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Smart Decoupling

Dealing with unfunded mandates in performance-based ratemaking.

Fortnightly Magazine - May 2012

that utilities have the assurance that they’ll be able to recoup these expenditures as part of their revenue requirement through a rate case or separate rate-setting process. Put another way, utilities won’t have an incentive to invest in non-traditional programs and technologies in situations where the recovery of costs associated with these initiatives isn’t specifically addressed. Absent a specific cost recovery mechanism, utilities would effectively be penalized, through a lower earned return on equity, by making incremental and prudent investments in new and innovative programs whose costs aren’t already reflected in rates.

An increasingly popular approach that has been adopted in several states and at the Federal Energy Regulatory Commission is to allow a utility to earn a return on certain types of investments that are considered more policy-driven, while dealing with other expenditures through a cost tracking mechanism. This type of differential rate treatment is fair, reasonable and within the purview of regulators because it doesn’t penalize the utility for investing in a prudent manner.

By the same token, however, consumers must not be harmed by paying for imprudent investments or paying twice for the same expenditure. To ensure the protection of both of these parties, it’s critical that the expenditures relate to programs, activities, and incremental work not accounted for when the base rates were set.

According to economic theory, “incremental” cost is defined as the change in total cost associated with a specified change in output. Typically, incremental costs are reported on a per-unit basis. In the utility case, that would mean costs per kilowatt-hour of electric service provided to the customer. And while the definition and identification of incremental costs is fairly straightforward under a traditional ratemaking model that establishes utility rates for a single year based on a combination of actual or projected costs, it’s less easily discerned for utilities operating under performance-based multi-year rate plans that likely contain an earnings sharing mechanism.

In this new world of decoupling, earnings sharing, and performance-based ratemaking, regulators must account for the exogenous costs that utilities incur to deal with new obligations that might not have existed at the time the multi-year rate plan was adopted. These new mandates and costs can be considered “incremental.”

And for a utility under performance-based ratemaking or an earnings sharing mechanism, an approach to programmatic cost recovery that focuses on the costs of these incremental activities, as opposed to an accounting-based approach to costs that are above and beyond the base period costs, will satisfy the prohibition against double recovery of costs and honor the terms of both the earnings-sharing mechanisms and cost recovery of incremental investments.

With an earnings-sharing mechanism, the link between sales and revenues is broken, and the utility is incented to achieve efficiencies and retain the financial savings associated with these achievements. This provides the utility with the opportunity to earn greater rewards in exchange for the assumption of greater risk. To preserve the benefits that the utility struck with its customers, regulators compare periodic incremental activities to base period activities and permit the utility to recover the costs of