Utility Decoupling: Giving Utilities Incentives to Promote Energy Efficiency

California utility Southern Edison has proposed [1] distributing one million free compact fluorescent light bulbs to help low-income families reduce their lighting costs. It also offered customers the chance to exchange halogen lamps for new, energy-efficient Energy Star fluorescent lamps. And, it offered energy-efficiency programs that have saved more than four billion kilowatt hours - enough energy to power 500,000 homes for an entire year- and reduced greenhouse gas emissions by more than two million tons, the equivalent of removing 250,000 cars from the road. 

Why would a utility promote programs that cut sales of its electricity product? The answer is simple: California adopted a novel approach towards utility pricing that separates a utility's ability to make money from the amount of electricity that it sells, otherwise known as decoupling [2]. 

How Decoupling Works

In conventional utility regulation [5], utilities make money based on how much energy they sell.  A utility's rates are set based largely on an estimation of costs of providing service over a certain set time period, with an allowed profit margin, divided by a forecasted amount of unit sales over the same time period. If the actual sales turn out to be as forecasted, the utility will recover all of its fixed costs and its set profit margin. If the actual sales exceeds the forecast, the utility will earn extra profit. 

However, if actual sales fall below the forecast, the utility will earn less profit and may not be able to recover all of its fixed costs. Under conventional regulation, therefore, promoting any kind of energy efficiency measure is clearly against a utility's interest. Any type of measure to encourage green building or more energy efficiency appliances therefore often faces opposition from utilities because it would undermine their profit.

Decoupling breaks the link between the utility's ability to recover its agreed-upon fixed costs, including the profit margin, from the actual volume of sales that occur through a rate adjustment mechanism. If a utility promotes less energy use, they are rewarded rather than punished.

Under decoupling, there are a number of ways to compute the rate adjustment, but the basic principle is that if the actual sales are less than what was forecasted, there is a slight upward adjustment in rates to compensate the utility.  Adjustments typically would only be between 2-3 percent and some jurisdictions have applied caps on possible adjustments to protect consumers.

Any rate increase per kilowatt hour is usually offset [6] by lower energy use and usually lower overall energy bills due to increased conservation and lower energy consumption. Typical rate changes due to current decoupling is almost imperceptible to consumers. And instead of utilities passing on [7] the costs of building new plants to meet increased energy demand, under decoupling, consumers avoid the costs of new power plant construction and benefit instead from decreased energy consumption.

The California Experience

In 1982, California adopted [9] an Electric Revenue Adjustment Mechanism and became the first state to decouple utility revenue from sales and removed disincentives for energy efficiency and conservation. The program was successful [10]and reduced rate volatility.  In 1996, however, the California Public Utilities Commission (CPUC) concluded that deregulating the utilities would be a better alternative to decoupling and the legislature subsequently adopted most of the recommendations and the utilities became deregulated. Under the bill, AB 1890 [11], the utilities' rates were no longer regulated by the CPUC and instead the utilities would compete on the open market with other energy sellers. The results were categorically disastrous [12]. 

In their haste to cash out, two of the state's biggest utilities sold off too much of their generating capacity, leaving them with too little of their own existing energy supply. As a result, after a hot summer and a cold winter, the utilities were left at the mercy of independent producers who had acquired the generating capacity and could manipulate the wholesale market. Demand quickly ate up the cheap wholesale supply of energy and companies like Duke Energy, Reliant of Texas, and Enron made a killing [13] selling power at high rates to the companies that had just sold them their generators. And, as we highlighted [14] last week, California is just one of many states to have disastrous experiences with deregulation. Deregulation has not delivered energy savings and has often undermined state programs, as in California, that were promoting energy conservation.

After the mass electricity shortages in 2000 and 2001, California re-adopted [15]decoupling in a groundbreaking energy-efficiency campaign that includes two billion dollars of approved investments in efficiency from 2006 to 2008.  Every dollar invested by the utilities in efficiency measures have generated more than two dollars in savings for customers.

Other State Experiences with Decoupling

After experimenting with various mechanisms, Oregon adopted decoupling [17]for its natural gas utility in 2001. Oregon's decoupling is considered "partial decoupling" because the rate adjustment mechanism only calculates based on 90 percent of the difference between actual and projected sales. Through decoupling, residential rates [18] have increased by just $0.00212 per therm, or unit of gas. The program was originally meant to end in 2002 but has been reauthorized through 2009.

Just a few months ago, Maryland's Public Service Commission approved [19] a plan to decouple its utilities. While decoupling in and of itself will not cut electricity demand, it does mean that utilities can provide incentives for conservation programs without losing revenue. Under Maryland's plan, if customers cut energy use, the rate for distribution costs is increased in later months, thus allowing the utility to cover its fixed and maintenance costs. Customers still save money on fuel costs, which is the largest component of their electric bills. The decision was adopted in the wake of large rate-increase applications by two of Maryland's utilities. As stated [20]by Pepco Holdings chief financial officer, "We look at it as a significant win for both the customer and the utility. If we have reduced usage, the utility is not harmed."

Idaho approved [21] a three year decoupling pilot program for Idaho Power, the state's largest utility. In the final order establishing the pilot program, Idaho's Public Utility Commission (PUC) addressed some concerns from local advocates, the Idaho Community Action Network [22], and included:

• A three percent cap on new charges
• Showing of serious commitment to conservation by Idaho Power, above and beyond what Idaho Power proposed to do
• Closely monitoring the program.

The state legislature had also urged the PUC to adopt decoupling as part of an overall energy efficiency and conservation plan in the state's 2007 Idaho Energy Plan, which was compiled by an Interim Committee on Energy, Environment and Technology at the request of the House.

New York's Public Service Commission also passed orders [23] this year requiring utilities to develop proposals for decoupling mechanisms. This isn't the first time New York has implemented decoupling. Previously, in the early 1990's a form of decoupling was implemented for several of the utilities whereby utilities were given a share of the savings that resulted from demand reductions to offset lost revenues and profits. When the electricity market was deregulated, the demand side reduction incentives were largely discontinued.

In deciding to decouple, the Commission pointed to existing rate designs that could discourage utilities from actively promoting energy efficiency, renewable technologies and distributed generation. In particular, the Commission stated that the extent to which utilities rely on volumetric or marginal consumption for cost recovery acts as a disincentive for energy conservation and efficiency measures. 

Last session, Minnesota Representative Jeremy Kalin [24]introduced HF 1221 [25], a section of which introduced decoupling of energy sale from revenues. Rep. Kalin's bill was adopted into Minnesota's larger Next Generation Energy Act [26], which was signed into law by Governor Pawlenty. Minnesota's act is an excellent example of model legislation by combining:

• Energy efficiency goals, like reducing per capita use of fossil fuels by 15 percent
• Promotion of energy conservation by requiring electrical utilities to aim for annual energy savings goal of 1.5 percent of gross annual retail energy sales
• Investment in renewable energy research
• Implementation of first steps to decouple utility revenues from amount of energy sales 

The Minnesota plan sets up criteria and standards for decoupling and establishes pilot programs for decoupling.

How not to do it:  Taking a different approach, Duke Energy Carolinas filed [27] an energy-efficiency plan with the North Carolina Utilities Commission.  Instead of decoupling, the "save a watt" program calls energy efficiency a "fifth fuel" and would promote energy conservation through paying for energy audits, offering energy-saving suggestions, and subsidizing the purchase of compact fluorescent light bulbs and high-efficiency heating and cooling systems. In return, consumers would be charged [28]90 percent of what it would cost to build an additional power plant. 

While the idea behind the proposal is on the right track, as proposed, the Duke Energy plan does not impose any benchmarks or mandates on the energy company for specific efficiency targets. Yet, customers are still saddled with the costs of an additional power plant. The plan needs to either encompass mandatory efficiency targets for Duke Energy or bypass the proposal and adopt a straight forward decoupling plan.

The Challenges to Implementing Decoupling

The Regulatory Assistance Project [30] offers several resources on decoupling and energy efficiency measures. They have a detailed discussion of decoupling in their Energy Efficiency Policy Toolkit [31] and it's clear that adopting decoupling is a complex, involved process. First, the biggest challenge is in developing the actual mechanism for decoupling that works with the rest of the state's rate structure. A formula must be used to determine the rate adjustment mechanism and what, if any, incentives will be given to further encourage energy efficiency measures.

Second, some manufacturing groups, like the Electricity Consumers Resource Council [32], have opposed decoupling, claiming that it is not an effective way of promoting energy efficiency and saying they are concerned about potential rate increases. Yet, despite such rhetoric, decoupling has not resulted [33] in any significant rate increases in states that have adopted it and consumers end up with more control over their utility bills to offset increase with conservation measures. Any rate increase would be offset by with voluntary conservation efforts and moreover, cost-effective efficiency eliminates the need to purchase units of energy that would be more costly and utilities distribute fewer commodities with no corresponding loss of distribution revenue. 

Conclusion

States have really embraced [35] energy efficiency targets, like Illinois [36]' recent requirement that utilities implement cost-effective energy efficiency measures to reduce electricity usage by 2 percent of demand by 2015. Implementing these mandates without breaking the traditional method of utility rate structure is unlikely to be effective over the long-term. Instead, by adopting decoupling, states can work with utilities to promote energy efficiency by giving financial incentives that encourage both utilities and consumers to reduce energy use.