Utility Rate Decoupling

A mechanism to encourage regulated utilities to support
energy efficiency for their customers

Utility Finance Structures

Under traditional regulatory rate structures, utility revenues are proportional to sales of electricity and natural gas, while many utility costs are fixed regardless of sales. Consequently, programs that improve energy efficiency among their customers, and thus reduce their sales, can have a negative effect on utility profits. This “throughput incentive” is a significant barrier to effective utility energy-efficiency programs. Because energy efficiency is the cheapest, safest and cleanest way to meet our energy needs, it is important to encourage utilities’ to invest in effective customer energy efficiency programs. Decoupling is a rate adjustment mechanism that addresses this market barrier.

Decoupling

Decoupling refers to policies designed to “decouple” utility profits from total electric or gas sales so utilities do not have an incentive to try to sell more energy. Decoupling modifies traditional ratemaking practices to adjust rates frequently to ensure that utility revenue is neither more nor less than what is needed to cover costs and a fair return.

Rate Making

Because utilities operate as monopolies within their service areas, investor-owned utilities do not set their own rates. Instead, public utility commissions (PUCs) set rates every several years at a level sufficient for the utility to recover costs and a fair return on investment. But utility revenues subsequently change based on actual energy consumption, resulting in utilities receiving more or less revenue than the PUC said they needed. Decoupling instead sets the revenue needed to cover known costs, then allows rates to change with consumption to meet the revenue target.  Decoupling can be implemented by adding a “true-up” mechanism, which automatically adjusts rates based on consumption on a more frequent basis. Decoupling can also be implemented through alternative methods, such as a balancing account, which is used to store excess revenue or make up for revenue shortfalls.

Efficiency Programs and Policies

Decoupling is not itself designed to increase energy efficiency. Rather, it removes the “throughput” incentive that discourages utilities. To promote energy efficiency, decoupling policies should be combined with policies that require or incentivize energy efficiency. An Energy Efficiency Resources Standard (EERS), which requires utilities to meet energy-saving targets with customer efficiency programs, is one such policy. Positive financial incentives for effective energy efficiency programs, such as performance bonuses, enhanced rates of return, or shared savings, also should be combined with decoupling.

Effects on Ratepayers

Decoupling can affect ratepayers in a variety of ways. Ratepayers should ultimately benefit from the efficiency opportunities and incentives the policy is intended to encourage. Individual consumers would benefit from reducing their energy usage as rate adjustments are spread among all ratepayers.  And consumers collectively would benefit from lower energy use since savings in fuel and other variable costs (for natural gas, the large majority of costs) would be passed on to them. As consumers broadly engage in energy efficiency, energy costs may also decrease for all ratepayers as high costs are avoided for new plants and pipelines. Decoupling may also reduce volatility in energy bills due to weather and other factors (and certainly reduces risk for utilities). It preserves customers’ incentives for efficiency while removing utilities’ disincentives.

Michigan: Effectively Combining Decoupling and Energy Efficiency

In 2008 Michigan passed the Clean, Renewable, and Efficient Energy Act. In addition to allowing decoupling by certain utilities, the bill required electric and natural gas utilities to aid consumers in increasing their energy efficiency. According to a recent report by the Michigan Public Service Commission the programs implemented since 2009 are expected to yield lifetime energy savings of $404 million. Savings for 2009 alone achieved 137% of the intended targets.

Other Mechanisms

The decoupling method is only one of several ways to address the throughput incentive issue. The simplest way to address this would be to charge ratepayers a flat fee that covers all fixed costs, in a system known as Straight Fixed Variable Rate Design. However, such a system would reduce efficiency and conservation incentives for ratepayers by reducing their individual savings from lower energy use.

Other methods, called Lost Revenue Adjustment Mechanism (LRAM), Net Lost Revenue Recovery, or Conservation and Load Management Adjustment, seek to distinguish between revenue impacts of energy efficiency and other variables, such as weather and economy, in adjusting rates. This avoids making rates fluctuate due to weather and other causes. But it fails to remove the full throughput incentive and requires sophisticated measurement and verification of program savings, and hence may allow utilities to benefit from ineffective efficiency programs.