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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

for lost sales from energy efficiency and reward utilities for energy efficiency programs at the same level as earnings for supply-side rate-based investments and expenditures. The bottom line should make the utility indifferent between making a supply-side investment or spending money on energy-efficiency programs.

A number of rate-making approaches would compensate utility stockholders for managing and taking the risks associated with energy efficiency programs. For example:

• Include energy-efficiency expenditures in rate base;

• Award shareholders a fixed percentage of the energy-efficiency expenditures;

• Award shareholders a fixed percentage of the value of the energy savings;

• Increase the allowed return-on-equity rate when energy-savings targets are met or exceeded, and decrease the allowed return when targets are not met; and

• Capitalize the energy-efficiency expenditures and earn a return.

Each option above has its advantages and disadvantages, but a true supply-side equivalent would reward the utility for a successful energy-efficiency program based on the benefits or net energy savings—the savings on customers’ bills, minus the cost of the energy-efficiency program, which customers pay in utility rates.

Note the source of funds for the program is not at issue here. The funds are built into utility rates as part of expenses. The goal is to reward the utility for managing the energy-efficiency program and meeting or exceeding targets.

Such an approach can produce a win-win situation for both customers and shareholders. Customers enjoy the majority of the efficiency benefits, while shareholders earn cash rewards for encouraging and holding management accountable for developing and implementing cost-effective energy-efficiency related programs.

Shareholders, through the board of directors, will respond to earnings potential. If the utility loses money through energy-efficiency programs that, by definition, are intended to reduce sales, shareholders will tend to reward a management team that drags its feet in developing and managing energy-efficiency programs to their fullest extent. However, if shareholders see that equal and even greater earnings can result from a highly efficient and well-run energy efficiency program, the shareholders will pressure management to maximize the energy efficiency gains from every dollar spent on these programs. Within this economic incentive lies the beauty of having utilities manage energy-efficiency programs.

In utility rate-making, the benefit to the customer, if met by a supply-side asset, includes the return to the common shareholder as part of the price of the product—electricity and natural gas. Similarly, the benefit to the customer, if met by a demand-side program, should include a return to the common shareholder as part of the savings the customer enjoys by efficiently using that product.

This rationale supports the conclusion that total net benefits to energy consumers (the price of the energy times the quantity of energy saved, less the cost of the energy-efficiency program) should be shared with utility common shareholders at the same level shareholders would get from a supply-side, rate-based asset. If the utility can supply the benefit through demand-side efforts cheaper than that same benefit can be supplied through a supply-side alternative, so much the better.

Earnings-Equivalency Model

Because regulators only authorize utilities to earn reasonable returns on supply-side investments