Incentivizing Utility-Led Efficiency Programs

August 6, 2013

Interest in energy efficiency in the utility industry continues to grow due to its potential to address many of the industry's most pressing concerns: increasing construction costs and uncertainty of cost-recovery for new generation, system reliability, public opposition to siting of new generation and transmission facilities, and environmental costs.  Energy efficiency also continues to be a clear public policy and regulatory goal in many states.

Yet it is widely recognized that spending on energy efficiency programs has a detrimental effect on utility revenues, by reducing sales of the utility's core product, electricity or gas.  The reasoning is straightforward: while a utility's variable costs change in proportion to sales volume, fixed costs associated with distribution and customer service do not.  Therefore, a reduction in sales due to efficiency improvements leads to a reduction in revenue that is larger than the costs avoided.  This net lost revenue affects the utility's balance sheet, reducing the return to its investors and providing a strong incentive for utilities not to invest in programs that help their customers use energy more efficiently.  

Utility Ratemaking

Utility ratemaking hinges on the concept of the revenue requirement.  Because electricity and gas utilities have traditionally been treated as natural monopolies, governing bodies or ratemaking commissions were set up to ensure that ratepayers are charged a fair rate, while allowing utilities to recover their operating expenses and to receive a reasonable return on their capital investments. The revenue requirement has several components: variable costs; amortized fixed costs of capital; an authorized, "reasonable" rate of return for shareholders; and authorized earnings for the utility.  The costs are estimated by the utilities, and the reasonable rate of return and authorized earnings are set by the governing body.  The revenue requirement (in dollars) is divided by electricity or gas sales (in kilowatt-hours or therms) to yield the rate charged to customers ($/kWh or $/therm). 

Types of Revenue Recovery

Mechanisms that are put in place to mitigate the disincentive to invest in energy efficiency are known collectively as 
revenue recovery.  These fall into three categories (click on the links for more information):

  • Program cost recovery: Recovery of the direct costs of an energy efficiency program
  • Lost margin recovery: Recovery of lost margin from a reduction in sales due to successful implementation of a program
  • Performance incentives: A means of incentivizing utility investment in efficiency and allowing a return on investment for energy efficiency programs similar to that for supply-side resources

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