States across the United States are increasingly prioritizing electrification of transportation and buildings to meet their decarbonization goals. Utilities are an important driver of this investment, so it’s critical that their business incentives be aligned with the public policy goals of an affordable, reliable, decarbonized and efficient energy system.
To keep costs down for electric customers and avoid inefficient utility spending, we need to remove utilities’ incentive – embedded in traditional cost of service regulation – to increase sales and deemphasize energy efficiency investments. Decoupling, which does just that, will be more crucial than ever in an era of electrification to ensure that we grow utility investment in the clean energy economy in a smart, efficient way. Having decoupling in place while pursuing beneficial electrification can help keep costs of electrification down, make decarbonization goals more achievable, and secure the benefits of electrification for customers. Utility regulators in states across the country should preserve, adopt or update decoupling policies as needed to meet decarbonization goals that require beneficial electrification alongside energy efficiency.
Under traditional regulation, utility revenues are largely based on sales – the more they sell, the more they earn. Energy efficiency decreases sales and thus revenues, so utilities are effectively disincentivized to pursue it. Decoupling makes utilities indifferent to sales by providing them with revenues at the level approved by the regulator, regardless of how much they sell.
Decoupling works by periodically (monthly, quarterly or annually, for example) comparing the commission-authorized revenue and the actual revenue. Customers see a surcharge when sales are lower than expected, and a refund when sales are higher than expected. Because ratepayers see refunds when increased sales result in revenues that are greater than authorized, they have a built-in protection against overpaying. Typically, without this mechanism, a utility could over-recover for years without consumers having a mechanism to review or challenge this. Decoupling supports the expansion of energy efficiency by removing the disincentive to invest in these resources, contributing to lower rates over the long term.
From a utility’s perspective, decoupling reduces risk for its shareholders by enabling more accurate cash flow projections and avoiding earnings volatility. That risk isn’t necessarily shifted to customers. Reduced risk can enable a shift toward lower-cost debt and away from higher-cost equity, resulting in customer savings. Eighteen states have recognized these benefits and adopted decoupling for electric utilities, and 26 states have done so for gas utilities.
Is decoupling still needed?
Decoupling removes the motivation to increase sales, and beneficial electrification results in increased electricity sales. This relationship raises the question: As the grid gets cleaner and we want to encourage the electrification that reduces greenhouse gas emissions, should we re-link utility revenues to the total volume of electricity sold?
We don’t think so, and we see four reasons why keeping decoupling – and adopting it where it isn’t yet policy – supports decarbonization, including both energy efficiency and electrification.
First, decoupling can help keep a utility’s spending in check while it pursues electrification. Absent a decoupling mechanism, utilities have incentives to increase sales, regardless of whether that growth comes from efficient and beneficial forms of electrification. Without decoupling, utilities may pursue inefficient electrification, for example by promoting electric resistance heating, or downplaying the importance of weatherization and building envelope improvements.
Second, decoupling can help make state carbon goals more achievable. Multiple studies have shown that meeting aggressive carbon goals by mid-century will require both energy efficiency and smart electrification – evidence that these approaches are not in conflict with one another. Decoupling ensures that utilities are not disincentivized to pursue efficiency (though required energy savings targets set in policy are also needed).
Third, decoupling helps ensure that customers benefit from the extra revenue utilities receive from electrification. Without decoupling, the additional revenue utilities earn through electrification won’t materialize as customer benefits until the next rate case. In states without required or automatic rate cases, shareholders may capture an outsized share of that benefit. And getting decoupling in place now can help secure the benefits of electrification for future ratepayers. The transition to electrified transportation, space heating and water heating will take many years to fully materialize. As it does, decoupling has the potential to provide benefit to ratepayers as utilities generate more revenues – but then must refund the excess revenues to their customers, as required under a decoupling mechanism.
Finally, it is important to note that “decoupling” is not a one-size-fits-all policy and the design of decoupling mechanisms matters a great deal in determining their success. For example, commercial and industrial customers with decoupling during the COVID-19 pandemic might face surcharges when usage unexpectedly goes down during social distancing. On the other hand, with increases in residential usage, residential customers may receive bill credits. Important design choices include whether and how allowed revenues are adjusted over time, which customer classes are included in decoupling, and the allowed size of surcharges or credits. Fortunately, decoupling is customizable, and it can be designed to protect customers and meet state environmental goals.
While it’s critical to maintain and refine revenue decoupling policies, that won’t be sufficient to deliver the transportation and building decarbonization needed to meet state climate goals. Even with decoupling, utilities will inherently prefer actions that increase sales and “grow the company” (i.e., electrification), rather than actions that decrease sales (i.e., energy efficiency). Shifting toward performance-based regulation, which rewards utilities for outcomes instead of further capital investment, can go beyond just removing the disincentive to invest and can align utilities’ earnings opportunities with decarbonization.
State policymakers should consider requirements to pursue beneficial electrification opportunities aggressively (e.g., by evolving Energy Efficiency Resource Standards (EERS) to value energy savings regardless of fuel or by setting technology-specific goals as in Maine and New York). At a minimum, states should update their fuel switching rules and set cost-effectiveness criteria that enable beneficial electrification in ratepayer-funded programs.
One final issue is the disruption in utility sales caused by the impacts of COVID-19 and the question of whether decoupling is the right mechanism to address associated utility revenue shortfalls. Decoupling is smart for the long term as we move towards electrification, which will take many years, while COVID-19 revenue impacts are hopefully short-lived. State policymakers should work to address long-term objectives, even while temporarily adjusting as necessary to meet the immediate concerns.
In summary, while it may seem that revenue decoupling conflicts with state goals to electrify buildings and transportation, these approaches actually work together for better outcomes. Having decoupling in place while pursuing beneficial electrification can reduce the costs of electrification, support decarbonization, and ensure electrification benefits customers. We encourage regulators to consider how decoupling fits with other policy and regulatory approaches that can align to better help them achieve their goals.
Rachel Gold is director of the utilities program at the American Council for an Energy-Efficient Economy. Jessica Shipley is a senior associate at RAP.