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Smart Decoupling

Dealing with unfunded mandates in performance-based ratemaking.

Fortnightly Magazine - May 2012

Regulators across the United States are placing increased emphasis and importance on smart grid programs, renewable and clean energy standards, transmission system upgrades, and environmental programs. Together, these initiatives will require electric utilities to invest unprecedented amounts of capital and incur increased operating expenses over relatively short periods. However, in many cases these additional investments aren’t covered in utilities’ existing rates—which makes them, in effect, unfunded mandates. The significant challenges associated with these exogenous costs calls for state regulators to re-examine current regulatory policies regarding recovery of capital costs and operating expenses.

The traditional regulatory compact is centered on the idea that an electric utility is a capital-intensive, centralized monopoly connected to a regional grid, with a mission of reliably serving its customers through the sale of electricity, while rewarding shareholders for the risks they bear. To honor that compact, utility investments traditionally have been tied to growth in both customers and load. This model is shifting, however, as policy makers ask utilities to adopt a broader focus—to support efficient energy usage, offer more customer choice among products and services at various prices, be more competitive, have greater reliability, and implement and administer programs outside of traditional service offerings.

Traditional ratemaking must be reconfigured into a new regulatory paradigm that answers the overarching question of how investments in energy innovation and cleaner technologies should be treated in the ratemaking process to encourage and incent such investments. The answer to this question, in part, involves two key concepts. First, there must be recognition that utilities are assuming new and different obligations directed at investment in cleaner energy resources and smarter technologies, and are moving further away from capital programs dominated by traditional investments. Second, new approaches to rate design and cost recovery must promote conservation, energy efficiency, smart consumption and reductions in environmental impacts, as opposed to focusing on consumption and capital expansion. Clearly, caution and fiscal prudence must be exercised by both utilities and regulators. Utilities must ensure investments are just and reasonable, while regulators must be sure that customers will see the benefits of these investments, and are protected from double-recovery or unreasonably high costs.

The Policy-Driven Mandate

Many states already have introduced revenue decoupling mechanisms. Under a decoupled regime, a utility is indifferent to changes in sales volume because its ability to earn the allowed return on equity is no longer affected by the level of its sales. This enables utilities to invest in energy efficiency, renewable resources, grid improvements and environmental measures without risk of earnings declines due to greater efficiency.

Revenue decoupling by itself, however, doesn’t address cost recovery for new regulatory initiatives introduced while a utility is operating under an existing extended rate plan. It also doesn’t address cost recovery in situations—inside or outside of rate cases—where a new policy mandate adds uncertainty to prior assumptions about costs and timing. In these situations, it’s critical

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