Energy Efficiency and Utility Finance: Decoupling and Incentive Mechanisms Presented to the Wisconsin Industrial Energy Group November 6, 2008

How Do Energy Efficiency Programs Affect Utility Finances? n Energy efficiency programs reduce sales, which produces both short-run and long-run effects on utility earnings. n Short-run earnings impacts are, by their nature, short- lived. In Wisconsin, they can be addressed in an approximate sense by the rate case process, or in a more exact sense by a decoupling mechanism. n The long-run earnings impacts associated with energy efficiency are a more challenging problem for utilities.

n Decoupling mechanisms break the link between energy efficiency efforts and utility earnings. They focus on risk reduction. They tend to reduce the uncertainty of cash flows. n If the utility promotes energy efficiency, its earnings do not go down as a result. n If the utility promotes sales, its earnings do not go up as a result. n Incentive mechanisms create a link between energy efficiency and utility earnings. n If the utility meets its energy efficiency targets, it receives a rate-of-return bonus. n If the utility fails to achieve those targets, it receives a penalty.

n California utilities, which have aggressive energy efficiency programs, are subject to both decoupling and incentive mechanisms. n Which mechanism is the key driver of utility energy efficiency efforts?

n Decoupling mechanisms focus on reducing shortfalls in the rate of return. n What about the reductions in the size of the rate base? n The rate of return is only one of three key drivers of utility stock prices. The two other key variables are the size of the rate base and the investors’ required return. n Would you prefer to earn 10.1% on $1,000,000 of investment, or 10.0% on $2,000,000? n Investors will prefer the strategy that maximizes the net present value of the cash flows, and not necessarily the one that maximizes the rate of return. (Source: Energy Center of Wisconsin, A Financial Framework for Analyzing Incentives and Disincentives for Wisconsin Utilities to Promote Energy Efficiency, September 17, 2008, p. 12.)

n In recent times, most utility investors have focused on the rate of capital investment as the key driver of utility earnings and stock prices. n Capital spending, followed by rate relief, should continue to be the key driver of American Electric Power’s earnings growth. (Source: The Value Line Investment Survey, December 28, 2007.) n Decoupling mechanisms compensate utilities for lost earnings between rate cases (lost revenues). They do not compensate them for lost earnings due to slower rate base expansion (lost assets). n Do decoupling mechanisms eliminate the disincentive for utilities to promote energy efficiency?

n Capital expansion was not financially attractive for utilities in the 1970s and early 1980s. n Why? Financial market conditions were not good (high inflation rates, high interest rates, declining stock prices). Authorized rates of return were below the cost of capital. n Building power plants drove stock prices down, not up, in that environment. n Could we return to such an environment? n If we did, utilities would have a financial incentive to slow the rate of capital expansion. That’s what energy efficiency does.

Paper issued

Key Conclusions n Decoupling mechanisms focus on short-run earnings. If that is the utility management’s focus, then decoupling mechanisms may be effective in changing utility views about energy efficiency. n Decoupling mechanisms do not address the lost assets that result from energy efficiency efforts. If utility management focuses on that aspect, then incentive mechanisms will be more effective than decoupling mechanisms. n All bets are off, however, if raising capital becomes problematic (e.g., difficult to do, or expensive), utilities may view energy efficiency as a means of reducing the need to raise capital. n The conclusion depends on one perspective. We see different Wisconsin utilities taking different positions on these issues.