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Striking the Balance in Energy Efficiency Regulation Between Utility Incentives and Customer Costs

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As Americans continue to face rising affordability challenges and struggle to pay their utility bills, consumer advocates are understandably concerned about keeping bills as low as possible. Energy efficiency is the lowest-cost resource and provides customers with the opportunity to reduce how much they spend on electricity. It is a critical resource in the fight against global warming and offers numerous benefits to customers, the utility system and the environment.

Nevertheless, energy efficiency is sometimes viewed as an added cost, where the rate impacts are felt in the present but the benefits not until the future. And for some ratepayer advocates, it is difficult to swallow the idea that utilities get incentive payments out of customers’ wallets for something advocates believe the utility should be doing anyway. For the utility, it is hard to explain to their shareholders, to whom they have a fiduciary duty, why they chose resource options that provide no return over ones that do. An innovative approach to program cost recovery and utility incentive mechanisms — one that rewards performance and achievement of outcomes while protecting ratepayers — is needed to address stakeholders’ concerns and get the balance right.

An alternative to traditional cost recovery

Typically, energy efficiency program costs are recovered through a rider. Paying all the program costs up front while the benefits accrue over the life of the program[1] creates a timing dissonance, resulting in short-term costs and long-term benefits. An alternative is to amortize the program cost over the average life of the programs or portfolio.[2] This would result in energy efficiency being treated the same as supply resources, in which the cost of a power plant is amortized and recovered over a period of years. Carrying costs for the deferred program recovery would also need to be added and could be based on the weighted average cost of capital or some other reasonable mechanism. This mechanism would more closely align costs with benefits so that as the cost of energy efficiency is paid by the customer, it is offset by reduced system costs and lower bills for program participants. As programs accelerate to the scale needed to meet states’ affordability or climate goals, some states may choose to fold the cost of energy efficiency into base rates. The key challenge is to ensure that this approach adequately incentivizes actual efficiency savings, not just spending, which performance incentive mechanisms (PIMs) can address.

Setting performance incentives

Just as utilities earn a return on supply resources, a return or incentive is appropriate for demand-side resources to create a win-win situation in which consumers get the lowest-cost option and shareholders receive a return. The Net Shared Saving Mechanism used in states like Minnesota and Arkansas is one of the most common approaches. It allows the utility to earn a percentage of the program savings as established by the regulator. The Energy Savings mechanism used in Connecticut and elsewhere allows the utility to receive a pre-set incentive based on meeting certain targets.[1]  Another approach is the New York Earnings Adjustment Mechanism, which allows utilities to earn an incentive payment based on performance measured outcomes, program or action based. (More information and examples of PIMs can be found here.)

Two other mechanisms are worth serious attention. The first, the multifactor test (used in Michigan and Massachusetts), allows utilities to earn rewards for meeting pre-established goals based upon multiple metrics that can be tailored to policy goals such as energy savings for low-income customers or peak demand reductions. The advantage is that it creates a close tie between reward and performance; however, depending on the design, it could have sharper ratepayer impacts. The second, the amortized return on equity-based mechanism (used in Illinois) treats energy efficiency like other resources, truly putting it on an even playing field; however, the downside is that it does not link incentives to outcomes as well as other mechanisms, as it primarily rewards spending – like other supply-side options do.

We recommend that policymakers consider a mechanism that incorporates the best of all the above mechanisms — by creating the Outcome-Based Amortized Incentive which would utilize the multifactor test to establish Quantifiable Performance Indicators such as those discussed above, that are policy-driven. This mechanism includes the option to have tiered incentive payments for exceeding the established targets. Recovery of the incentive payments would be amortized along with the program costs over the same period of time. If regulators are uncomfortable with having to factor in carrying costs, then a rider could be deployed instead. This is similar to the return of and return on investments for supply-side investments except that the return on demand-side investments can be less due to lower risk.

Balancing outcomes and costs

To maximize energy efficiency opportunities, it is important to design an incentive that is transparent, appropriately sized and rewards energy efficiency performance (not just spending). Outcome-based performance measurements are key to ensuring that every ratepayer dollar is well spent. This level of accountability is not typically found with supply-side options, so in addition to optimizing energy efficiency as the lowest-cost option, consumers receive quantifiable mechanisms to ensure that the spending achieves the intended results. Amortizing program costs and incentives more clearly aligns the timing of when the program cost is incurred and when the benefit is seen. Further, this approach creates a structure to target benefits by linking performance to policy outcomes.

As states and PUCs encourage utilities to ramp up energy efficiency, they will need solutions that incentivize performance and minimize ratepayer impact. Amortization of program costs, coupled with the Outcome-Based Amortized Incentive Mechanism, can help achieve that goal.

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[1] For simplicity, we discuss this issue in terms of the program that may consist of a number of measures. For example, a home weatherization program could include measures such as light bulb upgrades, insulation and appliance replacements.

[2] The portfolio consists of all the programs that make up the energy efficiency plan for a given year.