Helping Utilities Invest in Energy Efficiency

By Glen Andersen and Jocelyn Durkay | Vol . 23, No. 15 / April 2015

NCSL NewsDid you know?

  • Energy efficiency programs offer the lowest-cost approach to meeting energy needs and reducing emissions.
  • Traditional regulations for investor-owned utilities, whose profits depend on the amount of energy they sell, make it difficult for them to embrace energy efficiency.
  • Strategies that encourage utilities to invest in energy efficiency include “decoupling” earnings from sales.

Using energy resources more efficiently lowers energy costs and enhances economic productivity for industries, businesses and consumers. Although state policymakers and utilities generally recognize the benefits of energy efficiency, long-established practices for regulating investor-owned utilities—under which the amount of money they make is based on the amount of energy they sell—make it difficult for utilities to embrace energy efficiency. This dilemma is causing many lawmakers to look for innovative solutions that both save energy and help keep utilities in the black.

Under the traditional regulatory approach, utilities owned by investors (as opposed to those owned by co-ops, municipalities and others) increase profit when they sell more energy, not less. This “throughput incentive” conflicts with ratepayers’ goals to reduce their bills by using energy more efficiently. In addition, under traditional regulation, utilities are provided with a return on capital investment, such as a new power plant, while they are compensated far less for efforts that reduce consumption and eliminate the need for a new plant. Since most of utilities’ expenses are fixed costs—for pipes, wires, power plants and equipment—those with successful energy efficiency programs suffer lower sales, lessening their ability to recover fixed costs. Although utilities do experience some benefits from energy efficiency—including increased customer satisfaction, lower emissions and lower infrastructure costs—the risk of lower cost recovery often outweighs these benefits.

What if utilities recovered their costs in a way that didn’t rely on how much energy they sold and were rewarded instead for delivering reliable energy at the lowest price? Twenty-four states and the District of Columbia have adopted a “revenue decoupling” strategy to ensure that lowering the amount of energy consumed does not threaten a utility’s bottom line. Decoupling separates earnings from sales, removing the disincentive inherent in the traditional model for saving energy and investing in energy efficiency. Under decoupling, regulators determine how much revenue is needed to cover utility costs and allow rates to adjust automatically, during each billing cycle or yearly, to incorporate fluctuations in consumption. The traditional model sets the rates first, creating for utilities a less predictable revenue stream for recovering costs and an incentive to sell more energy.

While decoupling removes the throughput incentive, it does not necessarily motivate utilities to choose efficiency, since they often earn a higher return by building a new power plant. To level the playing field, many states enable utility shareholders to earn a return on their efficiency investments, just like they would for power plant investments. These “shared savings” policies allow the utility, when it meets certain efficiency goals, to receive a percentage of the savings that result from reduced energy purchases.

Another strategy designed to encourage utilities to invest in energy efficiency is known as lost revenue adjustment. Under this model, states allow public utilities commissions (PUCs) to adjust rates so utilities can recover the amount of revenue they lose from the lower sales that result from incorporating efficiency measures.

While these strategies are meant to provide incentives for utilities to exercise energy efficiency, they can place upward pressure on energy rates. Consumers may still save money, however, because their monthly bills go down when they use less energy or use it more efficiently.

State Action

Twenty-four states and the District of Columbia allow some form of revenue decoupling—12 allow it for natural gas utilities, three states and the District of Columbia allow it for electric utilities, and nine states allow decoupling for both types of utilities. At least 18 states provide performance incentives, and 17 offer some degree of lost revenue adjustment.

Rhode Island enacted legislation in 2010 establishing revenue decoupling for both electric and natural gas utilities. Utilities with more than 100,000 customers are required to file decoupling proposals with the PUC and must submit spending and rate reconciliation proposals annually. The law also allows performance incentives for electric utilities that employ shared savings policies.

In Michigan, legislation passed in 2008 has allowed investor-owned utilities to earn a return on their efficiency investments if they reach certain savings goals. The utilities are permitted to earn up to 15 percent of program spending if they reach 125 percent of their savings goals. An assessment compiled by the Michigan Department of Public Service, which is required by law, found that utilities met the 125 percent goal in 2012, producing an electricity savings totaling more than 1 million megawatt hours and gas savings of more than 4.28 billion cubic feet. The department expects customers to experience lifelong energy savings of $4 for every $1 that was spent on efficiency programs in 2012.

Kentucky authorized the PUC to approve demand-side management mechanisms that allow electric and natural gas utilities to recover their lost revenue. Lost revenue adjustments are determined on a case-by-case basis, and recovery is limited to a three-year period or the next PUC rate adjustment period. The program excludes large industrial customers.

Most recently, Kansas in 2014 authorized electric and natural gas utility cost recovery for specific programs, including energy efficiency. Cost recovery mechanisms can include decoupling, lost revenue adjustments, shareholder incentives or other modifications to traditional electric or gas rate structures.

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