Utility Incentives for Demand Response and Energy Efficiency

Transcription

1 White Paper Utility Incentives for Demand Response and Energy Efficiency Whitepaper Introduction Energy policy discussions of the twenty-first century have focused in part on the increased need for investments in demand response (DR) and energy efficiency (EE) as mechanisms for reducing emissions, conserving natural resources, and avoiding the need for capital expenditures. Electric utilities are in a unique position to catalyze wide-scale deployment of DR and EE 1 because of their size and scale, financial resources, and existing relationships with customers. However, regulatory policies must be properly structured to realize widespread utility investments in DR and EE. Legislators and utility regulators are well-positioned to create regulatory mechanisms to foster increased utility investment in cost-effective DR and EE technologies. This paper discusses the existing methodologies for regulatory treatment of DR and EE incentives in the United States. 1 DR and EE both fall under the umbrella category of demand side management (DSM). DR is often considered a form of EE and in many situations the regulatory treatments may be similar. However, the focus of DR differs from EE. DR is dispatchable and focused on cost-effective strategies to reduce system peak loads and system load changes (e.g., ancillary services). EE is generally not dispatchable and focused instead on reducing overall customer electricity consumption.

2 Traditional Utility Regulation Hinders Investment in DR and EE Traditional utility regulation favors supply-side resources 2 over DR and EE resources. First, utilities earn a rate of return on investments in generation, transmission and distribution infrastructure. The absence of a parallel incentive for DR and EE investments creates a bias against demand-side resources. This has been described in the economic literature as the Averch-Johnson Effect. 3 That is, where a firm s profits are linked to its capital investment, as is the case with utilities under traditional regulatory structures, there is an embedded incentive for the firm to increase its capital outlay in a manner that does not necessarily maximize producer and consumer surplus. Stated another way, traditional regulatory frameworks create a disincentive for utilities to meet resource needs using approaches that are less capital intensive. Thus, faced with otherwise equivalent alternatives of building a power plant that contributes to profitability or making investments in DR and EE that allow for cost-recovery only, a utility would generally prefer to build a power plant. Second, traditionally, a utility s revenue has been directly tied to kilowatt-hour sales of electricity. That is, the more electricity a utility s customers use, the more revenue that utility earns. Under this paradigm, since DR and EE reduce customer consumption, DR and EE can reduce a utility s revenues, even in cases where the direct costs of DR and EE investments are recoverable by the utility. While revenue loss due to DR and EE investments may be small in comparison to a utility s gross revenue, the impact on total profits can be substantial given the high fixed costs that utilities face. To illustrate this point, a 5 percent decline in revenue for the average investor-owned utility in 2007 would have meant a 17 percent decline in operating income. 4 Like any business, investor-owned utilities have a fiduciary obligation to maximize shareholder value. Thus, when faced with two investment decisions such as the choice between building a power plant or investing in DR and EE a rational utility will chose the one that is most profitable. Acting in any other way can negatively impact its ability to conduct business and attract investor capital. Thus, despite the fact that utilities are well-positioned to deploy cost-effective DR and EE programs, financial factors have prevented widespread adoption of DR and EE as a core component of the utility business model. 2 Supply-oriented solutions may be generation, transmission, or more robust distribution networks than are necessary to serve load. 3 Behavior of the Firm Under Regulatory Constraint. Harvey Averch & Leland L. Johnson, American Economic Review (December 1962), Vol. 52 Issue 5, p. 1052, 18 pages. 4 EnerNOC analysis of industry Consolidated Income Statement, contained in EEI 2007 Financial Review, page 7 org/whatwedo/dataanalysis/ IndusFinanAnalysis/Documents/ Industry_Financial.pdf 5 Aligning Utility Incentives with Investment in Energy Efficiency, Environmental Protection Agency (November 2007) documents/incentives.pdf Regulatory Models for the Treatment of DR and EE Regulatory models for the treatment of DR and EE vary greatly from state-to-state, and even utility-to-utility within a state. Even when categorizing different regulatory approaches, there is tremendous variety within each category. A recent paper published by the Environmental Protection Agency in connection with the National Action Expense Rate case rider Capitalize Performance payment Program cost recovery Rate case deferral Margin Performance incentives Source: National Action Plan for Energy Efficiency, Environmental Protection Agency Plan for Energy Efficiency 5 presents a framework (see graphic below) that describes three major categories of regulatory approaches to DR and EE investments: program cost recovery, performance incentives, and lost margin recovery. Lost margin recovery Decoupling Shared savings ROR adder Lost revenue adjustment mechanism (LRAM) EnerNOC, Inc.

3 White Paper What follows is a discussion of different cost recovery and performance incentive approaches. This discussion does not seek to address lost margin recovery mechanisms such as decoupling. While decoupling can address lost utility margins, the decoupling concept implicates a number of other broad policy considerations. A properly-designed performance incentive mechanism can indirectly address recovery of lost margin revenue (eliminating a disincentive) as well as create a balanced regulatory platform that will properly incent utilities to evaluate DR and EE investments as part of an overall energy strategy to ensure reliable electric service at reasonable costs to customers. Program Cost Recovery As its name suggests, under a cost-recovery mechanism, a utility can recover prudently-incurred costs of DR and EE investments on a dollar-for-dollar basis, typically through a rider or customer surcharge. Cost recovery is designed to make a utility whole on its DR and EE investments. However, there are challenges with this approach. First, cost recovery alone will not address the lost margin revenue the utility will face due to reduced energy sales from DR and EE programs. Second, cost recovery does not factor in opportunity costs: DR and EE investments displace supply-side investments for which the utility can earn a profit. Absent a statutory or regulatory mandate, program cost recovery alone will generally not attract utility interest in DR and EE programs. Even with a mandate, the utility is generally not motivated to apply substantial resources to pursue robust programs or foster innovation. Targets and Incentives and Penalties Governors, state legislatures, and utility commissions in some states have set specific targets for utilities around demand reduction or energy savings. A financial carrot and stick can be attached to the targets to provide increased incentive to invest in programs that will deliver the desired results. Typically, this approach will use bands to determine the incentives or penalties a utility will face. For example, utilities may face a financial penalty if they fail to achieve at least 70 percent of the target, receive a pro-rated percentage of the incentive for achieving 70 to 110 percent of the target, and an additional reward for achieving more than 110 percent of the target. Sometimes the incentive is tied to a percentage of the shared savings from avoided costs (discussed below), but the incentive may be structured and funded by a variety of means. While state commissions must ultimately approve the target level, the target may be in the form of a commission-determined regulatory mandate or a utility-suggested target. The most successful programs that achieve the desired goals and objectives are those that ensure utility cooperation with properly designed regulatory performance incentives. While commissions have the power to mandate utilities to implement DR and EE programs with or without incentives or penalties. A mandate without an incentive, perhaps with cost recovery only, will likely lead to utility s pursuing minimum participation. The utility will not be motivated to be innovative in exploring cost-effective strategies that will gain widespread customer participation. Shared Savings Under this approach, the utility receives a percentage share of the energy savings from a DR or EE investment. The savings are generally calculated as the avoided costs of an additional supply-side resource minus the DR or EE investment. A shared savings approach will generally allow for incentives above a threshold level of DR and EE participation, and may include penalties for failing to achieve the desired DR or EE objective. Typically, a utility will receive an increasing percentage of shared savings as participation or savings levels increase. This structure creates an incentive for promoting cost-effective DR and EE, but also encourages careful cost management because excessive or inefficient spending reduces the incentives available. Rate of Return In some jurisdictions, utilities can capitalize and earn a rate of return on their DR and EE investments. Under this approach, a utility will generally accumulate costs associated with investments in DR and EE as regulatory assets, and later recover those costs in the utility s next rate case. The primary advantage of this approach is that it puts DR and EE on an equal footing with supply-side investments. In these circumstances, utilities will have no embedded disincentives in pursuit of a least-cost, optimally-efficient approach to meeting customers electric needs either through a demand- or supplyside solution. A few states have implemented, or are considering implementing, rate of return adders to investments in DR and EE. In these cases, DR and EE investments earn a higher rate of return than traditional supply-side investments. A rate of return mechanism allows the utility the opportunity to earn a profit on DR and EE investments in the same manner as other capital 3

4 investments in a utility s rate base. This puts utilities in a position of pursuing optimal resource planning with both supply and demand resources, unencumbered by a negative impact to a utility s profitability from pursuing demand resource options. Avoided Cost An emerging model, put forth originally by Duke Energy, proposes that the utility be compensated for demonstrated DR and EE savings by receiving a percentage of the utility s avoided supply costs. Under the proposed Duke approach, know as Save-A-Watt, the utility would recover the amortization of and a return on 90 percent of the costs avoided by producing save-a-watts. 6 The Save-A-Watt proposal has not received final approval. As noted above, there is tremendous variation in the basic incentive mechanisms employed by state utility commissions to align utility incentives to promote an efficient level of cost-effective DR and EE investments. The right approach can vary by state, utility, even utility program, and should be considered in terms of what approach will motivate the utility to achieve positive program results. The utility should be motivated to deploy all cost-effective DR and EE strategies up to a level that is optimally efficient for the utility and its customers. Program cost recovery alone will not achieve that result, while incentives that are too generous will lead to overspending on DR and EE programs beyond a level that is cost-effective. 6 Duke Energy (2007). Application of Duke Energy Carolinas, LLC for Approval of Save-a-Watt Approach, Energy Efficiency Rider and Portfolio of Energy Efficiency Programs. Docket No. E-7, Sub 831, filed May 7, commerce.state.nc.us/cgi-bin/ webview/senddoc.pgm?dispf mt=&itype=q&authorization= &parm2=taaaaa72170b&par m3= Case Studies of Aligning Utility Incentives to Promote Deployment of DR and EE Targets with Incentives and Penalties Connecticut Funding for Conservation & Load Management (C&LM) programs in Connecticut comes from a systems benefit charge on customers electric bills that is collected by the state Energy Conservation Management Board (ECMB). The State s distribution utilities (Connecticut Light & Power and United Illuminating) administer C&LM programs with ECMB funding and Department of Public Utility Control (DPUC) approval. The Connecticut DPUC and ECMB encourage C&LM initiatives with financial incentives known as program management fees. Each year, utilities propose their energy savings goals and other performance metrics eligible for performance incentive payments, which must be approved by the DPUC. If utilities then achieve at least 70 percent of their goal, they are eligible to earn pre-tax incentives of 1-8 percent of their C&LM expenditures, in addition to program cost recovery. Achieving 70 percent of a utility s goal translates into a 1 percent management fee; achieving 100 percent of the goal equates to a 5 percent management fee; and achieving 130 percent of the goal would mean an 8 percent management fee. The utilities can also earn a reasonable rate of return when they market and sell their C&LM programs as well as incentives for demand savings from load reduction programs. Penalties for failure to achieve energy savings goals are not considered in Connecticut, like they are in California. Shared Savings - Minnesota Minnesota encourages investment in cost-effective DR and EE by allowing utilities to share in the net savings that their programs create for customers, provided they achieve a certain percentage of their target. Each utility in the state is required to show that their demandside expenditures (with minimum spending levels as a function of energy sales) result in net ratepayer benefits. Net ratepayer benefits are calculated as utility program costs netted against avoided supply-side costs, according to a standard avoided cost calculation. A portion of net customer benefits, with the exact amount dependent on savings achieved relative to targets, is then given to the utility as an incentive. If savings of 90 percent or less of the goal are achieved, the utility receives no incentive. The percentage of net benefits paid to the utility increases as savings levels increase. The utility s incentive is capped at 30 percent of its spending requirement and achieving the maximum requires hitting 150 percent of the savings goal. This shared savings mechanism combines the target with incentive mechanism and is designed to ensure that a utility s program is cost-effective. If programs are not cost-effective, then there are no net benefits and no incentives are paid. No significant incentive is provided unless a utility meets or exceeds its savings target at the minimum spending requirements. As the cost-effectiveness increases, net benefits and incentives increase accordingly EnerNOC, Inc.

5 White Paper Rate of Return Nevada Las Vegas boomed in the 1990 s and early 2000 s. New businesses and residents came to Nevada in droves, dramatically pushing up electricity demand. Nevada experienced 4.5 percent average annual growth in electricity consumption from 1980 to 2005, the highest of any state in the nation and more than double the national average of 2.2 percent over that period. 7 In 2001, the Public Utilities Commission of Nevada reversed a 1997 decision that had effectively ended customerfunded energy efficiency. Nevada utilities reestablished their energy efficiency programs, but statewide spending hovered at around $3 million through 2002 and $11 million to $14 million from 2003 to In 2004, Nevada became the first state to permit utilities to earn a bonus rate of return on DR and EE investments. In simple terms, utility DR and EE investments become regulatory assets that are eligible to earn a return of up to 5 percent more than traditional supply-side investments on the equity portion of the authorized return. With the ability to earn more money by investing in demand-side resources, coupled with the inclusion of energy efficiency in the state s Renewable Portfolio Standard in 2006, Nevada utilities have dramatically increased their spending on DR and EE. Nevada utility spending on DR and EE hit $38 million in 2007, a nearly three-fold increase from the $14 million that was spent in Conclusion A challenge for state utility commissions is to adopt policies that a) achieve a least-cost model, b) counterbalance the Averch-Johnson Effect, and c) encourage the right level of investment in DR and EE resources as well as traditional utility infrastructure. State utility commissions have the authority to increase utility-sponsored DR and EE by creating a favorable regulatory environment for utility DR and EE investment so that utilities will pursue an optimally-efficient strategy to meet the needs of their customers. In general, state utility commissions today want the utilities in their jurisdiction to pursue DR and EE programs due to the environmental and economic Avoided Cost North and South Carolina In 2007, Duke Energy Carolinas received national attention by proposing a DR and EE rider in North Carolina and South Carolina that was counter to traditional regulatory mechanisms for DR and EE. 9 Duke s proposal was referred to as Save-A-Watt (SAW). Rather than recommending a cost recovery mechanism that is a function of how much the utility spends on DR and EE investments, SAW is a function of the cost of the supply-side resources Duke avoids with successful implementation of DR and EE. Duke s proposal called for the utility to receive 90% of the return of and on the supply-side investment [Duke] would have made to provide the same capacity and energy over the same life as the measures and programs included within the portfolio of energy efficiency programs. 10 Duke contends that if it did not invest in DR or EE, then a certain amount of additional capacity and energy would be procured, the costs for which would be borne by ratepayers. By asking for 90% of the return that Duke would earn if it had invested in supply-side resource alternatives, Duke points out that there are benefits to customers and the utility. Customers will see lower bills than they otherwise would have faced, and Duke can truly consider saved watts the fifth fuel in its portfolio. 11 Duke s SAW program has yet to receive regulatory approval in either North Carolina or South Carolina. benefits these programs offer customers. Commissions should therefore ensure that utilities receive regulatory signals consistent with these objectives. In addition to program cost recovery, state utility commissions should consider a constructive level of utility performance incentive through a mechanism that is appropriate for the utilities in the state. A properlydesigned performance incentive mechanism can align a utility s corporate objectives with that of ensuring a costeffective level of DR and EE activity for the benefit of its customers. 7 US Department of Energy, Energy Efficiency and Renewable Energy. apps1.eere.energy.gov/states/ electricity.cfm/state=nv#total 8 Update on Utility Energy Efficiency Programs in the Southwest, Southwest Energy Efficiency Project, May 2008, news/2008/ dsm_ Program_Review.pdf 9 See, Thomas Friedman, Go Green and Save Money, The New York Times, 22 August 2007, nytimes.com/2007/08/22/ opinion/22friedman. html?scp=2&sq=save-awatt%20duke&st=cse. 10 Duke Energy (2007). As further described in Duke s SAW filing: Under traditional regulation, a utility is allowed to recover the depreciation and operating costs for a new plant and also earn a rate of return on the un-depreciated plant. Under the save-a-watt regulatory approach, the utility would be allowed to recover 90% of the depreciation and operating costs avoided by not building the new plant and also earn a return. 11 Coal, natural gas, nuclear, and renewable energy being the first four fuels. 5

6 Appendix A Summary of Select State Incentive Mechanisms Cost Recovery Targets Shared Savings Rate of Return Description Notes Arizona Share of net economic benefits up to 10% of total DSM spending California Penalties if fail to achieve 65% of goal. No penalty or incentive if achieve between 65% and 85%. Receive 9% of net system benefits if achieve 85% to 100% and 12% of net system benefits if achieve more than 100% of goal Colorado cel Energy is eligible for $2M after tax disincentive offset for pursuing DSM goals plus shared savings as long as at least 80% of energy savings goals are achieved. The incentive is tied to energy savings achieved and the net economic benefits of the programs, with overall revenue capped at 20% of expenditures By 2018: Utilities must achieve 5% energy savings and peak demand reductions (from 2006 base year) Connecticut Management fee of 1-8% of program costs (before tax)-- 1% for meeting at least 70% of target, 5% for meeting target, 8% for meeting 130% of target. Additional 1-5% return authorized. Florida (pending) (pending) Cost recovery through non-bypassable customer surcharge Recent legislation authorizes PSC to provide financial rewards/penalties and rate of return for DR and EE investments Georgia Georgia Power earns 15% of the net savings from a residential DR program, provided they achieve certain participation levels Hawaii Up to 5% of net systems benefit, provided goals are met. No incentive if do not meet goals, 1% benefit for meeting goal, additional 1% benefit for exceeding goal by 2.5%, 5%, 7.5%, or 10% or more (up to 5% max). Illinois Energy Efficiency Resource Standard sets statewide savings targets and penalties for failure to achieve targets (EE: save 1%/yr by 2012, 2%/yr by 2015 and beyond; Reduce peak demand by 0.1%/year 2008 and beyond) Iowa Utilities receive automatic pass-through via tariff rider on customer bills IUB approves utility EE plans and recently ordered plans to increase energy savings to 1.5% of retail energy sales by the year 2012 Kansas (possible) Recent KCC order states willingness to consider rate of return on a case-by-case basis Kansas Legislative Statute authorizes rate of return plus an adder of 0.5% to 2.0% for DR and EE investments Maryland As part of EmPower Maryland Act, utilities must file plans that will allow them to meet 10% per capita energy sales and 15% per capita demand reduction by EnerNOC, Inc.

7 White Paper Appendix A Summary of Select State Incentive Mechanisms Cost Recovery Targets Shared Savings Rate of Return Description Notes Massachusetts Systems benefit charge collected by distribution utilities. Utilities can receive up to 5% of program costs if targets are met. Green Communities Act of 2008 mandates utilities to invest in all costeffective energy efficiency Michigan (pending) (pending) Recent legislation establishes energy saving targets (1%/yr by 2012 and beyond) and allows utilities to request that EE costs be capitalized to earn a rate of return plus an adder if targets are exceeded. Performance incentive cannot exceed 15% of the total cost of the EE programs. Minnesota A utility begins earning incentive payments based on net system benefits when it surpasses 90% of its target. Size of incentive increases at every percentage point above 90% but never exceeds system benefits and is capped at 30% of a utility s actual expenditures Montana DR and EE program costs can be capitalized and are eligible for a 2% adder Nevada Full recovery of program costs through systems benefit charge. EE/DR investment can be capitalized and earn up to 5% additional return on equity New Hampshire Utilities can earn 8-12% of program costs for meeting established cost-effectiveness and savings targets New Mexico (possible) February 2008 bill authorizes utilities an opportunity to earn a profit on costeffective energy efficiency and load management resource development that, with satisfactory program performance, is financially more attractive to the utility than supply-side utility resources Same bill establishes EE targets of 5% savings by 2014 and 10% savings by 2020 North Carolina (possible) August 2007 bill created Renewable Energy and Energy Efficiency Portfolio Standard, authorizes utilities to capitalize DSM costs, and allows NCUC to approve DSM incentives which could include a rate of return adder and/or shared savings Duke Energy s Save-A-Watt proposal is still pending (pending in South Carolina as well). In this approach, Duke would receive a rate of return on 85% of the avoided costs from demonstrated EE savings. Ohio Duke Energy was recently approved for an annually reconciled rider that includes adjustments for shared savings with a 10% shareholder incentive if at least 65% of targeted savings are achieved. Pennsylvania EE plans must propose a cost-recovery tariff or adjustment mechanism Each utility must submit a plan to the PUC by July 1, 2009 to reduce energy consumption by 3% and peak demand by 4.5% by

8 Appendix A Summary of Select State Incentive Mechanisms Cost Recovery Targets Shared Savings Rate of Return Description Notes Rhode Island Utilities can earn incentives if they achieve 60%-125% of a program s savings targets. The base return for achieving savings target is 4.4% of the EE program s budget. Comprehensive Energy Conservation, Efficiency and Affordability Act of 2006 requires utilities to acquire all cost-effective energy efficiency Texas A utility s base rate may include an amount for energy efficiency program costs. Exceeding demand reduction goals, within the prescribed cost limit, is awarded a performance bonus of 1% of the net benefits for every 2% that the demand reduction goal has been exceeded, up to 20% of the program costs. Can also receive additional bonus if exceed 120% of demand reduction goal with at least 10% of its savings achieved through Hard-to-Reach programs. Wisconsin (case by case) Wisconsin Power & Light (Alliant Energy) earns rate of return equal to what it would earn on supply-side investments for a C&I EE program Utilities can request rate of return, but no other programs currently receive it. EnerNOC compiled the information in this table from sources it believes to be reliable, as of February Sources: ACEEE State Energy Efficiency Policy Database ( Aligning Utility Incentives with Investment in Energy Efficiency, Environmental Protection Agency for the National Action Plan for Energy Efficiency, (November 2007) Aligning Utility Incentives with Energy Efficiency Objectives, ACEEE (October 2006), N= EnerNOC research Boston, MA 75 Federal Street Suite 300 Boston, MA Office: Fax: Stamford, CT 68 Southfield Avenue Suite 215 Stamford, CT Office: Fax: New York, NY 14 Wall Street Suite 6A New York, NY Office: Fax: San Francisco, CA 500 Howard Street Suite 400 San Francisco, CA Office: Fax: info@enernoc.com Baltimore, MD 1414 Key Highway Suite L Baltimore, MD Office: Fax: Southern CA 906 Palomares Avenue La Verne, CA Office: Fax: Houston, T 1010 Lamar Suite 1040 Houston, T Office: Mississauga, Ontario 2425 Matheson Blvd East 7th Floor Mississauga, Ontario L4W 5K4 Office: Fax: EnerNOC, Inc. All rights reserved. No text can be reprinted without permission.