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

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

3. November 2007 3 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

4. November 2007 4 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

5. November 2007 5 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

6. November 2007 6 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)

7. November 2007 7 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

8. November 2007 8 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

9. November 2007 9 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

10. November 2007 10 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)

11. November 2007 11 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

12. November 2007 12 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

13. November 2007 13 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

14. November 2007 14 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

15. November 2007 15 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)

16. November 2007 16 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

17. November 2007 17 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

18. November 2007 18 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

19. November 2007 19 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

20. November 2007 20 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

21. November 2007 21 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

22. November 2007 22 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

23. November 2007 23 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

24. November 2007 24 CA Energy Consulting Alternatives to Decoupling  Lost Revenue Adjustments  Straight Fixed Variable Rates  Frequent Rate Cases  Forecast Test Years

25. November 2007 25 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

26. November 2007 26 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

27. November 2007 27 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

28. November 2007 28 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

29. November 2007 29 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

30. November 2007 30 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

31. November 2007 31 CA Energy Consulting Forecast Test Years  Use a forecast test year in standard ratemaking methods to account for the expected effects of DSM programs

32. November 2007 32 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

33. November 2007 33 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)

34. November 2007 34 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