**(March 2010)** *New Day for Prudence:* I am sending this letter at the request of Robert Gruber, who is the executive director of the Public Staff-North Carolina Utilities Commission (...

## New York Negawatts

Balancing risks and opportunities in efficiency investments.

the utilities are likely to reach at least 92 percent of their targets on average, assuming the same performance levels historically observed for energy-efficiency programs. There’s a 5-percent probability that savings would exceed the targets, and a 5-percent probability that the utilities will achieve only 81 percent of their saving targets collectively. The results also show considerable opportunities for achieving greater-than-expected savings, as probabilities associated with both tails of distribution are significant; the upper quintile of savings lies above 2,150 GWh.

#### Shareholder Earnings Potential

The distributions of shareholder incentives relative to maximum-allowed earning potentials and actual amounts are shown in *Figure 5 * in relative and absolute terms. The results suggest utilities will, in all likelihood, earn at least 63 percent of the allowed maximum incentives, and the probability of an imposed penalty being nearly zero, assuming typical performance by the six utilities. On average, the six utilities stand to earn approximately $51 million in net present value terms over the course of their three-year plans. This figure lies slightly below the $53 million median and significantly below the $81 million maximum possible earnings.

In contrast to the distribution of energy savings, measures of the central tendency of earnings lie significantly below the maximum (target) given how the incentive mechanism is structured. While energy savings can exceed the target in any year, total annual shareholder incentives are capped at $27 million at the target. As a result, while above-target savings in one year might offset below-target savings in a later year, savings aren’t allowed to carry over to later years and be rewarded.

Distribution of potential earnings shows significant variability. The standard deviation is estimated at $16 million, which is 20 percent of mean savings. As in *Figure 5 *, the distribution of earnings is asymmetrical and negatively skewed. In addition, the inter-quartile range of earnings lies between $41 million and $61 million. Utilities face a 5-percent probability of earnings falling below $22 million and an equal likelihood of earning more than $75 million annually. The probability of a penalty is close to zero.

#### Fair or Efficient?

The New York shareholder incentive mechanism has four features with significant implications in terms of its effectiveness in encouraging energy-efficiency investments and how such investments will be rewarded. First, incentives are tied to annual, rather than cumulative, targets. Utilities qualify for incentives according to the savings level achieved each year, relative to the established annual target. Second, incentive payments are capped once savings targets are reached. Third, a dead band occurs between 70 percent and 80 percent of savings, when utilities earn nothing for their efforts. Finally, potential penalties stop to accrue once a utility’s performance falls to 50 percent of the annual target.

Basing incentives on annual targets is problematic because it doesn’t allow for smoothing random variations in savings between years. A utility might make the optimal amount of investment in energy efficiency and achieve the three-year savings target, yet fall short of the annual target in one or more years, thus earning less than the maximum due to factors beyond its control. ^{10 }