An Overview of Revenue Decoupling Mechanisms Dan Hansen Christensen Associates Energy Consulting November 2007

2 CA Energy Consulting Outline  Purpose of revenue decoupling (RD)  Different forms of RD  Alternatives to RD  Arguments for RD  Arguments against RD

November CA Energy Consulting Purpose of Revenue Decoupling  Traditional regulated rates recover fixed costs through volumetric rates  Provides utility with: — An incentive to increase usage — A disincentive to promote conservation and energy efficiency  Problem: revenues and sales are directly related  Solution? “Decouple” revenues from sales

November CA Energy Consulting Purpose of Revenue Decoupling (2)  By removing link between sales and revenues, decoupling makes the utility indifferent to the effects of conservation  Decoupling does not provide an incentive for the utility to promote conservation  Utility revenues are typically “recoupled” to some other factor(s), such as the number of customers  Natural gas industry: RD is also used to address declining use per customer

November CA Energy Consulting Basic Decoupling Concept  Basic form of RD: RD Deferral = Allowed Revenue – Actual Revenue “Allowed” revenue is also called “base” revenue  A positive number means the utility under- recovered, and will lead to a future rate increase  A negative number means the utility over- recovered, and will lead to a future rate decrease

November CA Energy Consulting Basic Decoupling Concept (2)  Typically every 6 or 12 months, the RD deferral is rolled into rates as follows: Rate change from RD = RD Deferral / E(Usage)

November CA Energy Consulting Where is Decoupling Used?  Electricity: — California — New York: PSC requiring decoupling proposals — Idaho Power pilot — Maryland — Connecticut: legislation requiring decoupling or SFV — Massachusetts: ordered investigation of decoupling  Natural Gas: — Many states, including IN, MD, NC, NJ, OH, OR, UT, WA — Most are RPCD, many adjust for weather effects

November CA Energy Consulting Types of Decoupling The exact terms that people use vary, but here is a list of the types of RD:  Full decoupling  Partial decoupling  Revenue per customer decoupling  Statistical re-coupling

November CA Energy Consulting Full Decoupling  Full decoupling is just the basic form described earlier: Deferral t = REV B t – REV A t  That is, the deferral in year t is equal to base revenue in that year minus actual revenue  Base revenue can vary across years, either according to a formula or a pre-specified “rate plan”  The base revenue formula can include adjustments for factors such as inflation and changes in productivity

November CA Energy Consulting Full Decoupling: Pros and Cons  Pros: — Certainty with respect to total level of distribution revenues (relative to RPCD) — Difficult to “game”  Cons: — Removes incentive to promote economic development — Removes incentive to provide high quality customer service — Removes incentive to enroll new customers (where there is no obligation to serve)

November CA Energy Consulting Partial Decoupling: Percentage of Full Decoupling  Partial decoupling applies a pre-specified percentage to full decoupling: Deferral t = F x (REV B t – REV A t )  F can vary from 0 (no decoupling) to 1 (full decoupling), but is usually set at around 0.90 where it is used

November CA Energy Consulting Partial Decoupling, Percentage: Pros and Cons  Pros: — Reduces risk shifting relative to full decoupling (to the extent that it occurs)  Cons: — Percentage (F) seems to be set as a compromise position, with no theoretical basis — Percentage dilutes the incentive effects

November CA Energy Consulting Partial Decoupling: Removing the Effect of Weather  Another form of partial decoupling removes the effect of weather from deferrals: Deferral t = REV B t – REV A,WN t  Note the “WN” superscript on actual revenue, indicating that the revenue value is adjusted for deviations from normal weather conditions  The goal is to prevent RD-induced rate changes because of weather fluctuations

November CA Energy Consulting Partial Decoupling, Remove Weather: Pros and Cons  Pros: — Can lead to less variation in rates than full decoupling  Cons: — More complicated and controversial to set parameters Errors in the normal weather definition can skew decoupling deferrals toward either the utility or ratepayers — Removes opportunity to reduce weather risk for both the utility and its ratepayers

November CA Energy Consulting Revenue per Customer Decoupling  Revenue per customer decoupling (RPCD) changes base revenue with the current number of customers: Deferral t = C t x (RPC B t – RPC A t )  C t is the number of customers at time t, and “RPC” refers to revenue per customer  Can also be written in terms of use per customer: Deferral t = C t x R t x (UPC B t – UPC A t )  R t is the per-unit rate  RPC B t can be adjusted according to a formula (e.g., including inflation and productivity adjustments)

November CA Energy Consulting Revenue per Customer Decoupling: Pros and Cons  Pros: — Provides an incentive to promote economic growth — Provides an incentive to provide high quality customer service — “Recouples” revenues in a comparatively simple way — Easier to administer than some other options (e.g., SR)  Cons: — Utility has an incentive to “game” the number of customers and use (or revenue) per customer values — Changes in revenues may not be closely related to changes in costs

November CA Energy Consulting Statistical Recoupling  Statistical recoupling (SR) uses the results of a statistical model to determine base usage levels (total, not per customer): Deferral t = R t x (Q B,E t – Q A t ) Q B,E t = F(weather, economic conditions, retail price, number of customers)  The goal of SR is to limit deferrals to only the effects of conservation  Attempts to do so by “normalizing” for the effects of other major drivers of usage

November CA Energy Consulting Statistical Recoupling: Pros and Cons  Pros: — Can eliminate deferrals due to changes in economic conditions or commodity prices  Cons: — Likely to lead to a very contentious process to reach agreement upon a statistical model for baseline usage

November CA Energy Consulting Examples of Decoupling Deferrals  Assume: — 100,000 customers initially — Baseline use per customer = 15,000 kWh per year — $0.02 per kWh for fixed costs  Therefore: — Baseline revenue per customer = $300 per year — Total baseline revenue = $30 million per year

November CA Energy Consulting Comparison of Full Decoupling to RPCD  Suppose use per customer increases by 10% — Actual RPC = $330 — Actual Revenue = $33 million — Number of customers stays the same  Under full decoupling: Deferral = Base Revenue – Actual Revenue Deferral = $30m - $33m = $3m Refund  Under RPCD Deferral = C t x (RPC B t – RPC A t ) Deferral = 100,000 x ($300 - $330) = $3m Refund

November CA Energy Consulting Comparison of Full Decoupling to RPCD (2)  Suppose the number of customers increases by 10% — Actual number of customers = 110,000 — Revenue per customer stays the same  Under full decoupling: Deferral = Base Revenue – Actual Revenue Deferral = $30m - $33m = $3m Refund  Under RPCD Deferral = C t x (RPC B t – RPC A t ) Deferral = 110,000 x ($300 - $300) = $0

November CA Energy Consulting Comparison of Full Decoupling to RPCD (3)  How much would the $3 million refund affect rates in the next year? Rate Change = Deferral / E(Usage) Rate Change = -$3m / (100,000 x 15,000) Rate Change = -$0.002 per kWh  This is a 10% decrease in the fixed cost portion of the rate  The percentage decrease in the total rate will be significantly smaller

November CA Energy Consulting Other Forms of Decoupling  Partial decoupling as a percentage of full: — Deferral = F x $3m refund  Partial decoupling removing the effect of weather: — Deferral is reduced (closer to zero) by an amount equal to the change in revenue per customer that is due to weather  Statistical recoupling: — If parameters are set correctly, deferral would be $0, unless the increase in RPC would have been higher in the absence of conservation

November CA Energy Consulting Alternatives to Decoupling  Lost Revenue Adjustments  Straight Fixed Variable Rates  Frequent Rate Cases  Forecast Test Years

November CA Energy Consulting Lost Revenue Adjustments  Lost Revenue Adjustments (LRAs) compensate the utility for lost revenues from utility sponsored Demand-Side Management (DSM) programs  Requires estimates of load reductions from each DSM program

November CA Energy Consulting Lost Revenue Adjustments: Pros and Cons  Pros: — Adjusts revenues only for reductions in revenues due to utility-sponsored conservation  Cons: — DSM load reductions can be difficult to measure and will likely lead to disputes — Limits scope of DSM programs to be offered — Utility has an incentive to promote DSM programs or measurement methods that will produce over-estimates of load reductions — Does not address the utility’s incentive to grow load under standard rates

November CA Energy Consulting Straight Fixed Variable Rates  Straight Fixed Variable (SFV) Rates recover fixed costs through fixed charges and variable costs through variable charges  May significantly increase customer charges and demand charges relative to “standard” rates  Tends to reduce energy charges

November CA Energy Consulting Straight Fixed Variable Rates: Pros and Cons  Pros: — Provides foundation for most efficient pricing, with addition of “externalities” (i.e., pricing for factors such as pollution) in energy rate — If SFV prices are set correctly, customers decide how much to conserve based on the “correct” price signals  Cons: — Adverse bill impacts for low use (and likely low income) customers — Difficult to account for externalities in pricing — If no accounting for externalities, customer-level incentive to conserve is reduced

November CA Energy Consulting Frequent Rate Cases  Supporters assert that more frequent rate cases allow for rates to better track changes in usage levels  Will allow the utility to recover the revenues lost from conservation more quickly

November CA Energy Consulting Frequent Rate Cases: Pros and Cons  Pros: — Familiar procedure for all parties  Cons: — Does not alter the utility’s incentives regarding conservation or load growth — Once rates are set, the utility has an incentive to maximize load regardless of the duration of time until the next rate case

November CA Energy Consulting Forecast Test Years  Use a forecast test year in standard ratemaking methods to account for the expected effects of DSM programs

November CA Energy Consulting Forecast Test Years: Pros and Cons  Pros: — Can reduce regulatory lag relative to “frequent rate cases” alternative  Cons: — Does not alter the utility’s incentives regarding conservation or load growth — Once rates are set, the utility has an incentive to maximize load regardless of the duration of time until the next rate case

November CA Energy Consulting Arguments for Decoupling  Removes utility disincentive to promote conservation and energy efficiency  Removes utility incentive to promote load growth  Does not alter fixed charges, so no distributional effects (i.e., does not harm low-use customers like SFV does)  Retains customer-level to conserve in “standard” rates  Does not require measurement of DSM load reductions  Expands the range of conservation activities that the utility is likely to engage in (relative to LRAs)

November CA Energy Consulting Arguments against Decoupling  “Too broad”: leads to rate changes that far exceed the effects of utility-sponsored DSM programs  Single-issue ratemaking: focus is only on conservation  Shifts normal business risks from the utility to its ratepayers  Provides clear benefit to utility; no clear benefits to ratepayers  Concern about rate impacts for customers who do not conserve