Performance Incentives

May 14, 2012

While program cost and lost margin recovery mechanisms serve to mitigate the utility disincentive to invest in energy efficiency due to a reduction in sales, they do not necessarily provide an incentive for such investment.  Even with a decoupling mechanism in place, investor-owned utilities often still have an incentive to make supply-side investments because of the beneficial effect on stock price. 

To incentivize energy efficiency investment, it is often argued that utilities should be allowed to earn a return on their investment in energy efficiency programs that is on par with investments in supply-side resources such as new generating capacity.  Because performance incentives are relatively easier to enact than decoupling, they are widely used by states that have mechanisms in place beyond program cost recovery.  About 25 states currently have, or are considering, some type of performance incentive. Several common approaches include: performance target incentives, shared savings incentives, and rate of return incentives. 

Performance Target Incentives

Performance target incentives reward utilities for meeting savings targets by returning a set percentage of the program costs to them.  Penalties for failure to meet targets are also used by some states to strengthen the incentive.  For example, Rhode Island established an incentive mechanism for Narragansett Electric in 2005 consisting of two components: 1) five performance-based metrics for specific program achievements;and 2) kWh savings targets by sector. Different incentive amounts are awarded for meeting threshold, full target and stretch goals.

Shared Savings Incentives

Shared savings incentives allow utilities to share some portion of the net benefits of a successful energy efficiency program with the ratepayers, instead of allowing all benefits to flow to the latter. The Minnesota PUC, for example, has the authority to share the net savings from energy efficiency programs between ratepayers and the utility undertaking the program. Utilities are awarded with a set percentage of net savings from successful programs, with the award increasing as savings increase. At 150% of the savings goal, the utility would receive 30% of its efficiency budget as required by statute.

Rate of Return Incentives

Rate of return incentives allow utilities to earn a rate of return on investment that is roughly equal to the return on supply-side investments.  This type of incentive is important for investor-owned utilities because of their financial responsibility towards their shareholders, and because of the traditional bias towards rewarding supply-side investments with a higher return.  This higher return leads to higher earnings for shareholders compared with an energy efficiency program, even though the latter delivers incremental resource requirements at lower cost.  Rate of return incentives seek to address this imbalance by increasing energy efficiency program returns to investment. 

Nevada, for example, until recently allowed utilities to earn as much as an extra 5% return-on-equity (ROE) for applicable, approved DSM costs. Base ROE is 10.25%, meaning that utilities could earn up to 15.25% ROE. This fraction is to be determined in individual rate cases; the provision calls for applying the utlity's debt-to-equity ratio nto the fraction of capitalized (rate base) DSM costs, and then applying the extra 5% ROE to that amount. This incentive amount for DSM is automatic as long as utilities follow approved plans and budgets.

The major advantage of incentives is that they put energy efficiency and supply-side investments on relatively equal financial footing, enabling shareholders to earn a comparable return on either investment.  Arguments against incentives include the cost and difficulty of implementing a robust evaluation mechanism to verify savings for performance-based incentives, as well as the view that ratepayers should not have to pay utilities for simply complying with regulatory mandates for energy efficiency.  Kihm (2009) also notes that the difference in scale of investments in energy efficiency programs versus supply-side resources encourages utilities to continue to favor the latter over the former, even when their respective rates of return are equal.  

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