Decoupling is Risky Business for Consumers
Contribution by: John B. Coffman, General Counsel, Consumers Council of Missouri
Decoupling is currently drawing a lot of attention as a way to change the methodology for cost of service ratemaking for energy utilities. Utilities have applied the word "decoupling" to a variety of different rate mechanisms, but generally, the term refers to attempts to sever the regulatory connection between the amount of energy sold by a utility and the amount of revenue that the utility can collect from its customers. The Consumers Council of Missouri is skeptical of decoupling; the purpose of this article is to explore the nature of some problems that I believe decoupling poses for consumers.
Some utilities like decoupling because it reduces their risk of doing business. What business wouldn't welcome a more predictable income stream, independent of uncertainties regarding the actual sale of its products or services? Interestingly, some advocates of energy efficiency and environmentalists view decoupling as a way to further their agendas, attracted by the hope that decoupling could reduce a utility's opposition to energy efficiency. However, this sentiment is not universal among environmentalists. In my opinion, decoupling holds little promise of encouraging consumer benefits that outweigh the additional risks that consumers would be forced to bear. In fact, decoupling can be counter-productive to the goal of saving energy because it deprives consumers of the full utility bill savings of their efficiency efforts (witness AARP's "Save More/Pay More" campaign).
Consumers Council's has concerns about decoupling that are shared by a broad spectrum of consumer advocates, from organizations such as AARP and the National Consumer Law Center (NCLC), which represent residential consumers, to organizations like the Electricity Consumers Resource Council (ELCON) that represent large industrial consumers.1 A significant majority of the members of the National Association of State Utility Consumer Advocates (NASUCA) are also critical of decoupling.2 State public utility commissions in Washington and Maine have experienced unfavorable results with decoupling experiments, partly due to the way that recession economics can magnify the negative impact of decoupling. Several other state utility commissions, while rejecting some version of decoupling as being unfair to consumers, have nonetheless embarked upon lesser variations of it, or adopted "partial decoupling" that attempts to isolate only those revenue changes that can be verified as being directly linked to the utility's energy efficiency efforts.
In order to fully understand the concerns that consumer advocates have with decoupling, it is important to note how decoupling fits into a trend of changes that have been proposed to "improve" the regulatory process. From a consumer perspective, decoupling may not be the worst idea currently being debated in the context of encouraging utility sponsored energy efficiency programs. For example, mechanisms to allow utilities to recover so-called lost revenue, straight-fixed/variable rate designs and other proposals that would dramatically increase the customer charge (the minimum portion of a monthly utility bill) can also harm utility customers. All of these mechanisms vary from jurisdiction to jurisdiction with regard to the degree of risk transferred to consumers and with regard to the consumer protections that may accompany them. Each should be judged on its own merits and shortcomings.
Before discussing decoupling in more detail, I want to explain some basics about the ratemaking system with which decoupling would tinker. By virtue of the regulatory compact, an electric company agrees to serve customers as a public utility, taking on the obligation to provide electric service at "just and reasonable" rates, generally interpreted by Missouri courts as an obligation to provide service on a least cost basis.3 The state of Missouri grants energy utilities the exclusive franchise to serve a group of customers within a defined territory, plus the opportunity to earn a reasonable rate of return, in exchange for serving those customers in the most prudent and economically efficient manner. The applicable legal standard to which the utility must abide is to provide that utility service in the least cost manner, not necessarily the manner that produces the greatest shareholder profits.4
Pursuing a certain amount of energy efficiency is the least cost resource option for investor-owned utilities in our state for meeting the future demand for electricity, based upon the most recent integrated resource planning (IRP) reviews. Thus, it would appear logical that Missouri electric utilities currently have a legal obligation to invest in every reasonable opportunity for energy efficiency. Surely such utilities should face a potential disallowance for power plant construction costs, if they have not first exhausted all reasonable energy efficiency programs. Consumer advocates have a right to ask why any sweetening of the pot is necessary in order to induce the pursuit of this least cost option, which is the utility's obligation to the public under the current ratemaking paradigm.
Moreover, a preference for energy efficiency is already official state policy. In 2007, the Missouri General Assembly passed 393.1040 RSMo, which states that it is "the policy of this state to encourage electrical corporations to develop and administer energy efficiency initiatives that reduce the annual growth in energy consumption and the need to build additional electric generation capacity." In 2009, the Missouri Energy Efficiency Investment Act (MEEIA) was adopted, which allowed the Missouri Public Service Commission (MoPSC) to approve a variety of financial incentives to electric utilities related to "cost-effective measurable and verifiable efficiency savings." Some electric utilities have recently secured agreements under MEEIA that involve ramping up energy efficiency investments.5
So how much must consumers pay to induce utilities to pursue least cost energy efficiency investments? I acknowledge that the "throughput disincentive" describes a real economic phenomenon; it is a reflection of the risk that energy efficiency efforts could dampen utility earnings, at least on a short-term basis between rate cases. But as discussed above, it is not the purpose of utility regulation to maximize profits; rather it is to protect the public by ensuring that regulated utilities engage in cost efficient behavior. Some states have succeeded in bypassing this problem by setting up third-party providers, independent from the energy utility, whose specific task it is to implement desired energy efficiency goals.
The current utility ratemaking system has worked well to promote cost efficiency for about 100 years. But, in my opinion, fuel adjustment clauses and experimentation with other piecemeal mechanisms have caused serious damage to that system's inherent incentives for cost efficiency. Based on those experiences, consumer advocates are fearful of further tinkering. The calculation of revenue concurrently with all other relevant factors is an important pillar of cost of service regulation. If this framework is dismantled through decoupling, in order to eliminate the "throughput disincentive," I fear the inherent incentives that currently promote cost efficiency will be also be eroded.
I would like to note here that implementing decoupling itself will not provide an incentive for anything. Eliminating a disincentive is not the same as creating an incentive for the utility to perform in a certain way. Breaking the regulatory link between utility service and utility revenue is analogous to partial deregulation, and as such, implementing decoupling will, at least partly, diminish current ratemaking incentives for efficient utility performance.
Returning to the role of risk and its proper allocation under cost of service ratemaking, it is important to understand that this is a zero-sum game. When a new ratemaking policy is used to alleviate some risk to the utility, the risk doesn't simply evaporate. Rather, that risk is shifted to consumers – sometimes sub-groups such as only residential customers, but can also be all customers. Does the utility deserve extra compensation for the so-called risk of running energy efficiency programs? In reality, running such programs appears to be fairly low risk, especially compared to the risk of cost overruns that haunt most large power plant construction projects. Even if an energy efficient utility is not earning the generous profits that risky power plant construction could bring, it will certainly still be receiving an opportunity to earn a profit that is commensurate with its risk.
Decoupling is often expressed as shifting the risk of revenue variability to consumers because of a desire to counteract a perceived perverse incentive contained within cost of service regulation. Assuming that this "throughput disincentive" has an undesirable effect, we should still ask if it is fair to shift the harm of that undesirable effect onto consumers. We should also explore whether decoupling would create a different perverse incentive -- one that discourages consumers from embracing energy efficient choices by taking away the economic savings they achieve when they reduce their usage (the "Save More/Pay More" effect).
This brings us to the role of a utility's return on equity (ROE). Keeping the lights on requires attentive management, and partly in recognition of risks inherent in that obligation, cost of service ratemaking grants the investor-owned utility (IOU) an ROE commensurate with those risks. Some advocates of decoupling acknowledge that it reduces a utility's business risk. They suggest that this reduced risk should be factored in the calculation of the ROE. This would be consistent with cost of service ratemaking and should be done whenever a new risk-shifting adjustment is made to rates. However, rarely do public utility commissions make downward adjustments to ROE's. When it does happen, it is usually a temporary modification. The new risk-shifting mechanism often becomes permanent, while the corresponding downward ROE adjustment to protect consumers is forgotten in the next rate case. And with decoupling, even if the risk reducing effect is recognized in the ROE calculation in a rate case, that recognition is disconnected from the regular decoupling rate increases showing up on consumer bills between rate cases.
Decoupling is usually implemented as a piecemeal adjustment to rates as revenue is recalculated at regular intervals. As such, decoupling suffers from the same problems as single-issue surcharges -- such as a fuel adjustment clause -- that can raise rates outside the context of a rate case based on certain expenses. If the revenue component of ratemaking is similarly adjusted in isolation, the utility's balance sheet is not being examined in its entirety to ensure that all relevant factors are being considered. If unknown factors cause a miscalculation when utility revenues and utility sales are being reconciled to compute a rate, it is more likely to be discovered by auditors who are examining the utility's records in a full-blown rate case. Adjustments made outside of rate cases tend to miss things, to the detriment of consumers. Regardless of how many prudence reviews are conducted when rates are changed outside a full rate case, if one component of a utility's cost of service is put on autopilot, consumers are at risk of being charged too much.
No compelling evidence has surfaced to show that utilities cannot wait for a general rate case to account for a revenue reduction. Any shortfall related to revenue reductions will be short-lived, because utilities can -- and do -- file for a general rate increase as frequently as they feel it is needed, whenever the combined impact of all relevant factors cause it to begin to under-earn.
One of the worst risks consumers have to fear from decoupling is that it may reward the utility -- and conversely punish consumers -- as a result of revenue reductions that are unrelated to energy efficiency programs. This risk is particularly acute with so-called full decoupling, which does not attempt to isolate the cause of any dip in utility revenues. A host of reasons unrelated to the impact of energy efficiency may cause utility revenues to fluctuate. Some of those reasons may be related to good management, and some may be related to mismanagement. Public utility commissions need to be able to make judgments regarding which is which.
Some of the reasons for reduced revenues are outside the control of the utility. These reasons can be extreme weather or a significant economic event, like the recession that began in 2008. In the latter example, when revenues were dropping due to hard times, full decoupling would have shielded the utility from the recession while raising rates at the same time on households and businesses that were cutting back on energy usage for purely economic reasons.
Decoupling can also be particularly unfair to low-income customers or customers who use the bare minimum amount of energy necessary to get by who cannot take full advantage of the utility's efficiency and demand-side management spending, to which they are forced to contribute. To the extent decoupling raises rates for some customers to the benefit of others, it is potentially discriminatory and not in the public interest.
If decoupling were to be adopted in Missouri, despite the cautionary criticism expressed here, harm to consumers should be minimized. Regulators should ensure that cost recovery and incentives are fair and reasonable and linked to the performance of the utility in meeting or exceeding its goals for reducing energy usage. Customers should expect to receive smaller utility bills if they consume less energy. If decoupling sends the message to consumers that savings achieved through energy efficiency can be taken back by the utility, the effort to promote energy efficiency will likely fail. Utility bills should not increase because consumers as a whole have been successful in their efforts to use energy more efficiently.
3.393.130.1, 393.140(11) RSMo.; Furthermore, the least cost obligation is codified in the “Policy Objectives” of Missouri Public Service Commission’s Integrated Resource Planning (IRP) Rule, updated subsequent to the passage of MEEIA, which states that “minimization of the present worth of long-run utility costs” should be the utility’s “primary selection criterion in choosing the preferred resource plan” [4 CSR 240-010(B)] (emphasis added).
4.393.130.1, 393.140(11) RSMo.; Furthermore, the least cost obligation is codified in the “Policy Objectives” of Missouri Public Service Commission’s Integrated Resource Planning (IRP) Rule, updated subsequent to the passage of MEEIA, which states that “minimization of the present worth of long-run utility costs” should be the utility’s “primary selection criterion in choosing the preferred resource plan” [4 CSR 240-010(B)] (emphasis added).
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