Lost Margin Recovery

November 17, 2010

Energy efficiency programs are designed to reduce the amount of electricity and gas that customers use, but this reduction in sales impacts utilities' marginal revenue.  Lost margin recovery attempts to mitigate this impact, and has been one of the most widely debated areas of policy related to utility-led energy efficiency programs.

Of those states that have enacted or are planning to enact policy for lost margin recovery, decoupling is the most commonly proposed mechanism.  The term "decoupling" refers to the effort to sever the link between utility sales and revenues.  In practice, this means that the regulatory body periodically "trues up" any difference between a utility's actual sales for a particular year and sales projections submitted by the utility as part of its revenue requirement. This true-up mechanism affects customer rates symmetrically: higher than expected sales lead to a rate decrease, while lower than expected sales lead to a rate increase.  Actual utility earnings are thus brought in line with earnings authorized by the governing body, removing – or at least mitigating – the utility's disincentive to invest in energy efficiency programs due to reduced sales.  


Interest in decoupling has continued to grow.  An analysis by National Action Plan for Energy Efficiency in 2007 found that 27 states and Washington, DC had electric or gas decoupling either in place or pending, while 23 states had neither decoupling in place nor pending legislation.  These were broken down as follows:

  • 4 states -- both electric and gas decoupling
  • 11 states -- decoupling in place for gas only
  • 1 state -- decoupling in place for electric only
  • 14 states -- pending legislation for either gas or electric decoupling

A more recent study by the Institute for Electric Efficiency (2010) found that the number of states with decoupling mechanisms in place for electric utilities had grown to twelve; these include California, Connecticut, the District of ColumbiaIdahoMarylandMassachusettsMichiganMinnesotaNew YorkOregonVermont and Wisconsin. Eight more states have regulation pending, including Delaware, HawaiiIndianaNew HampshireNew JerseyNew MexicoUtah and Wyoming.

To take one example: Wisconsin's decoupling program (or "revenue stabilization mechanism") went into effect on January 1, 2009, and stipulates an annual true-up mechanism with a $12 million cap for under- or over-collection. The Public Service Commission of Wisconsin's order requires the Wisconsin Public Service Corporation (WPSC) to complete three community-based pilot programs over the course of four years, which will be evaluated on a regular basis.

Proponents of decoupling argue that, because the throughput incentive drives a wedge between a utility's responsibility to deliver investment returns to its shareholders and the promotion of energy efficiency amongst its customers, some mechanism of lost margin recovery is essential to the realization of robust energy efficiency gains.  Other advantages of decoupling include shielding utility revenues from fluctuations in sales; obviating the need for an evaluation, measurement and verification program; and reducing the need for frequent rate cases, with a corresponding reduction in regulatory costs.

One major criticism of decoupling is that it removes the normal business risk faced by utilities by guaranteeing that revenues are in line with sales, no matter the source of the difference (whether from the efficiency program itself, weather, the economy or something else).  In response, some commissions have approved the use of formulas for calculating the true-up that attempt to account for factors other than the efficiency program itself.

Kihm (2009) argues that decoupling is appropriate only in situations where regulators keep a utility's allowed rate of return close to its cost of capital.  Any difference between the two encourages large-scale investments by the utility because doing so raises the stock price, to the benefit of investors.  This situation holds whether or not a decoupling mechanism is in place.  Therefore, while decoupling may make utilities indifferent to fluctuations in sales, it does not necessarily remove the incentive to make large supply-side investments that benefit shareholders.

Lost Revenue Adjustment Mechanisms

A second means of recovering lost marginal revenue is through a lost revenue adjustment mechanism (LRAM).  This mechanism, unlike decoupling, does not attempt to completely sever the link between revenue and sales, but instead attempts to determine the portion of lost revenue that results only from a successful energy efficiency program.  This lost revenue is recovered through a rate adjustment, removing the utility disincentive to invest in efficiency.  Several states have opted for this type of mechanism, including ColoradoKentuckyLouisianaNorth CarolinaSouth CarolinaOhio and Oklahoma. For example, all electric utilities in Kentucky have proposals for lost revenue recovery mechanisms in place. The regulatory body considers these for approval on a case-by-case basis.

LRAMs have several disadvantages.  They require a robust evaluation program to accurately estimate savings from the energy efficiency measures, and such programs can be expensive.  Lack of precise savings verification can lead to contentious rate cases and gaming by utilities in an attempt to maximize the savings, and therefore the cost recovery, from their energy efficiency programs.  In addition, while the disincentive to invest in energy efficiency is removed through this type of mechanism, it does not remove the incentive for utilities to seek more revenues through increased sales.

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