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Smart Decoupling

Dealing with unfunded mandates in performance-based ratemaking.

Fortnightly Magazine - May 2012

costs associated with incremental activities. The company would be responsible for, and is permitted to recover, the costs associated with the base period, and to capture the cost savings associated with any operational efficiencies achieved, without offsets for any other cost recovery mechanisms. Anything that differs from this approach eliminates the bargained-for elements of the earnings sharing mechanism, and would confer a double counting of benefits to customers.

The California Solution

Several state commissions that have adopted earnings sharing mechanisms and exogenous cost recovery mechanisms have addressed the double-recovery issue, most often through rules governing what costs are eligible for exogenous, or “Z-factor,” cost recovery. California has the most developed set of rules for determining which costs are eligible for Z-factor cost recovery.

The California Public Utility Commission (CPUC) has explained that for utilities operating under PBR regimes the Z-factor serves to “provide utilities protection from unforeseen and exogenous events.” (See California Public Utilities Commission, Decision 10-12-053, In the Matter of the Application of San Diego Gas & Electric Company (U902E) for Authorization to Recover Unforeseen Liability Insurance Premium and Deductible Expense Increases as a Z-Factor Event, Dec. 23, 2010, p. 5.) Accordingly, the CPUC adopted a number of criteria governing the eligibility of a particular expense for Z-factor treatment. These criteria include: a) a demonstration that the costs were reasonably and prudently incurred; b) the cost was for an activity that’s incremental to base year activities; c) the costs incurred are mandated through regulatory, legislative or judicial requirements and aren’t at the discretion of the utility; d) the costs aren’t a normal cost of doing business; e) the costs are measurable and have a meaningful impact on utility financial results; and f) any update of costs allowed under the earnings sharing mechanism can’t include the costs associated with the program or project activities. These criteria directly address the issue of double recovery of costs by removing the effect of the cost from the earnings sharing determination and by ensuring that program and project costs are truly incremental and recoverable.

An activity-based approach to cost recovery not only ensures the absence of double recovery, but also recognizes the unique circumstances of earnings sharing mechanisms. Earnings sharing mechanisms appropriately balance the interests of customers and the utility by breaking the link between sales and revenues and providing incentives for the utility to control costs. As a result, the utility is incented to achieve cost savings and operational efficiencies by retaining a portion of its earnings above a specified threshold amount, while surrendering a portion of its earnings below a specified threshold. An earnings sharing mechanism provides the utility with the opportunity to earn greater rewards in exchange for the assumption of greater risk.

In establishing the mechanism for recovery of incremental program costs, regulators must strive to avoid disturbing the incentives that the utility and regulators committed to under the terms of the earnings sharing mechanism. An approach to incremental program cost recovery, based on incremental activities rather than historic cost thresholds, satisfies the prohibition of double recovery of costs while preserving the