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Earning on Conservation

An earnings-equivalence model helps utilities and regulators calculate appropriate returns for conservation investments.

Fortnightly Magazine - December 2007

contained in the ratebase, management focus on energy-efficiency solutions is more likely to achieve the regulator’s energy savings goals when the incentives to do so are equal to or greater than additional supply-side alternatives. Thus, the returns to shareholders on supply-side resources are a logical basis for determining the magnitude of incentives. Customers and society as a whole benefit from mechanisms that encourage utilities to achieve the greatest possible energy savings within approved budgets.

The earnings-equivalency model describes a tiered-rate, shared-savings mechanism. The earnings calculation would be based on the cumulative net energy savings benefits created by program installations from the first year through the year an incentive claim is made by the utility. The dollar value of earnings at any point would equal the product of the multi-tiered performance earnings rate (PER) and the performance earnings basis (PEB). Performance earnings begin after successful achievement of the minimum performance standard (MPS).

The threshold for eligibility to receive performance rewards should be set at a value between 0 and 100 percent of the assigned savings goals set by the regulator. The lower the minimum-performance standard, the higher the ultimate reward level will be. An MPS of 75 percent is suggested. Once a utility meets the pre-set level of its savings goal, the performance rate is calculated using the corresponding net benefits attained above this threshold.

An incentive mechanism will align utility incentives with customer interests, because utility shareholders will earn at least a portion of the earnings they would otherwise receive if the energy-efficiency expenditures were invested in utility plant. In return, customers will benefit from energy cost savings in excess of the energy efficiency expenditures.

The PEB is the net benefit to customers—that is, the net dollar amount customers will save on their energy bills through the energy-efficiency program. For example, if the customer saves 4 therms of gas because of the energy-efficiency program, and that gas is worth $2.50 per therm, the total savings is $10. If the program cost is $1 per therm, the PEB would equal $6.

Once the MPS is achieved, and until 100 percent of the goal is met, the reward earnings must be set at a pre-selected earnings rate, as a percentage of the PEB—in this case, 15 percent. To continue the previous example, if the customer saves 4 therms with a PEB of $6, for an achievement level below 100 percent, the reward to the utility would be 90 cents. Thus, the customer would see real dollar savings of $5.10.

Because most energy-efficiency programs last approximately 12 years, the earnings equivalency is calculated for a 12-year period (see Table 1, “Cost of Capital”) . After considering the utility’s cost of capital, the ratebase for each of the 12 years must be calculated by considering both straight-line and accelerated depreciation. For the purposes of this analysis, the weighted state and federal tax rate is 40.746 percent, with a book life of 12 years and a tax life of 6 years.

With the ratebase known for each of the 12 years, simple math will provide the earnings