter making the case that such efficiency efforts force companies to work against their own business interests. 


The reason for the disagreements is easy to see: utility revenue is most typically driven by the number of ­kilowatt-hours sold. This new approach to rate-setting breaks that connection, so utilities can continue to prosper, even as electricity sales fall.


The process of rate decoupling (also called “revenue regulation”) eliminates utilities’ “throughput incentive”—the motivation to boost sales by pushing out more electricity to customers—from their business models. Instead, state public utility commissions work with utilities to determine a fair return on the utility’s equity investments, providing what is, essentially, guaranteed income. Then kilowatt-hour rates are set for the various tiers of residential, commercial and industrial customers to create that income, as they would be otherwise. However, if revenue for any given year rises above the agreed-upon threshold—thanks to extreme weather, for example—the excess is returned to customers. Similarly, if successful efficiency measures or an economic downturn lead to revenues falling below the threshold, customers’ rates will rise accordingly.


Key to these plans is a built-in revenue adjustment mechanism that can handle revenue excesses or shortfalls without the need for the utility to present a full rate-case request. This is a big advantage for utilities and, arguably, their customers. 


Rate case hearings can be contentious and expensive, and the costs can end up being baked into consumers’ monthly bills. Some have argued that guaranteed revenues could make it less expensive for utilities to get financing for capital investment projects because banks would see lower risk. A 2013 report by the Cambridge, Mass.-based Brattle Group, “The Impact of Revenue Decoupling on the Cost of Capital for Electric Utilities,” disputes this notion and argues against ratemakers, considering it as a possibility when establishing an allowed rate of return on equity.


Thirteen states and Washington, D.C., have adopted some form of rate decoupling, including the top seven states in the American Council for an Energy- Efficient Economy’s 2015 State Energy Efficiency Scorecard. In addition, a number of states have adopted some form of loss-recovery to ensure energy-efficiency improvements don’t negatively affect shareholder returns.


While much of the attention in rate-decoupling is directed toward maintaining electric utilities’ financial health, the programs can benefit consumers, as well. While energy-efficiency programs can mean higher rates, the demand reductions that result can mean lower customer bills, as has been the case in California, which first initiated rate-decoupling in 1981. As a 2013 study by the National Resources Defense Council (NRDC) shows, though kilowatt-hour rates are comparatively high in California, its customers’ annual electric bills are the ninth-lowest in the United States, nearly $700 less than those for the average household in Texas. Because of the success of efficiency efforts, average per-capita electricity demand has remained flat in California over the past 40 years, while the rest of the nation has seen a 50-percent increase.


Rate-decoupling programs are becoming more common just as the idea of what an electric utility is and does changes in the face of another decoupling—that of the long-assumed partnership between economic growth and increased electricity demand. As Bloomberg New Energy Finance noted in its “Sustainable Energy in America: 2016 Factbook,” electric-load growth last year rose an anemic 0.5 percent, compared to a projected 2.4 percent increase in gross domestic product (GDP). And, though the U.S. GDP grew by 10 percent between 2007 and 2015, primary energy consumption actually fell 2.4 percent over that period. Utilities that continue to focus revenue-building efforts only on pushing more kilowatts over their wires face the possibility of hard times in the near future.


Regardless of the motivation, there are strong indicators that the general notion of recognizing and addressing the impact energy-efficiency programs could have on utilities’ bottom lines will only become more important in rate-design cases. Both the NRDC and the Edison Electric Institute, the organization that represents interests of investor-owned utilities, have come out in favor of rate decoupling. Finding common ground between these two organizations is both a rare event and a sign the practice is likely to become more common.

About the Author

Chuck Ross

Freelance Writer

Chuck Ross has covered building and energy technologies and electric-utility business issues for a range of industry publications and websites for more than 25 years. Contact him at chuck@chuck-ross.com.

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