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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

Traditionally, utility shareholders and their utilities have a bias toward supply-side resources as opposed to demand-side reduction programs. The reason for this bias is obvious—supply-side resources, such as new production facilities, add to the utility’s rate base, generating additional earnings.

Conversely, decreased sales (from energy efficiency) reduce the need for supply-side assets, thereby diminishing the utility’s earnings opportunities and possibly leading to under-earnings between rate cases. Furthermore, reductions in demand may result in excess supply-side resources that are likely to be excluded from rate base because they do not meet the “used and useful” standard.

Consequently, energy utilities place a great deal of emphasis on sales or throughput. In short, increased sales increase the need for supply-side assets and more earnings.

However, there is a solution: Allow energy utilities to benefit from earnings rewards for demand-side reduction. From an earnings perspective, such a solution would place demand-side alternatives on par with supply-side projects.

The DOE recently recommended this solution in a March 2007 report. 1 However, the department did not offer a methodology for calculating a supply-side earnings equivalent for a demand-side energy efficiency program. Such a methodology will help utilities develop effective conservation incentive programs.

Supply-Side Bias

Today, in response to growing demand for electricity and natural gas, many energy experts predict the United States will need hundreds of new electric generating plants and more emphasis on liquefied-natural-gas facilities (LNG) and new domestic sources of natural gas. Current projections anticipate an increase in U.S. energy demands by more than one-third by 2030, with electricity demand rising by more than 40 percent. 2 Confronted with the growing demand for energy—as well as the environmental consequences of obtaining or producing that energy—some state regulators are entertaining new regulatory regimes to reward utilities for their energy efficiency activities.

In most cases, demand-side investments aren’t capital intensive and thus present few opportunities to generate shareholder earnings. In fact, most demand-side programs require a lot of cash, labor, and outsourcing that show up on the income statement as expenses. Furthermore, in the few instances when capital investments are necessary to accomplish a demand-side goal, that investment is short lived or becomes the property of the customer.

Even more frustrating for the utility are the risks associated with operating a demand-side program. For example, if savings goals are not met, regulators often impose penalties, negatively affecting earnings. When most of the readily available energy efficiency programs have been accomplished, meeting the utility’s energy efficiency goals becomes more difficult. 3

A simple solution would give utilities a financial stake in saving energy. To accomplish this goal, regulators must adopt programs that compensate utilities