An Overview of Revenue Decoupling Mechanisms

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

2. Outline • Purpose of revenue decoupling (RD) • Different forms of RD • Alternatives to RD • Arguments for RD • Arguments against RD

3. 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. 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. 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. 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. 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. 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. Full Decoupling • Full decoupling is just the basic form described earlier: Deferralt = REVBt – REVAt • 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. 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. Partial Decoupling:Percentage of Full Decoupling • Partial decoupling applies a pre-specified percentage to full decoupling: Deferralt = F x (REVBt – REVAt) • F can vary from 0 (no decoupling) to 1 (full decoupling), but is usually set at around 0.90 where it is used

12. 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. Partial Decoupling:Removing the Effect of Weather • Another form of partial decoupling removes the effect of weather from deferrals: Deferralt = REVBt – REVA,WNt • 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. 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. Revenue per Customer Decoupling • Revenue per customer decoupling (RPCD) changes base revenue with the current number of customers: Deferralt = Ct x (RPCBt – RPCAt) • Ct 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: Deferralt = Ct x Rt x (UPCBt – UPCAt) • Rt is the per-unit rate • RPCBt can be adjusted according to a formula (e.g., including inflation and productivity adjustments)

16. 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. Statistical Recoupling • Statistical recoupling (SR) uses the results of a statistical model to determine base usage levels (total, not per customer): Deferralt = Rtx (QB,Et – QAt) QB,Et = 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. 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. 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. 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 = Ct x (RPCBt – RPCAt) Deferral = 100,000 x ($300 - $330) = $3m Refund

21. 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 = Ct x (RPCBt – RPCAt) Deferral = 110,000 x ($300 - $300) = $0

22. 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. 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. Alternatives to Decoupling • Lost Revenue Adjustments • Straight Fixed Variable Rates • Frequent Rate Cases • Forecast Test Years

25. 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. 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. 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. 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. 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. 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. Forecast Test Years • Use a forecast test year in standard ratemaking methods to account for the expected effects of DSM programs

32. 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. 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. 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