Decoupling: The Key to Incenting Electric Utilities to Promote Energy Efficiency

What is Utility Decoupling?

Decoupling allows a utility to separate its regulated revenue from changes in energy sales. Thus, it addresses a potential disincentive to promote energy efficiency. In so doing, decoupling eliminates a critical barrier to increased utility-sponsored investment in cost-effective energy efficiency measures and other clean energy resources by, in effect, mitigating the impact of such investment on a utility’s revenues and thus shareholder return.

Context for Decoupling

Under traditional cost-of-service regulation, the price-setting process is designed to ensure that regulated utilities realize their targeted or allowed revenues through the allocation of that revenue predominantly on energy sales—kilowatts, kilowatt-hours, or therms. Consequently, a utility’s profitability depends on maintaining or, more often, increasing sales, even though such sales may be, from a broader societal perspective, economically inefficient and/or environmentally harmful.

Revenue requirements are traditionally set from the cost of providing service, thus allowing the utility to set its prices (rates) based on allowable revenue targets. Once these prices are set, the utility’s financial performance typically depends on two factors:

• Electricity Sales (relative to the original forecast used to set the rates) and
• Cost Management.

Importantly, under most circumstances, a utility’s marginal revenue (i.e., price) will significantly exceed its short-run marginal costs. Thus, the impact on profits from changes in sales can be profound. Moreover, any change in profits is disproportionately greater than the actual change in revenues.

Therefore, a utility is strongly incentivized to increase sales and, conversely, equally strongly incentivized to protect against any decrease in sales. This is referred to as the “throughput incentive,” which understandably inhibits a utility from supporting any investment in measures that will improve energy efficiency, and encourages the promotion of incremental sales, even if they are wasteful.

The Decoupling Solution

The solution to this “throughput incentive” is to adopt a methodology where  the realization and subsequent collection of a utility’s revenue is not related to actual volume of energy sales. Decoupling, representing this methodology, is the rate making process which breaks this link between sales volumes and revenues. It not only eliminates the “throughput incentive;” it allows the utility to focus its attention on customer energy service requirements and achieving efficiencies in its own operations.

Additional benefits of decoupling include:

• Revenues are immune to changes in unit energy sales.
• Volumetric, unit-based pricing structures are retained, thus preserving the linkage between consumer energy costs and consumption

In terms of application, decoupling is typically applied to the network delivery components of the gas and electric industries. The actual costs of the gas and electric commodity portions of service are typically recovered through purchased gas and fuel adjustment clauses or, if provided competitively, through payments to suppliers. Thus, the commodity costs are already decoupled and any change to these costs due to changes in sales or in the underlying price of the commodity will not impact profit.