The Transformer – November 28, 2007

Volume 4, Number 8

Decoupling 101:

Breaking the link between energy sales and utility revenue

Background

Who doesn’t love conservation? We all know that more efficient energy use is the cheapest and cleanest resource going. The recognition that “the cheapest kilowatt is the one we don’t use” hardly qualifies as a “Eureka!” moment any more.

So why must clean-energy advocates constantly prod utilities to enhance their energy efficiency programs? What makes the most cost-effective option a hard sell?

The simple fact is that because utilities bring in revenue by selling energy, they are less than enthusiastic about paying for programs that help their customers buy less. Over the years, efficiency advocates have learned that it often isn’t enough to point out efficiency’s advantage — lower cost and a cleaner environment — over supply-side alternatives. Convincing utilities to acquire all the available cost-effective conservation requires a more creative approach, one that severs the ironclad link between financial health and sales volume.

For every kilowatt-hour of electricity or therm of gas sold, utilities collect revenue to cover fixed costs (e.g., for poles and wires), energy costs (e.g., fuel) and, in the case of private utilities, return on equity (profit). If a utility aggressively promotes energy efficiency and thus reduces kilowatt-hour and therm sales, it may fail to collect sufficient revenue through rates to cover all fixed costs and may lose the profit associated with the sales. For the utility, this lost revenue constitutes a disincentive to expanding its efficiency programs.

Enter decoupling. The concept is deceptively simple: “decouple” a utility’s bottom line from the amount of energy it sells through periodic rate adjustments – upward to make up for losses from reduced sales, or downward to reflect any “windfall” revenues from higher-than-expected sales. In this way the utility becomes indifferent to how much it sells.

This issue of The Transformer looks more closely at decoupling, its pros and cons, the barriers to its widespread adoption, and recent progress toward inclusion of decoupling mechanisms in Northwest utilities’ rate cases.

Adjust this

A textbook decoupling mechanism provides for annual rate adjustments that allow utilities to recover their fixed per-customer costs (as determined in the most recent rate case) — no more and no less — whether sales rise or fall. Fixed costs include such expense items as meters and meter-reading that are unaffected by the amount of energy a customer uses. A utility that can’t recover its fixed costs faces weakened finances and higher borrowing costs. But decoupling ensures that a utility can collect its fixed costs regardless of customer usage and should ease utility concerns about reduced revenues from customers’ energy conservation or from improved building codes and appliance efficiency standards.

Sounds great. So why isn’t decoupling standard practice?

While the basic concept is simple, the details are complex – which is why many of the state commissions that regulate profit-making utilities have been slow to embrace decoupling. Those complex details determine the effectiveness and equity of the mechanism.

Some concerns, and some solutions:

1. Problem: Fewer rate cases. If a utility’s recovery of its fixed costs is guaranteed even when power or gas sales drop, the utility might initiate fewer rate cases. Since rate cases give regulators and consumers the chance to examine all the utility’s expenses, revenues and financial management practices, fewer rate cases could mean lessened oversight, and reduced ability to lower rates when a utility’s other costs fall.
Solution: Schedules and thresholds. Regulators have advanced two solutions. The first is securing utility agreement to periodic rate cases as a condition of decoupling approval. The second is setting a profit threshold that triggers a rate case.
2. Problem: Money for nothing. Environmental advocates see decoupling as a way to remove the disincentive for utilities to increase their efficiency and conservation efforts. But decoupling guarantees that the utility will recoup its per-customer fixed costs regardless of any changes in usage, not just those resulting from its own conservation programs. Should utilities be protected against loss of revenue from such causes as weather changes and economic downturns? What about declining usage per customer due to improved building codes, appliance efficiency standards and customer-funded measures largely independent from the utility’s actions? In the normal course of events, shareholders would absorb such revenue losses, and regulators are wary of shifting the burden to ratepayers.

Solution: Everyone wins. When, for whatever reason, a utility’s revenue won’t cover its fixed costs, a utility may become financially troubled, resulting in lowered bond ratings and increased borrowing costs that would be passed on to consumers. Utilities in such a predicament might start making deep cuts in programs, services and employees – to the detriment of customers and the environment.

Correctly done, decoupling reduces the utility’s risk of failing to recover its approved fixed costs. A utility facing less risk can borrow money at a lower rate, thus reducing its cost for capital. These savings can be passed on to customers through a reduction in the utility’s return on equity. A decoupling mechanism that reflects ALL changes in sales, including weather-related changes, reduces utility risk the most, so should lower rates the most. It can also blunt utility opposition to legislative efforts to improve building codes and efficiency standards.
3. Problem: Weather risk is part of the business. Warmer-than-normal winters reduce heating load and colder-than-normal winters increase heating load. These swings are a utility industry fact of life and a risk for which private companies are compensated with a profit. Decoupling can be applied to weather-related changes in utility sales as well as to those resulting from energy efficiency efforts. Why remove weather risk when the point of decoupling is removing a disincentive to energy efficiency investment?

Solution: Everyone wins again! More financial certainty helps consumers and allows the utility to focus on customer service and energy efficiency.  Decoupling applied to weather-related sales swings should work like this: After colder-than-normal months, customers would receive credits to offset the utility’s increased sales revenue. After warmer-than-average months, a small surcharge would be added to customers’ bills to reimburse the utility for the lower sales revenue. These adjustments smooth out customers’ bills (customers appreciate lower bills during the coldest months and can tolerate slightly higher bills during warm months) and smooth out the utility’s income. The reduced volatility in revenues leads to better bond ratings that lower the cost of capital. It’s a win-win for both utility shareholders and consumers.

Decoupling in the Northwest

Oregon has been in the forefront in the decoupling debate, and recently approved decoupling mechanisms (including weather adjustment) for NW Natural and Cascade Natural Gas companies. Decoupling does not currently apply (though it has in the past) to the two large investor-owned electric utilities, Portland General Electric and Pacific Power, mainly because the Energy Trust of Oregon takes care of their Oregon conservation.

Late last year, Cascade Natural Gas, Avista and Puget Sound Energy proposed decoupling mechanisms for natural-gas sales as part of their Washington state rate cases. The NW Energy Coalition and Natural Resources Defense Council participated in all three cases. After lengthy negotiations, the three utilities submitted settlement proposals agreed to by the Coalition and Washington Utilities and Transportation Commission staff, but opposed by the Office of Public Counsel and low-income advocates. The Commission approved the settlements for Avista and Cascade, but not for Puget. Ironically, commissioners said Puget’s past conservation efforts were so good that decoupling would provide no added benefit to customers.

Meanwhile, the Idaho Power Co., Idaho regulators and stakeholders, including NW Energy Coalition, negotiated an electricity decoupling mechanism. Parties forged an agreement on all details, and the Idaho Public Utilities Commission approved Idaho Power’s decoupling this spring.

In all the decoupling cases, Coalition support was contingent on a number of key elements:

• Utility commitment to a robust energy efficiency program. Decoupling eliminates a utility’s disincentive to support conservation, but does not create an actual incentive to do so.
• Utility commitment to file a general rate case every 2-3 years.
• Regular adjustments of baseline usage per customer and inclusion of new customers in the baseline during the utility’s next rate case.

State regulators adopted that perspective in each of the rate cases, and their orders approving decoupling included increased conservation funding levels for the utilities. The utilities were willing to make the commitments to aggressive conservation programs, because with decoupling they no longer lose money when customers save energy.

A must to avoid

Different interests put different spins on decoupling and endorse varying strategies for removing utility disincentives to pursuing all cost-effective energy efficiency. Some strategies have merit, most are partial fixes at best or and others should be avoided because they create unintended consequences.

One particularly poor alternative to decoupling for assuring fixed-cost recovery is significantly raising the utility’s customer charge – the amount a customer pays regardless of energy use. Some utilities propose increasing this charge — typically $4 to $7 per month in the Northwest — to $15 to $25 per month. While this fixes the utility’s problem, it erects a barrier to customer-driven efficiency and conservation. That’s because the fixed cost would encompass a larger share of the bill and energy savings would apply to a smaller portion. An energy efficiency measure would thus save a customer less money — reducing his or her incentive to conserve.

Looking ahead …

Decoupling — though a relatively simple concept — can pose complex design and implementation challenges to individual utilities. The devil is in the details. Decoupling advocates must work closely with utilities, regulators and consumer advocates to ensure that all the elements of a good decoupling mechanism are incorporated into any proposal. Using this approach, utilities and consumers need not be adversaries.

Yes, investor-owned utilities must make money, which comes from consumers, creating a natural tension. But development of energy efficiency and clean energy need not fall victim to that fight. Decoupling removes the profit motive from sales, allowing both utilities and consumers to enthusiastically support a clean and affordable energy future.

What do you think?

We are interested in your reactions to these articles. We will print as many responses as possible in future editions of The Transformer. Please email comments to marc@nwenergy.org.