Rate Decoupling and Economic and Design Considerations

Rate Decoupling and Economic and Design Considerations

Executive Summary
June 6, 2016

Executive Summary

The Basics

In an era of flat sales, escalating infrastructure costs and increased policy maker interest in energy efficiency and distributed energy, utility company concerns with under recovery of costs and frequent rate cases are prompting renewed interest in rate decoupling policy. 

Rate decoupling policy is primarily used to reduce utility opposition to energy efficiency and distributed energy policies. 

Electric and gas utility companies charge their customers regulator-approved rates in exchange for products (e.g. gas, electricity) and services (e.g. delivery of products). With traditional methods of ratemaking, electric and gas utilities make more money by selling and delivering more product. This rate structure can become financially problematic to utilities when sales do not keep pace with the costs to obtain and deliver these products. 

Rate decoupling policy is an incremental adjustment to the traditional ratemaking model that is primarily used to reduce utility opposition to energy efficiency and distributed energy policies that result in foregone sales.   

In simple terms, rate decoupling reduces the importance of sales levels in achieving the utility’s revenue requirement, the total amount the utility is allowed to charge its customers.  This is done by allowing the utility’s per KWh service rates to customers to fluctuate in response to total system sales in order to keep the revenue requirement constant. So if total system sales are lower than expected, the per KWh charge increases.  If sales are higher than expected, the per KWh charge decreases. 

There are alternative policy options to decoupling meant to ensure a utility covers the costs of providing service in specific scenarios.  Alternatives examined include straight fixed variable (SFV) rates, high customer charges, and minimum bills.  Policymakers need to carefully match the use of these policy tools with intended policy goals.  Comparatively, decoupling may be the best choice if the goal is to reduce barriers to energy efficiency while helping ensure utilities achieve their revenue requirement.

Economic Considerations

Utility customers can benefit from decoupling policy through reduced bill volatility and reduced utility opposition to energy efficiency and distributed generation.  However, customers are the most vulnerable to the potential drawbacks of decoupling policy.

Reduced ratemaking transparency and price signal dampening are important consumer impacts to consider when evaluating the ability of decoupling policy to achieve broader energy efficiency policy goals. 

Decoupling policy primarily benefits utility companies by providing greater revenue certainty, thus reducing financial risk. There is significant regulatory debate about monetizing the value decoupling policy provides for utility companies.  Specifically, since decoupling policy reduces revenue uncertainty for utilities, should this reduced risk equate to a lower regulator-granted profit margin?

Customers are the most vulnerable to the potential drawbacks of decoupling policy.  

Access to analysis of the relationship between decoupling policy and equity cost of capital impacts is limited.  However, Wharton (2015) finds no statistically significant reduction in the cost of capital resulting from adoption of decoupling policy.  Vilbert (2014) postulates this may be due to the policy’s inability to impact volatile market expectations, non-diversifiable risk, and net risk reduction. A case-by-case assessment by regulators is required to evaluate the impact a specific decoupling policy design will have on a specific utility company’s cost of equity.  Hempling (2011) presents five key questions that regulators can use to evaluate this relationship on a case-by-case basis.

The “Averch-Johnson effect” states that a utility will have an incentive to overinvest if its regulated rate of return is greater than its cost of capital.  Decoupling is not meant to address the Averch-Johnson effect, however, in certain instances (i.e. when the rate of return is set higher than the utility’s cost of capital) decoupling may serve to strengthen the effect when sales are low by realizing the allowed revenue requirement.

Policy Design Considerations

If decoupling is to be pursued the following policy design considerations may be helpful to maximize benefits and reduce drawbacks.

Consumer Benefits and Protection

  • Decoupling adjustments must be bidirectional to offer benefits to both utilities and consumers.
  • Test consumer reactions to decoupling policies through pilot programs before full implementation.
  • Decoupling adjustment amounts can be limited or capped, to protect consumers.
  • Evaluate decoupling impacts within the context of other automatic adjustments and bill riders.

Minimize Economic Inefficiencies

  • Calculate and apportion adjustments appropriately on a per rate class or rate schedule basis.
  • Develop and implement a systematic method to evaluate return on equity impacts.
  • Evaluate price-dampening impacts to ensure consumers maintain price signals sufficient to incent cost-effective energy usage reductions.

Achieve Policy Goals

  • Identify goals first, then determine if decoupling or alternatives are the best fit.
  • Only full decoupling (as opposed to limited or partial decoupling) has the ability to break the link between utility sales and profitability.
  • Complementary policies may be needed to actively promote efficiency and distributed energy goals, as decoupling serves only to reduce barriers.

This executive summary provides a brief overview of the issues explored in the Kleinman Center for Energy Policy’s report, “Rate Decoupling: Economic and Design Considerations.”  Download the complete PDF report.