rap revenueregulationanddecoupling 2011 04

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Revenue Regulation

and Decoupling:A Guide to Theory

and Application

June 2011

The Regulatory Assistance Project

Homeoffice

50 State Street, Suite 3

Montpelier, Vermont 05602

phone: 802-223-8199

fax: 802-223-8172

www.raponline.org


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Revenue Regulation and Decoupling

Contents

Preace iv

1 Introduction 1

2 Context or Decoupling 2

3 How Traditional Decoupling Works 3

3.1 Revenue Requirement

3.1.1 Expenses

3.1.1.1 Production Costs

3.1.1.2 Non-Production Costs

3.1.2 Return

3.1.3 Taxes

3.1.4 Between Rate Cases

3.2 How Decoupling Works

3.2.1 In the Rate Case (Its the same)

3.2.2 Between Rate Cases (Its dierent)

4 Full, Partial, and Limited Decoupling 11

4.1 Full Decoupling

4.2 Partial Decoupling

4.3 Limited Decoupling

5 Revenue Functions 14

5.1 Ination Minus Productivity

5.2 Revenue per Customer (RPC) Decoupling

5.3 Attrition Adjustment Decoupling

5.4 K Factor

5.5 Need or Periodic Rate Cases

5.6 Judging the Success o a Revenue Function

6 Application o RPC Decoupling: New vs Existing Customers 22

7 Rate Design Issues Associated With Decoupling 24

7.1 Revenue Stability Is Important to Utilities

7.2 Bill Stability Is Important to Consumers

7.3 Rate Design Opportunities

7.3.1 Zero, Minimal, or Disappearing Customer Charge

7.3.2 Inverted Block Rates

7.3.3 Seasonally Dierentiated Rates

7.3.4 Time-o-Use Rates

7.4 Summary: Rate Design Issues


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8 Application o Decoupling: Current vs Accrual Methods 31

9 Weather, the Economy, and Other Risks 33

9.1 Risks Present in Traditional Regulation

9.2 The Impact o Decoupling on Weather and Other Risks

10 Earnings Volatility Risks and Impacts on the Cost o Capital 36

10.1 Rating Agencies Recognize Decoupling

10.2 Some Impacts May Not Be Immediate, Others Can Be

10.3 Risk Reduction: Reected in ROE or Capital Structure?

10.4 Consumer-Owned Utilities

10.5 Earnings Caps or Collars

11 Other Revenue Stabilization Measures andHow They Relate to Decoupling 41

11.1 Lost Margin Recovery Mechanisms

11.2 Weather-Only Normalization

11.3 Straight Fixed/Variable Rate Design (SFV)

11.4 Fuel and Purchased Energy Adjustment Mechanisms

11.5 Independent Third-Party Efciency Providers

11.6 Real-Time Pricing

12 Decoupling Is Not Perect: Some Concerns Are Valid 4412.1 Its an annual rate increase.

12.2 Decoupling adds cost.

12.3 Decoupling shits risks to consumers.

12.4 Decoupling diminishes the utilitys incentive to control costs.

12.5 What utilities really want sales or is to have an excuse to add to

rate basethat is the Averch Johnson Eect.

12.6 Decoupling violates the matching principle.

12.7 Decoupling is not needed because energy efciency is already encouraged,

since it liberates power that can be sold to other utilities.12.8 Decoupling has been tried and abandoned in Maine and Washington.

12.9 Classes that are not decoupled should not share the cost o

capital benefts o decoupling.

12.10 The use o requent rates cases using a uture test year

eliminates the need or decoupling.

12.11 Decoupling diminishes the utilitys incentive to restore service

ater a storm.

12.12 The problem is that utility profts dont reward utility perormance.

13 Communicating with Customers about Decoupling 51

14 Conclusion 54


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Preface

This guide was prepared to assist anyone who needs to understandboth the mechanics o a regulatory tool known as decoupling andthe policy issues associated with its use. This includes public utilitycommissioners and sta, utility management, advocates, and others

with a stake in the regulated energy system.Many utility-sector stakeholders have recognized the conicts implicit in

traditional regulation that compel a utility to encourage energy consumptionby its customers, and they have long sought ways to reconcile the utility

business model with contradictory public policy objectives. Simply put,under traditional regulation, utilities make more money when they sell moreenergy. This concept is at odds with explicit public policy objectives thatutility and environmental regulators are charged with achieving, includingeconomic efciency and environmental protection. This throughput incentiveproblem, as it is called, can be solved with decoupling.

Currently, some orm o decoupling has been adopted or at least oneelectric or natural gas utility in 30 states and is under consideration in

another 12 states. As a result, a great number o stakeholders are in need,or are going to be in need, o a basic reerence guide on how to design andadminister a decoupling mechanism. This guide is or them.

More and more, policymakers and regulators are seeing that theconventional utility business model, based on profts that are tied toincreasing sales, may not be in the long-run interest o society. Economic andenvironmental imperatives demand that we reshape our energy portolios tomake greater use o end-use efciency, demand response, and distributed,clean resources, and to rely less on polluting central utility supplies.Decoupling is a key component o a broader strategy to better align theutilitys incentives with societal interests.

While this guide is somewhat technical at points, we have tried to makeit accessible to a broad audience, to make comprehensible the underlyingconcepts and the implications o dierent design choices. This guide isaccompanied by a spreadsheet that can be used to demonstrate the impacts odecoupling using dierent pricing structures or, as the jargon has it, rate designs.

This guide was written by Jim Lazar, Frederick Weston, and Wayne

Shirley. The RAP review team included Rich Sedano, Riley Allen, CamilleKadoch, and Elizabeth Watson. Editorial and publication assistance wasprovided by Diane Derby and Camille Kadoch.

1 Natural Resources Deense Council, Gas and Electric Decoupling in the U.S.,April 2010.


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1. Introduction

T

his document explains the undamentals orevenue regulation2,which is a means or setting a level o revenues that a regulated gasor electric utility will be allowed to collect, and its necessary adjunctdecoupling, which is an adjustable price mechanism that breaks the

link between the amount o energy sold and the actual (allowed) revenuecollected by the utility. Put another way, decoupling is the means by whichrevenue regulation is eected. For this reason, the two terms are typicallytreated as synonyms in regulatory discourse; and, or simplicitys sake, wetreat them likewise here.

Revenue regulation does not change the way in which a utilitys allowedrevenues (i.e., the revenue requirement) are calculated. A revenuerequirement is based on a companys underlying costs o service, and the

means or calculating it relies on long-standing methods that need not berecapitulated in detail here. What is innovative about it, however, is howa defned revenue requirement is combined with decoupling to eliminatesales-related variability in revenues, thereby not only eliminating weatherand general economic risks acing the company and its customers, but alsoremoving potentially adverse fnancial consequences owing rom successulinvestment in end-use energy efciency.

We begin by laying out the operational theory that underpins decoupling.

We then explain the calculations used to apply a decoupling priceadjustment. We close the document with several short sections describingsome refnements to basic revenue regulation and decoupling.

To assist the reader, a companion MS-Excel spreadsheet is also available.It contains both the examples shown in this guide, as well as a unctioningdecoupling model. It can be downloaded at http://www.raponline.org/docs/RAP_DecouplingModelSpreadsheet_2011_05_17.xlsb

2 Revenue regulation is oten called revenue cap regulation. However, when combined withdecoupling, the eect is to simply regulate revenue i.e., there is a correspondingoor onrevenues in addition to a cap.
http://www.raponline.org/docs/RAP_DecouplingModelSpreadsheet_2011_05_17.xlsbhttp://www.raponline.org/docs/RAP_DecouplingModelSpreadsheet_2011_05_17.xlsbhttp://www.raponline.org/docs/RAP_DecouplingModelSpreadsheet_2011_05_17.xlsbhttp://www.raponline.org/docs/RAP_DecouplingModelSpreadsheet_2011_05_17.xlsb


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2. Context for Decoupling

Decoupling is a tool intended to break the link between how muchenergy a utility delivers and the revenues it collects. Decouplingis used primarily to eliminate incentives that utilities have toincrease profts by increasing sales, and the corresponding

disincentives that they have to avoid reductions in sales. It is most oten

considered by regulators, utilities, and energy-sector stakeholders in thecontext o introducing or expanding energy efciency eorts; but it shouldalso be noted that, on economic efciency grounds, it has appeal even in theabsence o programmatic energy efciency.

There are a limited number o things over which utility managementhas control. Among these are operating costs (including labor) and servicequality. Utility management can also inuence usage per customer (throughpromotional programs or conservation programs). Managers have very

limited ability to aect customer growth, uel costs, and weather. Decouplingtypically removes the inuence on revenues (and profts) o such actors and,by eliminating sales volumes as a actor in proftability, removes any incentiveto encourage consumers to increase consumption. This ocuses managementeorts on cost-control to enhance profts.

In the longer run, this eort constrains uture rates and beneftsconsumers. It also means that energy conservation programs (which reducecustomer usage) do not adversely aect profts. A perormance incentive

system and a customer-service quality mechanism can overlay decoupling tourther promote public interest outcomes.

Although it is oten viewed as a signifcant deviation rom traditionalregulatory practice, decoupling is, in act, only a slight modifcation. The twoapproaches aect behavior in critically dierent ways, yet the mathematicaldierences between them are airly straightorward. Still, it goes withoutsaying that care must be taken in designing and implementing a decouplingregime, and the regulatory process should strive to yield or both utilities and

consumers a transparent and air result.While traditional regulation gives the utility an incentive to preserve and,better yet, increase sales volumes, it also makes consumer advocates ocus onprice ater all, that is the ultimate result o traditional regulation. Becausedecoupling allows prices to change between rate cases, consumer advocatescan move the ocus o their eort rom prices to all cost drivers, includingsales volumes ocusing on bills rather than prices.


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3. How TraditionalRegulation Works

In virtually all contexts, public utilities (including both investor-ownedand consumer-owned utilities) have a common undamental fnancialstructure and a common ramework or setting prices.3 This common

ramework is what we call the utilitys overall revenue requirement.Conceptually, the revenue requirement or a utility is the aggregate o all othe operating and other costs incurred to provide service to the public. Thisincludes operating expenses like uel, labor, and maintenance. It also includesthe cost o capital invested to provide service, including both interest on debtand a air return to equity investors. In addition, it includes a depreciationallowance, which represents repayment to banks and investors o theiroriginal loans and investments.

In order to determine what price a utility will be allowed to charge,regulators must frst compute the total cost o service, that is, the revenuerequirement. Regulators then compute the price (or rate) necessary to collectthat amount, based on assumed sales levels. In most cases, the regulator relieson data or a specifc period, reerred to here as the test period, and perormssome basic calculations.

Here are the two basic ormulae used in traditional regulation:

Formula 1: Revenue Requirement = (Expenses + Return + Taxes) TesT Period

Formula 2: Rate = Revenue Requirement Units Sold TesT Period

The rate is normally calculated on a dierent basis or each customer class,but the principle is the same the regulator divides the revenue requirementamong the customer classes, then designs rates or each class to recover eachclasss revenue requirement. Table 1 is an example o this calculation, underthe simpliying assumption that the entire revenue requirement is collectedthrough a kWh charge.

3 Conditions vary widely rom country to country or region to region, and utilities ace anumber o local and unique challenges. However, or our purposes, we will assume thatthere is a undamental fnancial need or revenues to equal costs including any externallyimposed requirements to und or secure other expense items (such as required returns toinvestors, debt coverage ratios in debt covenants, or subsidies to other operations, as is otenthe case with municipal- or state-run utilities). In this sense, virtually all utilities can beviewed as being quite similar.


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3.1 RevenueRequirement

A utilitys revenue require-ment is the amount o revenuea utility will actually collect,only i it experiences the salesvolumes assumed or purposeso price-setting. Furthermore,only i the utility incurs exactlythe expenses and operatesunder precisely the fnancialconditions that were assumedin the rate case will it earn therate o return on its rate base(i.e., the allowed investment inacilities providing utility service) that the regulators determined was appropri-ate. While much o the rate-setting process is meticulous and oten arcane, theundamentals do not change: in theory a utilitys revenue requirement shouldbe sufcient to cover its cost o service no more and no less.

311 Expenses

For purposes o decoupling, expenses come in two varieties: productioncosts and non-production costs.4

3111 Production Costs

Production costs are a subset o total power supply costs, and arecomposed principally o uel and purchased power expenses with a bit o

variable operation and maintenance (O&M) and transmission expenses paidto others included. Production costs as we use the term here are those thatvary more or less directly with energy consumption in the short run. Themechanisms approved by regulators generally reer to very specifc accountsdefned in the utility accounting manuals, including uel, purchasedpower, and transmission by others.

4 A utilitys expenses are oten characterized as fxed or variable. However, or purposeso resource planning and other long-run views, all costs are variable and there is no suchthing as a fxed cost. Even on the time scale between rate cases, some non-production coststhat are oten viewed as fxed (e.g., metering and billing) will, in act, vary directly withthe number o customers served. When designing a decoupling mechanism, it is moreappropriate to dierentiate between production and non-production, since one purposeo the mechanism is to isolate the costs over which the utility actually has control in the shortrun (i.e., the period between rate cases).

Expenses 100,000,000

Net Equity Investment 100,000,000

Allowed Rate o Return 1000%

Allowed Return $10,000,000

Taxes (35% tax rate) $5,384,615

Total Return & Taxes $15,384,615

Total Revenue Requirement $115,384,615

Price Calculation

Revenue Requirement $115,384,615

Test Year Sales (kWh) 1,000,000,000

Rate Case Price ($/kWh) $01154

Traditional Regulation Example:Revenue Requirement Calculation

Table 1


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Production costs or most electric utilities are typically recovered througha ow-through account, with a reconciliation process that ully recoversproduction costs, or an approximation thereo.5 This is usually accomplished

through a separate uel and purchased-power rate (uel adjustment clause,or FAC) on the customers bill. This may be an adder that recovers totalproduction costs, or it may be an up-or-down adjustment that recoversdeviations in production costs rom the level incorporated in base rates.

In the absence o decoupling, a ully reconciled FAC creates a situation inwhich any increase in sales results in an increase in profts, and any decreasein sales results in a decrease in profts. This is because even i very high-cost power is used to serve incremental sales, and i 100% o this cost owsthrough the FAC, the utility receives a net addition to income equal to thebase rate (retail rate less production costs) or every incremental kilowatt-hoursold.6 An FAC is thereore a negative inuence on the utilitys willingness toembrace energy efciency programs and other actions that reduce utility sales.Decoupling is an important adjunct to an FAC to remove the disincentive thatthe FAC creates or the utility to pursue societal cost-eectiveness.7

Because they vary with production and because they are separatelytreated already, production costs are not usually included in a decouplingmechanism. I a utility is allowed to include the investment-related portion o

costs or purchased power contracts (i.e., it buys power to serve load growthrom an independent power producer, and pays a per-kWh rate or the powerreceived), it may be necessary to address this in the structure o the FAC toensure that double recovery does not occur. This can also be addressed byusing a comprehensive power cost adjustment that includes all power supplycosts, not just uel and purchased power. Unless otherwise noted, we assumethat production costs are not included in the decoupling mechanism.

5 Many commissions use incentive mechanisms in their uel and purchased-powermechanisms, to provide utilities with a proft motive to minimize uel and purchased-powercosts and to maximize net o-system sales revenues. For our purposes, these are deemed toully recover production costs. Some regulators include both fxed and variable power supplycosts in their power supply cost recovery mechanism, in which case all o those would beclassifed as production costs and deemed to be ully recovered through the power supplymechanism.

6 See Profts and Progress Through Least Cost Planning, NARUC, page 4, at:http://www.raponline.org/Pubs/General/Pandplcp.pd

7 I a utility does not have an FAC at all, or acquires power rom independent power producerson an ongoing basis to meet load growth, the ramework or decoupling may need to beslightly dierent. In those circumstances, revenues rom the sale o surplus power or avoidedpurchased power expense resulting rom sales reductions ows to the utility, not to theconsumers, through the FAC. In this situation, the defnition o production costs may needto include both power supply investment-related costs and production-related operatingexpenses or decoupling to produce equitable results or consumers and investors.


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3112 Non-Production Costs

Non-production costs include all those that are not production costs inessence, everything that is related to the delivery o electricity (transmission,

distribution, and retail services) to end users. This normally includes all non-production related O&M expenses, including depreciation and interest ondebt. In many cases, the base rates also include the debt and equity service(i.e., the interest, return, and depreciation) on power supply investments, inwhich case the orm o the FAC becomes important.

Statistically, a utilitys non-production costs do not vary much withconsumption in the short run, but are more aected by changes in thenumbers o customers served, ination, productivity, and other actors.8O course, a utility with a large capital expenditure program, such as thedeployment o smart grid technologies or signifcant rebuilds o agingsystems, will experience a surge in costs that is unrelated to customer growth.Decoupling does not address this issue, which is better handled in thecontext o a rate case or inrastructure tracking mechanism.

Non-production costs are usually recovered through a combination o a cus-tomer charge,9 plus one or more volumetric (per kWh, per kW) rates. A utilitymay ace the risk o not recovering some non-production costs i sales decline.Put another way, many o the costs do not vary with sales, so each dollar

decline in sales ows straight to and adversely aects the bottom line.

312 Return

For our purposes, the utilitys return is the same as its net, ater-tax proft,or net income or common stock.10 When computing a revenue requirementor a rate case, this line item is derived by multiplying the utilitys net equityinvestment by its allowed rate o return on common equity. We havesimplifed this return in the illustration, but will address it in more detail in

Section 10, Earnings Volatility Risks and Impacts on the Cost o Capital.In a rate case, the return is a static expected value. In between rate cases,

8 Eto, Joseph, Steven Stot, and Timothy Belden, The Theory and Practice o Decoupling,Lawrence Berkeley National Laboratory, January 1994. URL: http://eetd.lbl.gov/ea/EMS/reports/34555.pd

9 In place o a customer charge, one may also fnd other monthly fxed charges, such asminimum purchase amounts, access ees, connection ees, or meter ees. For our purposes,these are all the same because they are not based on energy consumption, but, instead, are a

unction o the number o customers.

10 Regulatory commissions oten calculate an operating income fgure in the process o settingrates; this does not take account o the tax eects on the debt and equity components o theutility capital structure. Net income includes these eects.

11 Shirley, W., J. Lazar, and F. Weston, Revenue Decoupling: Standards and Criteria, A Report to theMinnesota Public Utilities Commission, Regulatory Assistance Project, 30 June 2008, AppendixB, p. 36.
http://eetd.lbl.gov/ea/EMS/reports/34555.pdfhttp://eetd.lbl.gov/ea/EMS/reports/34555.pdfhttp://eetd.lbl.gov/ea/EMS/reports/34555.pdfhttp://eetd.lbl.gov/ea/EMS/reports/34555.pdf


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realized returns are a unction o actual revenues, actual investments, andactual expenses, all o which change between rate cases in response to manyactors, including sales volumes, ination, productivity, and many others.

As a share o revenues in a rate case revenue requirement calculation, thereturn on equity to shareholders may be as small as 5%-10%. As a result, smallpercentage changes in total non-production revenues (all o which largely aectreturn and taxes) can generate large percentage changes in net profts.11

313 Taxes

In a rate case, the amount o taxes a utility would pay on its allowedreturn is added to the revenue requirement.

In between rate cases, taxes buer the impact on the utilitys shareholderso any deviations o realized returns rom expected returns. When realizedreturns rise, some portion is lost to taxes, so shareholders do not garner gainsone-or-one with changes in net revenues. Conversely, i revenues all, sodo taxes. As a result, investors do not suer the entire loss. I the tax rate is33%, then one third o every increase or decrease in pre-tax profts will beabsorbed by taxes.

From a customer perspective, there is no buering eect rom taxes. To thecontrary, customers pay all additional revenues and enjoy all savings, dollar

or dollar.

314 Between Rate Cases

With traditional regulation, while thedetermination o the revenue requirement at the timeo the rate case decision is meticulous, the utility willalmost certainly never collect precisely the allowedamount o revenue, experience the associated

assumed levels o expenses or unit sales, or achievethe expected profts. The revenue requirement isonly used as input to the price determination. Onceprices are set, realized revenues and profts will be aunction oactual sales and expenses and will have only a rough relationshipwith the rate case allowed revenues or returns.

Put another way, traditional regulation fxes the price between rate casesand lets revenues oat up or down with actual sales. At this point, the rate

case ormulae no longer hold sway. Instead, two dierent mathematicalrealities operate:Formula 3: Revenues ActuAl = Units Sold Actual X Price

Formula 4: Proft ActuAl = (Revenues Expenses Taxes)ActuAll

These two ormulae reveal the methods by which the utility can increaseits profts. One approach is to reduce expenses. Providing a heightened

Traditionalregulation xes

the price betweenrate cases and

lets revenues foatup or down with

actual sales.


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incentive to operate efciently is sound. However, there is a oor belowwhich expenses simply cannot be reduced without adversely aecting thelevel o service, and to ensure that utilities cut at, but not bone, some

regulators have established service quality indices that penalize utilitiesthat achieve lower-than-expected customer service quality. The easierapproach is to increase the Units Sold, as this will increase revenues andthereore profts.12 This is the heart o the throughput incentive that utilitiestraditionally ace and this is where decoupling comes in.

3.2 How Decoupling Works

There are a variety o dierent approaches to decoupling, all o which

share a common goal o ensuring the recovery o a defned amount orevenue, independent o changes in sales volumes during that period. Someare computed on a revenue-per-customer basis, while others use an attritionadjustment (typically annual) to set the allowed revenue. Some operate on anannual accrual basis, while others operate on a current basis in each billingcycle. Table 2 categorizes these and provides an example o each approach; agreater discussion o these approaches is contained in the appendix.

Table 2

12 This is because, as noted earlier, the utility aces virtually no changes in its non-productioncosts as its sales change. This means that marginal increases in sales will have a large and posi-tive impact on the bottom line, just as marginal reductions in sales will have the opposite eect.

DecouplingMethodology

Accrual RevenuePer Customer

Current RevenuePer Customer

Accrual Attrition

Distribution-Only

Key Elements

Allowed revenue computedon an RPC basis; one rateadjustment per year

Allowed revenue computed onan RPC basis; rates adjusted eachbilling cycle to avoid deerrals

Allowed revenue determinedin periodic general rate cases;changes to this based onspecifed actors determined inannual attrition reviews; ratesadjusted once a year

Only distribution costs includedin the mechanism; all powercosts (fxed and variable)

recovered outside the decouplingmechanism

Example oApplication

Utah, Questar

Oregon, NorthwestNatural Gas Company;DC: Pepco

Caliornia, PG&E andSCE Hawaii, HawaiianElectric

Massachusetts, NGridMaryland, BG&E

Washington (PSE,1990-95)


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321 In the Rate Case (Its the same)

With decoupling there is no change in the rate case methodology, exceptperhaps or the migration o some cost items into or out o the production

cost recovery mechanism.13

Initial prices are still set by the regulator, basedon a computed revenue requirement.

Formula 1: Revenue Requirement = (Expenses + Return + Taxes) test Period

Formula 5: Price endof rAte cAse = Revenue Requirement Units Sold test Period

322 Between Rate Cases (Its dierent)

With decoupling, the price computedin the rate case is only relevant as a

reerence or beginning point. In act,the rate case prices may never actuallybe charged to customers. Instead, undercurrent decoupling (described below),prices can be adjusted immediately,based on actual sales levels, to keeprevenues at their allowed level. Ratherthan holding prices constant between

rate cases as traditional regulation woulddo, decoupling adjusts prices periodically, even as requently as each billingcycle, to reect dierences between units sold test Period and units sold ActuAl,as necessary to collect revenues Allowed. This is accomplished by applying theollowing ormulae:

Formula 6: Price Post rAtecAse = Revenues Allowed Units Sold ActuAl

Formula 7: Revenues ActuAl = Revenues Allowed

Formula 4: Profts ActuAl = (Revenues Expenses Taxes) ActuAl

Table 3 gives an example o the calculations.

13 Examples o costs that are sometimes recovered on an actual cost basis include nuclear decom-missioning (which rises according to a sinking und schedule), energy conservation programexpenses, and inrastructure trackers or non-revenue-generating reurbishments. Where autility does not have an FAC or purchases power rom independent power producers to meetload growth, it may be necessary to include all power supply costs, fxed and variable, in thedefnition o production costs.

There are two distinct

components o decouplingwhich are embedded inthe decoupling ormulae:

determination o theutilitys allowed revenuesand determination o the

prices necessary to collectthose allowed revenues.


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There are two distinctactions embedded in thedecoupling ormulae:

determination o the utilitysallowed revenues anddetermination o thepricesnecessary to collect thoseallowed revenues. The ormercan involve a variety omethods, ranging rom simplysetting allowed revenues atthe amount ound in the lastrate case to varying revenuesover time to reect non-sales-related inuences on costsand revenues, as discussed inSection 5, Revenue Functions.The latter is merely the calculation which sets the prices that, given saleslevels (i.e., billing determinants), will generate the allowed revenue.

Put another way, while traditional

regulation sets prices, then lets revenuesoat up or down with consumption,decoupling sets revenues, then lets pricesoat down or up with consumption. Thisprice recalculation is done repeatedly either with each billing cycle or onsome other periodic basis (e.g., annual),through the use o a deerral balancing

and reconciliation account.14

There are two separate elements in play in the price-setting component odecoupling. The frst is that prices are allowed to change between rates, basedon deviations in sales rom the test period assumptions. The second is therequency o those changes. We discuss the requency idea in greater detail inSection 8,Application o Decoupling: Current vs. Accrual Methods.

Expenses $100,000,000

Net Equity Investment $100,000,000

Allowed Rate o Return 1000%

Allowed Return $10,000,000

Taxes (35% tax rate) $15,384,615

Total Revenue Requirement $115,384,615

Price Calculation

Revenue Requirement $115,384,615Actual Sales (kWh) 990,000,000

Decoupling Price ($/kWh) $01166

Decoupling Adjustment ($/kWh) $00012

Decoupling Example:Revenue Requirement Calculation

Table 3

14 There are, however, good reasons to seek to limit the magnitude o deviations rom thereerence price. For example, many decoupling mechanisms allow a maximum 3% change inprices in any year, deerring larger variations or uture treatment by the regulator. Signifcantvariability in price may threaten public acceptance o decoupling and the broader policyobjectives it serves. Policymakers should be careul to design decoupling regimes with thisconsideration in mind.

While traditionalregulation sets prices, then

lets revenues foat up ordown with consumption,decoupling sets revenues,then lets prices foat downor up with consumption.


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4 Full, Partial, and LimitedDecoupling

We use a specialized vocabulary to dierentiate various approaches todecoupling.

4.1 Full Decoupling

Decoupling in its essential, ullest orm insulatesa utilitys revenue collections rom any deviationo actual sales rom expected sales. The cause othe deviation e.g., increased investment inenergy efciency, weather variations, changes in

economic activity does not matter. Any and all deviations will result in anadjustment (true-up) o collected utility revenues with allowed revenues.The ocus here is delivering revenue to match the revenue requirementestablished in the last rate case.

Full decoupling can be likened to the setting o a budget. Throughcurrently used rate-case methods, a utilitys revenue requirement i.e.,the total revenues it will need in a period (typically, a year) to provide sae,adequate, and reliable service is determined. The utility then knows

exactly how much money it will be allowed to collect, no more, no less. Itsproftability will be determined by how well it operates within that budget.Actual sales levels will not, however, have any impact on the budget.15

The most common orm o ull decoupling is revenue-per-customerdecoupling, which is more ully explained with other orms o decouplingin the next section. The Caliornia approach, wherein a revenue requirementis fxed in a rate case and incremental (or decremental) adjustments to it aredetermined in periodic attrition cases, is also a orm o ull decoupling.Tracking mechanisms, designed to generate a set amount o revenue to

15 This is the simplest orm o ull decoupling. As described in the next section, most decouplingmechanisms actually allow or revenues to vary as actors other than sales vary. The reasoning isthat, though in the long run utility costs are a unction o demand or the service they provide,in the short run (i.e., the rate-case horizon) costs vary more closely with other causes, primarilychanges in the numbers o customers.

Full decouplingcan be likened tothe setting o a

budget.


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cover specifc costs (independently o base rates and the underlying cost oservice) are not incompatible with ull decoupling. They would be reectedin separate tari surcharges or surcredits.

Full decoupling renders a utility indierent to changes in sales, regardlesso cause. It eliminates the throughput incentive. The utilitys revenues areno longer a unction o sales, and its profts cannot be harmed or enhancedby changes in sales. Only changes in expenses will then aect profts.

Decoupling eliminates a strong disincentive to invest in energy efciency.By itsel, however, decoupling does not provide the utility with a positiveincentive to invest in energy efciency or other customer-sited resources,but it does remove the utilitys natural antagonism to such resources due totheir adverse impact on short-run profts. Assuming that management has alimited ability to inuence costs and behavior, this allows concentration othat eort on cost reductions, rather than sales enhancements.

4.2 Partial Decoupling

Partial decoupling insulates only a portion o the utilitys revenuecollections rom deviations o actual rom expected sales. Any variation insales results in a partial true-up o utility revenues (e.g., 50%, or 90%, o the

revenue shortall is recovered).One creative application o partial decoupling was the combination

conservation incentive/decoupling mechanism or Avista Utilities inWashington. The utility was allowed to recover a percentage o its lostdistribution margins rom sales declines in proportion to its percentageachievement o a Commission-approved conservation target. I it achieved theull conservation target, it was allowed to recover all o its lost margins, buti it ell short, it was allowed only partial recovery.16 This proved a powerul

incentive to ully achieve the conservation goal.

4.3 Limited Decoupling

Under limited decoupling only specifed causes o variations in sales resultin decoupling adjustments. For example:

Onlyvariationsduetoweatheraresubjecttothetrue-up(i.e.,actual

year revenues [sales] are adjusted or their deviation rom weather-

normalized revenues). This is simply a weather normalizationadjustment clause. Other impacts on sales would be allowed to aectrevenue collections. Successul implementation o energy efciencyprograms would, in this context, result in reductions in sales and

16 Washington Utilities and Transportation Commission, Docket UG-060518, 2007. The recoverywas capped at 90%.


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revenues rom which the utility would not be insulated that is, allelse being equal, energy efciency would adversely aect the companysbottom line. Weather-only adjustment mechanisms have been

implemented or several natural gas distribution companies. Lost-marginmechanisms,whichrecoveronlythelostdistributionmargin related to utility-operated energy efciency programs, have beenimplemented or several utilities. These generally provide a removalo the disincentive or utilities to operate efciency programs, but maycreate perverse incentives or utilities to discourage customer-initiatedefciency measures or improvements in codes and standards that causesales attrition, because these are not compensated.

Reducedusagebyexistingcustomersmaybedecoupled,whereas

new customers are not included in the mechanism, on the theory thatthe utility is more able to inuence, through utility programs, the usageo existing customers who were a part o the rate-case determination oa test year revenue requirement.

Variationsduetosomeorallotherfactors(e.g.,economy,end-use

efciency) except weather are included in the true-up. In this instance,the utility and, necessarily, the customers still bear the revenue risksassociated with changes in weather. And, lastly,

Somecombinationoftheabove.Limited decoupling requires the application o more complex

mathematical calculations than either ull or partial decoupling, and thesecalculations depend in part on data whose reliability is sometimes vigorouslydebated. But more important than this is the undamental question that thechoice o approaches to decoupling asks: how are risks borne by utilities andconsumers under decoupling, as opposed to traditional regulation? Whatvalue derives rom removing sales as a motivator or utility management?

What value derives rom creating a revenue unction that more accuratelycollects revenue to match actual costs over time? What are the expectedbenefts o decoupling, and what, i anything, will society be giving up whenit replaces traditional price-based regulation with revenue-based regulation?

Limited decoupling does not ully eliminate the throughput incentive. Theutilitys revenues (and profts, thereore) are still to some degree dependent onsales. So long as it retains a measure o sales risk, the achievement o publicpolicy goals in end-use efciency and customer-sited resources, environmental

protection, and the least-cost provision o service will be inhibited.17

17 Limited decoupling is synonymous with net lost revenue adjustments. Net lost revenueadjustments is the term o art that describes earlier methods o compensating a utility or therevenue to cover non-production costs that it would have collected had specifed sales-reducingevents or actions (e.g., cooler-than-expected summer weather, or government-mandated end-use energy investments) not occurred.


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5 Revenue Functions

O

ne o the collateral benefts o decoupling is the potential orreducing the requency o rate cases. In its simplest orm, adecoupling mechanism maintains revenues at a constant levelbetween rate cases. However, this would inevitably put increasing

downward pressure on earnings due to general net growth in the utilitys coststructure as new customers are added and operating expenses are driven byination, to the extent these are not oset by depreciation, productivity gains,and, in certain cases, cost decreases.

To avoid this problem, the allowed (or target) revenue a utility cancollect in any post-rate-case period can be adjusted relative to the rate-caserevenue requirement. Most decoupling mechanisms currently in eect makeuse o one or more revenue unctions to set allowed revenues between rate

cases, and we describe the our standard ones here: (1) adjusting or inationand productivity; (2) accounting or changes in numbers o customers; (3)dealing with attrition in separate cases; and (4) the application o a K actorto modiy revenue levels over time. There may be others that are, in particularcircumstances, also appropriate.

5.1 Ination Minus Productivity

Beore development o the current array o decoupling options, a numbero jurisdictions used what has been called perormance-based regulation(PBR) relying on a price-cap methodology, instead o decouplingsrevenue-based approach. These plans, frst developed or telecommunicationsproviders, oten included a price adjuster under which the aected (usuallynon-production) costs o the utility were assumed to grow through the neteects o ination (a positive value) and increased productivity (a negative

18 Under normal economic conditions, ination will be a positive value and productivity anegative value, but there can be circumstances that violate this presumption an extendedperiod o deation, or instance. In act, when Great Britains state-owned electric transmissionand distribution companies were privatized in the late 1980s, their prices were regulatedunder PBR ormulas that included positive productivity adjustments. [Positive] X (that is, anapparent allowance or annual rates o productivity decreases o X percent) actors were chosenin order to provide the industry with sufcient uture cash ow in part to meet projected utureinvestment needs and also to increase the attractiveness o the companies to the investment


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value).18 Prices were allowed to grow at the rate o ination, less productivity,in an eort to track these expected changes in the utilitys cost o service. Insome cases, other actors (oten called Z actors) were added to the ormulae

to represent other explicit or implicit cost drivers. For example, i a unioncontract had a known inationary actor, this might be used in lieu o ageneral ination index, but only or union labor expenses.

This adjustment is being used in revenue-decoupling regulation, too,to determine a revenue path between rate cases. Rather than applying thisadjustment to prices, it is applied to the allowed revenue between ratescases.19 This approach is used in Caliornia, with annual attrition cases thatconsider other changes since the last general rate case, then add (or subtract)these rom the revenue requirement determined in the rate case.

With the ination and productivity actors in hand, the allowed revenueamount can be adjusted periodically. In practice, this adjustment has usuallybeen done through an annual administrative fling and review. In theory,however, there is no practical reason these adjustments could not be madeon a current basis, perhaps with each billing cycle.20 In application, the netgrowth in revenue requirement is usually spread evenly across all customersand all customer classes.

The ination-minus-productivity approach does not remove all

uncertainty rom price changes, because the actual ination rate used toderive allowed revenues (and, thereore, reerence prices) will vary over time.

community during their upcoming public auction. The initial regulatory timerame was set atthe fscal year 1990/1995 time period. See http://actrav.itcilo.org/actrav-english/telearn/global/ilo/rame/elect2.htm. (Note that this adjustment is actually reerred to as negative productivity,since it indicates a reduction, rather than an increase, in productivity. Mathematically, itsdenoted as the negative o a negative, and so or simplicitys sake weve described it as positive

here.)

19 Under this approach, a government-published (or other accepted third party source),broad-based ination index is used. The productivity actor, which serves to oset ination,is also an administratively determined or, in some cases, a stakeholder agreed-uponvalue. It should not, however, be calculated as a unction o the particular companys ownproductivity achievements. Doing so would reward a poorly perorming company withan overall revenue adjustment (ination-minus-productivity actor) that is too high (andwhich does not give it strong enough incentives to control costs) and would punish a highlyperorming company with a actor that reduces the gains it would otherwise achieve, in eectholding it to a more stringent standard than other companies ace.

20 See also Current vs. Accrual Methods, below, or more on the implications o using accrualmethodologies or decoupling versus using a current system. It goes without saying, ocourse, that price changes o this sort can only be eected through a simple, regularministerial process, i the adjustment actors on which they are based are transparent,unambiguous, and actual in nature (e.g., customer count). I, however, the adjustment isdriven by changes that are within managements discretionary say, capital budget thena more detailed review may be required to assure that prudent decisions are underlying therevenue adjustments.
http://actrav.itcilo.org/actrav-english/telearn/global/ilo/frame/elect2.htmhttp://actrav.itcilo.org/actrav-english/telearn/global/ilo/frame/elect2.htmhttp://actrav.itcilo.org/actrav-english/telearn/global/ilo/frame/elect2.htmhttp://actrav.itcilo.org/actrav-english/telearn/global/ilo/frame/elect2.htm


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5.2 Revenue-per-Customer (RPC) Decoupling

As noted earlier, analysis has shown that, in the time between rate cases,

changes in a utilitys underlying costs vary more directly with changes in thenumber o customers served than they do with other actors such as sales,although the correlation on a total expense basis to any o these is relativelyweak. When examining only non-production costs, however, the correlationsare much stronger, especially or the number o customers.

In 2001, we previously studied the relationships between drivers suchas system peak, total energy, and number o customers to investments indistribution acilities.21

RAP prepared studies or correlationsbetween investments in transormers andsubstations versus lines and eeders asthey relate to growth in customers served,system peak, and total energy sales. The dataindicate that customer count is somewhatmore closely correlated with growth in non-production costs, stronger thaneither growth in system peak or growth in energy sales. These data supportusing the number o customers served as the driver or computing allowed

revenues between rate cases, particularly in areas where customer growth hasbeen relatively stable and is expected to continue. The revenue-per-customer,or RPC method, may not be appropriate in areas with stagnant economies orvolatile spurts o growth, or where new customers are signifcantly dierentin usage patterns than existing customers, but in these situations, the attritionmethod may still work well.

The RPC value is derived through an added last step in the rate casedetermination. It is computed by taking the test period revenues associated

with each volumetric price charged, and dividing that value by the end-o-test period number o customers who are charged that volumetric price. Thiscalculation must be made or each rate class, or each volumetric price, andor each applicable billing period (most likely a billing cycle):

Formula 8: Revenue per Customer test Period =

Revenue Requirement test Period No o Customers test Period

With this revenue-per-customer number, allowed revenues can be

adjusted periodically to reect changes in numbers o customers. In any

The data indicate thatcustomer growth is closely

correlated to growth onon-production costs.

21 See Distributed Resource Policy Series: Distribution System Cost Methodologies orDistributed Generation available at http://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesorDistributedGeneration_2001_09.pdand theaccompanying Appendices at: http://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesorDistributedGenerationAppx_2001_09.pd
http://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGeneration_2001_09.pdfhttp://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGeneration_2001_09.pdfhttp://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGenerationAppx_2001_09.pdfhttp://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGenerationAppx_2001_09.pdfhttp://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGenerationAppx_2001_09.pdfhttp://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGenerationAppx_2001_09.pdfhttp://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGeneration_2001_09.pdfhttp://www.raponline.org/docs/RAP_Shirley_DistributionCostMethodologiesforDistributedGeneration_2001_09.pdf


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Statistical Summary

Standard Deviation $2,129,439

Average $608,215

Correlation 080

Statistical SummaryStandard Deviation $606

Average $74

Correlation 053

Statistical Summary

Standard Deviation $13,191

Average $4,551

Correlation 082

$500,000

$400,000

$300,000

$200,000

$100,000

$0

$500,000

$400,000

$300,000

$200,000

$100,000

$0

$500,000

$400,000

$300,000

$200,000

$100,000

$0

Growth in Lines & Feeders Investmentvs Growth in System Peak(Five Year Adjusted Average, 1995-1999)

Growth in Lines & Feeders Plant Investmentvs Growth in System Energy

(Five Year Average, 1995-1999/Excludes Negative Growth)

Growth in Lines & Feeders Plant Investmentvs Growth in Customers

(Five Year Average, 1995-1999/Excludes Negative Growth)

100 200 300 400 500 600 700 800

MW

1 2 3 4

MWH (000,000s)

20,000 40,000 60,000 80,000

Customer Growth

$(000s)

$(000s)

$(000s)

Table 4

Lines & Feeders


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post-rate-case period, the allowed revenues or energy and demand chargesare calculated by multiplying the actual number o customers served by theRPC value or the corresponding billing period. The decoupling adjustment is

then calculated in the manner detailed in the earlier sections.Formula 9: Revenues Allowed = Revenue per Customer test Period

X No o Customers ActuAl

Formula 10: Price ActuAl = Revenues Allowed Units Sold ActuAl

The table below demonstrates the RPC calculations or three billingperiods or a sample small commercial rate class. In this example, the billingperiods are assumed to be monthly. Note that the revenues per customer aredierent in each month, because o the seasonality o consumption in the testperiod.22

By calculating the energy and demand revenues per customer or each

Table 5

Deriving the Revenue per Customer Values

Small Commercial Class Example

Test Period Values

Billing Period 1 2 3

Number o Test Period Customers 142,591 142,769 142,947

Customer Charge $25.00 $25.00 $25.00

Total Customer Charge Revenues $3,564,775 $3,569,225 $3,573,675

Energy Revenue per Customer

Energy Sales (kWh) 181,238,883 189,304,436 170,240,013Rate Case Price $0.165 $0.165 $0.165

Total Energy Sales Revenues $29,904,416 $31,235,232 $28,089,602

Energy Revenue per Customer $209.72 $218.78 $196.50

Demand Revenue per Customer

Demand Sales (kW) 1,189,355 1,165,396 1,148,975

Rate Case Price $4.4600 $4.4600 $4.4600

Total Demand Sales Revenues $5,304,523 $5,197,667 $5,124,429

Demand Revenue per Customer $37.20 $36.41 $35.85

22 Most utilities typically have 22 or 23 billing cycles per month. For simplicity, we have assumedhere that all customers in a month are billed in the same billing cycle (one per month). In theuture, with new smart metering and communication platorms, a single billing cycle permonth, or all customers, may be possible.


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billing period, normal seasonal variations in consumption are automaticallycaptured. This causes revenue collection to match the underlying seasonalconsumption patterns o the customers.

Some decoupling schemes exclude very large industrial customers.Because the rates or these customers are oten determined by contractualrequirements and specifed payments designed to cover utility non-production costs, there may be little or no utility throughput incentiveopportunity relating to these customers anyway. Also, in many utilities, thisclass o customers may consist o only a small number o large and unique (inload-shape terms) customers, so that a class approach is not apt.

In cases in which new customers (that is, those who joined the systemduring the term o the decoupling plan) have signifcantly dierentconsumption patterns (and, thereore, revenue contributions to the utility)than existing customers, regulators may want to modiy the decouplingormula to account or the dierence. This can be accomplished by usingdierent RPC values or new customers and existing customers. The natureo this issue and methodologies or addressing it are discussed in Section 6,

Application o RPC Decoupling: New vs. Existing Customers.

5.3 Attrition Adjustment Decoupling

Some jurisdictions take a dierent approach to decoupling. They set baserates in a periodic major rate case, then conduct annual abbreviated reviewsto determine whether there are particular changes in costs that merit a changein rates. In such instances, the regulators adjust rate base and operatingexpenses only or known and measurable changes to utility costs andrevenues since the rate case, and adjust or them through a small incrementor decrement to the base rates (called attrition adjustments). The regulators

normally do not consider more controversial issues such as new power plantadditions or the creation o new classes o customers, which are reserved orgeneral rate cases.

In attrition decoupling, the utilitys allowed revenue requirement is theamount allowed in the frst year ater the rate case, plus the addition (orreduction) that results rom the attrition review. Every ew years, a newgeneral rate case is convened to re-establish a cost-based revenue requirementconsidering all actors.

5.4 K Factor

The K actor is an adjustment used to increase or decrease overall growthin revenues between rate cases.

In its simplest application, the K actor can be used in lieu o either the


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ination-minus-productivity method or the RPC method; it could be, orexample, a specifed percentage per year. Although one could vary the Kactor itsel over time, in this context the most likely application would

simply set an annual between-rate-case growth rate or revenues, resultingin a steady change (probably an increase) in year-to-year allowed revenuesor each period between rate cases. Such an approach has a high degree ocertainty, but runs the risk o being disassociated rom, and thereore out osync with, measurable drivers o a utilitys cost o service. All o the data usedin a rate case change over time, and the elements making up the K actor areno dierent. The K actor thereore may become obsolete within a ew years,providing another reason why periodicgeneral rate cases should be required byregulators under decoupling (and, arguably,under traditional regulation as well).

An alternative approach is to use the Kactor as an adjustment to the RPC allowedrevenue determination. Here, the K actorgrowth rate (positive or negative) would beapplied to the RPC values, rather than to theallowed revenue value itsel. This approach

would be useul when an additional revenue requirement is anticipated dueto identifable increases in revenues rom capital expenditures or operatingexpenses, or because o some underlying trend in the RPC values. Anexample would be a utility with a distribution system upgrade programdriven by reliability concerns, where the investment is not generating newrevenue. It may also be used as an incentive or the utility to make specifcproductivity gains, in which case the K actor would be a negative valuecausing revenues to be slightly lower than they otherwise would have been.

In any case, allowed revenues would still be primarily driven by thenumber o customers served, but the revenue total would be driven up ordown by the K actor adjustment.

Formula 11: Revenue Per Customer Allowed =

Revenue Per Customer test Period * K

Formula 12: Revenues Allowed = Revenue Per Customer Allowed X

No o Customers ActuAl

Formula 10: PriceActuAl

= RevenuesAllowed

Units SoldActuAl

A successul revenue

unction would be onethat keeps the utilitys

actual revenue collectionas close as possible to

its actual cost o servicethroughout the period

between rate cases.


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5.5 Need or Periodic Rate Cases

It is useul to have periodic rate cases in which all costs, expenses,

investments, programs, policies, and tari designs can be examined. Manyregulators have required general rate cases every three to fve years as part odecoupling (or set expiration dates or the decoupling mechanism). Anotherapproach would be a built-in decline in the allowed revenue (or RPC) aterthree to fve years. This would allow the utility to avoid a new general ratecase (in which all o the utilitys costs would be examined), but only i itreduced customer bills. This leaves the utility with the option to continueto retain a portion o expense containment savings motivated by decoupling(see Formula 4) without a rate case, i it can reduce costs sufciently to giveconsumers a measurable beneft.

5.6 Judging the Success o a Revenue Function

One o the shortcomings o traditional utility pricing approaches is thata utilitys actual revenue collection can be signifcantly higher or lower thanits actual cost o providing service. The dierent revenue unctions thatcan be applied with decoupling oer means o keeping the utilitys revenue

collections much closer to its actual cost o service over time. This shouldresult in smaller rate case revenue defciencies or excesses, lessening theirassociated potential or rate shock.

A successul revenue unction would be one that keeps the utilitys actualrevenue collection as close as possible to its actual cost o service throughoutthe period between rate cases. Indeed, the theoretically ideal result, by thisstandard, would be to have a zero revenue defciency or excess in the nextrate case and at most points in between, meaning that rates had tracked costs

perectly over time.O course, when judging the revenue unction on this basis, one should

disregard special circumstances that may cause a signifcant revenuedefciency, such as large additions to the utilitys plant-in-service accounts(e.g., the addition o a new transmission line, the installation o an expensivenew management inormation system, or the deployment o smart-gridadvanced metering inrastructure).


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6 Application of RPC Decoupling:New vs. Existing Customers

As much as hal o the change in average usage per customer overtime may be explained by dierences between existing and new

customers. Where new customers, on average, have signifcantlydierent usage than existing customers, their addition to the

decoupling mechanism can result in small cross-subsidies.New customers may be signifcantly dierent rom existing customers.

For example, new building codes and appliance standards may mean thatnew customers are undamentally more efcient. Typical new homes maybe larger or smaller than the average oexisting homes (or may reect a dierent

mix o single-amily and multi-amilyconstruction). I urban areas are becomingmore densely populated, it may mean thatnew customers are closer together, andthus there is a smaller distribution systeminvestment per customer. I line extensionpolicies require new customers to pay alarger share o distribution system expansion

costs than existing customers did, the investment added to the utility ratebase per customer may be smaller or new customers. I the regulator isconcerned that there may be meaningul dierences between new andexisting customers, it can require the utility to perorm a detailed analysis ousage characteristics (quantity, seasonality, time-o-day) or each cohort ocustomers connected to the system.

As illustrated in Table 6, new customers, on average, use 450 kWh in abilling period, but the rate case-derived RPC or existing customers is 500kWh, application o the test year RPC values to new customers has the eecto causing old customers to bear the revenue burden associated with the50 kWh not needed or used by new customers. This is because the allowedrevenue is increased by an amount associated with 500 kWh o consumption,whereas the actual contribution to revenues rom the new customers is onlythe amount associated with 450 kWh.

Where new customers,

on average, havesignicantly dierentusage than existing

customers, their additionto the decoupling

mechanism can result insmall crosssubsidies


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To correct or this, a separate RPC value can be calculated or newcustomers in our example, the amount or them would be $45.00. Asshown in Table 7, the RPC allowed revenues would not be increased rom$10,000,000 to $10,025,000. Instead, the increase would be equal to only$22,500.

This results in collection o an average o $50.00 rom existing customers

and $45.00 rom new customers, thus reecting the overall lower usageo new customers. On a total basis, the average revenues per customer areequal to $49.76. Accounting or these dierences aects the allowed revenueto assure no over- or under-recovery, while dierences in bills or these twotypes o customers are automatically reected in their respective units oconsumption applied to the decoupled price.

Table 6

Table 7

Number o Customers 200,000 10,000 210,000

Revenue per Customer $50.00 $45.00

Allowed Revenues $10,000,000 $450,000 $10,450,000

Average Unit Sales 500 450

Decoupled Price $0.100000 $0.100000Collected Revenues $10,000,000 $450,000 $10,450,000

Average Customer Contribution $50.00 $45.00 $49.76

Number o Customers 200,000 10,000 210,000

Revenue per Customer $50.00 $50.00

Allowed Revenues $10,000,000 $500,000 $10,500,000

Average Unit Sales 500 450

Decoupled Price $0.100478 $0.100478

Collected Revenues $10,047,847 $452,153 $10,500,000

Average Customer Contribution $50.24 $45.22 $50.00

Single RPC or Existing and New Customers

Separate RPC or Existing and New Customers

ExistingCustomers

ExistingCustomers

NewCustomers

NewCustomers

Total

Total


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7 Rate Design Issues AssociatedWith Decoupling

As it does with respect to increased investment in end-use energyefciency itsel, decoupling should also remove traditional utility

objections to electric and natural gas rate designs that encourageconservation, voluntary curtailment, and peak load management.

For example, assuming average usage o 500 kWh/month, the two ollowingrate designs produce the same amount o revenue, but the volumetric rateprovides a much stronger price signal or consumers to pursue energyefciency:

Table 8

Customer Charge $25.00 $5.00

Usage Charge $0.10 $0.14

Total Bill or 500 kWh average usage $75.00 $75.00

High vs Low Customer Charges

Rate Element High Customer Low Customer

Under volumetric pricing without decoupling, utilities have a signifcantportion o their revenue requirement or rate base and O&M expensesassociated with throughput. In addition, those with ully reconciled ueland purchased-power adjustment mechanisms completely recover the highcost o augmenting power supply during peak periods when expensivepower resources are used, so even increased peak-period sales generate adistribution sales margin.23 A reduction o throughput will likely reduce

23 See Subsection 3.1.1.1 above, and Moskovitz, Profts and Progress Through Least Cost Planning,1990, at pp. 3-5. Fuel adjustment mechanisms are the antithesis o energy efciencymechanisms. They guarantee that any additional sale, no matter how expensive to serve, addsto proft, and any oregone sale diminishes proftability. This is because the clauses ensure thatthe marginal uel or purchase cost o incremental sales will be ully recovered, so that the non-production cost component o base rates will always contribute to the bottom line (by eitherincreasing profts or reducing losses). www.raponline.org/Pubs/General/Pandplcp.pd .


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revenues at a greater rate than it will produce savings in short-run costs,simply because most distribution, billing, and administrative costs arerelatively fxed in the short run.

Conversely, with decoupling, the utility no longer experiences a netrevenue decrease when sales decline, and will thereore be more willing toembrace rate designs that encourage customers to use less electricity and gas.This can be achieved through energy efciency investment (with or withoututility assistance), through energy management practices (turning out lights,managing thermostats), or through voluntary curtailment.

Currently, the best examples o this are the natural gas and electricrate designs used by Caliornia electricity and natural gas utilities, wheredecoupling has been in place or many years. The residential rates applicableto most customers o Pacifc Gas and Electric (PG&E), typical o those o allgas utilities and at least the investor-owned electric utilities in the state, areshown in Table 9. Both the gas and electric rates are set up with a baselineallocation, which is set or each housing type and climate zone. Neither ratehas a customer charge, although there is a minimum monthly charge orservice. I usage in a month alls below the amount covered by the minimumbill, the minimum still applies.

Table 9

Table 10

Minimum Monthly Charge ~$3.00

Base Rate per therm $1.45131 $1.68248

Multi-Family Discount (per unit per day) $0.01770 $0.17700

Low-income Discount (per therm) $0.29026 $0.33650Mobile Home Park Discount (per unit per day) $0.35600 $0.35600

Minimum monthly Charge ~$3.50 ~$4.45Baseline Quantities $0.83160 $0.11559

101%-130% o Baseline $0.09563 $0.13142

131%-200% o Baseline $0.09563 $0.22580

201%-300% o Baseline $0.09563 $0.31304

over 300% o Baseline $0.09563 $0.35876

PG&E Natural Gas Rate at May 1, 2008

PG&E Natural Gas Rate at May 1, 2008

Rate Element

Rate Element

BaselineQuantities

LowIncome

ExcessQuantities

All OtherCustomers


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production component o the rate design automatically declines, so thatthey pay the allowed revenue requirement (and no more) or distributionservices. Conversely, when weather is unusually mild, and customer usage

declines, they would pay slightly more per unit or distribution services,again ensuring the utility receives its allowed revenue. This eect is mostpronounced when decoupling is applied on a current, rather than an accrualbasis, as discussed later.

7.3 Rate Design Opportunities

In 1961, James Bonbright published what is considered the seminal workon ratemaking and rate design or regulated monopolies. His context was,o course, traditional price-based utility regulation, and he identifed eightprinciples, some o which are in tension with each other, to guide the designo utility prices. That tension is demonstrated in particular by three o thoseprinciples that rates should yield the total revenue requirement, theyshould provide predictable and stable revenues, and they should be set so asto promote economically efcient consumption.24 In certain instances, moreeconomically efcient pricing structures could lead to customer behaviorthat results in less stable and, in the short run, signifcant over- or under-

collections o revenue. Decoupling mitigates or eliminates the deleteriousimpacts on revenues o pricing structures that might better serve the long-term needs o society. Some innovative rate designs that regulators may wantto consider with decoupling include:

731 Zero, Minimal, or Disappearing Customer Charge

A zero or minimal customer charge allows the bulk o the utility revenuerequirement to be reected in the per-unit volumetric rate. This serves the

unction o better aligning the rate or incremental service with long-runincremental costs, including incremental environmental and supply costs thatmay already be trending upward.25 During the early years o the natural gasindustry, this type o rate design was almost universal, as the industry wascompeting to secure heating load rom electricity and oil, and imposing fxedcustomer charges would have disguised the price advantage being oered and

24 Bonbright, James C., Principles o Public Utility Rates. Columbia University Press, New York,1961, p. 291.

25 For electric utilities depending on coal or the majority o their supply, valuing CO2 at thelevels estimated by the EPA to result rom passage o the Warner-Lieberman bill (in therange o $30 to $100/tonne) would add up to $.03/kWh to $.10/kWh to the variable costso electricity. For natural gas utilities, the environmental costs o supply are on the order o$0.30/therm, or approximately equal to total distribution costs or most gas utilities. Seehttp://www.epa.gov/climatechange/economics/economicanalyses.html.


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conused customers. Simple commodity billing was the easiest way to makecost comparisons possible or consumers. As natural gas utilities have takenon more o the characteristics o monopoly providers, they have sought to

increase fxed charges.The Caliornia utilities, under decoupling, have retained zero or minimalcustomer charges. In several cases, such as with the PG&E rates discussedearlier in Section 7, it comes in the orm o a disappearing minimum bill,in which customers with zero consumption pay a minimum amount, butonce usage passes 100 kWh or so (and 99% o consumption is by customersexceeding this minimum), they pay only or the energy used. In December2008, the Public Service Commission o Wisconsin approved a settlemento the parties that, among other things, created a decoupling mechanism or

Wisconsin Public Service Corporation and, at the same time, reduced thelevel o fxed customer charges.26

732 Inverted Rate Blocks

Inverted block rates, o the type shown earlier or PG&E, serve severaluseul unctions. First, they align incremental rates with incremental costs,including incremental capacity, energy and commodity, and environmentalcosts. Second, they recognize that upper-block usage (mostly or space

conditioning) is characterized by high seasonality, usage concentratedduring the peak hours, and low load-actor end-uses, all o which are moreexpensive to serve than other end-uses. Inverted block rates thereoreproperly collect the appropriate costs rom these inrequent but expensiveend uses. They also serve to encourage energy efciency and energymanagement practices by consumers. However, they reduce net revenuestability or utilities by concentrating recovery o return, taxes, and O&Mexpenses in the prices or incremental units o supply, which tend to vary

greatly with weather and other actors.

733 Seasonally Dierentiated Rates

Seasonal rates are typically imposed in service territories whose utilitiesexperience signifcant seasonal cost dierences. For example, a gas utilitywith a majority o its capacity costs assigned to the winter months willtypically have a higher winter rate than summer rate. With traditionalregulation, seasonal rates reduce net revenue stability or utilities, by

concentrating revenue into the weather-sensitive season.

26 Docket 6690-UR-119,Application o the Wisconsin Public Service Corporation or Authority toAdjust Electric and Natural Gas Rates, Order o December 30, 2008.


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734 Time-o-Use Rates

Rates that collect much higher amounts during the on-peak hours canconvey to consumers that usage during those hours puts the entire system

under stress and causes investment in new peaking capacity. However, peak-hour consumption is highly weather-sensitive, so time-o-use (TOU) ratesmake utility revenues more weather-sensitive, just like inverted block rates.Decoupling removes the revenue stability risk associated with TOU rates,allowing the utility to have efcient prices and still be assured o recoveringnon-production costs in years when weather is mild.

7.4 Summary: Rate Design Issues

A hypothetically correct rate design or an electric and gas utility canconsist o a customer charge that recovers metering and billing costs (theseare both incremental and decremental with changes in customer count) andan inverted block rate structure based on the load actors o typical end-uses.The rates shown or PG&E in Caliornia are designed along these lines.

For electric utilities, lights and appliances have steady year-round usagecharacteristics, and thereore the lowest cost o service. For gas utilities,water heating, cooking, and clothes drying have steady year-round usage

characteristics. For both types o utilities, space conditioning (heating andcooling) loads, which are associated with the upper blocks o usage, have thelowest load actors, and thereore the highest costs o service.

Taking a hypothetical electric utility with typical meter reading and billingcosts, capacity costs o $15/kW per month, and energy costs o $.05/kWhproduces the ollowing cost-based rate design:

Table 11

Customer Charge $5.00

First 400 kWh Lights/Appliances 70% $0.03 $0.05 $0.08

Next 400 kWh Water Heat 40% $0.05 $0.05 $0.10

Over 800 kWh Space Conditioning 20% $0.10 $0.05 $0.15

Cost-based Rate Design - Hypothetical Rates

Rate ElementEnergyCost

LoadFactor

TotalCost

CapacityCost


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Establishing theoretically deensible rate designs such as those usedby PG&E provides consumers with very clear economic signals about thecosts their usage imposes, but evidence in Caliornia is that even with these

high prices, utility energy efciency programs are an essential element o asuccessul energy policy. The inverted rates tend to drive consumers to theprograms, but i the programs are not available, they may be unlikely (orunable) to respond to the incremental cost-based prices.

Decoupling is a tool that allows the utilitys interest in stable net revenues,the consumers interest in stable bills, and the societys interest in cost-based pricing all to be met. Under decoupling, the utility can implementan inverted rate, knowing that lost distribution revenues that are incurredwhen sales decline will be recovered. I implemented on a current basis asproposed in Section 8 o this report, decoupling can also stabilize customerbills, by reducing the unit rates in months when extreme weather causes asignifcant variation in sales rom the levels assumed in the rate case whererates are set.


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8 Application of Decoupling Current vs. Accrual Methods

Under traditional regulation, utilities have oten had dierentadjustment actors on customer bills. Perhaps the most common

is the uel and purchased-power adjustment clause (FAC) orelectric utilities and the purchased gas adjustment (PGA) clause

or gas utilities. In both o these cases, utilities compute the actual costsor these items, and then customer bills are adjusted to reect changes inthose costs. There is oten a lag in the determination o these costs, and theadjustment actor itsel is oten based on the orecast units o sales expectedin the period when adjustment will be collected. As a result, actual collectionsusually deviate rom expected collections, and a periodic reconciliation must

be made to adjust revenues accordingly.In the application o decoupling, many states use a similar approach or

make the calculations on an annual basis. Any accrued charges or creditsare held in a deerral account or subsequent application to customers bills.

When applied in this manner, the same reconciliation routines are used toassure collection o the amounts in the accrual account.

The variations in rates and bills caused by decoupling mechanismsare typically very small compared with those caused by FAC and PGA

mechanisms. While decoupling adjustments tend to deal with variationsin usage o a ew percent, the price o natural gas can change by 50% ormore over the year ater a general rate case. Further, as described earlier,decoupling tends to moderate billing variations, whereas the FAC and PGAmechanism tend to magniy bill variations, because the cost o gas tends torise in cold winters when demand is highest, and the cost o power tends torise in the summer with cooling-related demands.

When a lag is present in the application o these adjustments, it hasthe eect o disassociating individual customers rom their respectiveresponsibility or the adjustment. The result may be a shit in revenueresponsibility among those customers, and between years. For example,i a warmer-than-average winter produces a signifcant deerral o costs tobe collected, and it is collected the ollowing year, it is possible that thesurcharge will be eective during a colder-than-average winter, exacerbatingcustomer bill volatility, during a period when the customer is otherwise


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accruing credits or the ollowing year.Unlike commodity adjustment clauses, however, there are no orecasting

components needed in decoupling. This is true even or utilities whose

rate cases use a uture test year. While uture test years necessarily involveorecasting the revenue requirement, the calculation o the actual price tobe charged to collect that revenue requirement is a unction o actual unitso consumption. To calculate the price with Revenue Cap Decoupling, oneneed only divide the Allowed Revenue by the Actual Unit Sales. To calculatethe price with RPC Decoupling, one must frst derive the Allowed Revenues(based on the current number o customers), and then divide that numberby Actual Unit Sales. In either case, all o the inormation needed to makethe calculation is known at the time that customer bills are prepared. Forthis reason, the required decoupling price adjustment can be applied on acurrent rather than an accrual basis. This also means there will be no error incollection associated with orecasts o consumption and, hence, no need or areconciliation process.

This can be done by using the same temperature adjustment data usedto produce the test-year normalized results, except to calculate a daily ormonthly (or more likely a billing cycle) RPC with the data, not just an annualRPC. In each billing cycle, the allowed RPC can be a time-weighted average

o the number o days in each month o the year included in the billingcycle,27 or it can be built up rom daily inormation.28

27 For example, i the allowed RPC is $50 or March and $40 or April, and thebilling cycle runs rom April 16 to March 15 (i.e., 15 days in April and 15 days inMarch), the allowed RPC would be $45.

28 For more inormation on this point, see section 3.1.1.2 Non-Production Costs.


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9 Weather, the Economy,and Other Risks

While traditional regulation aims to determine a utilityscosts and then provide appropriate prices to recover those

costs, there are a number o actors that prevent this romhappening. Foremost among these are the eects o weather

and economic cycles on utility sales and customer bills. These eects aredirectly related to how prices are set. Full or limited decoupling, and someorms o partial decoupling, will have a direct impact on the magnitude othese risks.

For the most part, ull decoupling will eliminate these risks completely.Limited decoupling partially eliminates these risks. Partial decoupling may

or may not aect these risks, depending upon whether the presence o aparticular risk is desired.

9.1 Risks Present in Traditional Regulation

The ultimate result o a traditional rate case is the determination o theprices charged consumers. In simple terms, a utilitys prices are set at alevel sufcient to collect the costs incurred to provide service (including

a air rate o return the utilitys profts). Because most o the revenuesare normally collected through volumetric prices, based on the amount oenergy consumed or the amount o power demanded, the assumed units oconsumption are critical to getting the price right.29

As noted earlier, the basic pricing ormula under traditional regulation is:

Formula 13: Price = Revenue Requirement Units o Consumption

This ormula is applied using Units o Consumption associated withnormal weather conditions. As long as the units o consumption remainunchanged, the prices set in a rate case will generate revenues equal to the

29 By right, we mean consistent with the cost o service methodology.


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utilitys Revenue Requirement. Also,i extreme weather occurs as oten asmild weather, over time the utilitys

revenues will, on average, approximatethe revenue requirement. In theory,this protects the company rom under-recovery, and customers rom over-payment o the utilitys cost o service because there should be an equalchance o having weather that is moreextreme or milder than normal.

In reality, this is hard to accomplish, because in any given year, the actualweather is unlikely to be normal. Thus, even i the traditional methodologyresults in prices that are right and the weather normalization method usedwas accurate, the actual revenues collected by the utility and paid by thecustomers will be a unction o the actual units o consumption, which aredriven, in large part, by actual weather conditions, according to the ollowingormula:

Formula 3: Actual Revenues = Price * Actual Units o Consumption

With this ormula, extreme weather increases sales above those assumedwhen prices were set, in which case utility revenues and customer bills willrise. Conversely, mild weather decreases utility revenues and customer bills.

To the extent that the utilitys costs to provide service due to the weather-related increases or decreases in sales do not change enough to ully osetthe revenue change, then the utility will either over- or under-recover itscosts. With traditional regulation, in economic terms, weather-driven sales

changes cause a wealth transer between the utility and its customers that isunrelated to the amount that the utility needs to recover and that customersought to pay. This transer is not a unction o any explicit policy objective.Rather, it is simply an unintended consequence o traditional regulation.There is a volatility risk premium embedded in the utilitys cost o capital thatreects the increased variability in earnings associated with weather risk. Thispremium may be reected in the equity capitalization ratio, the rate o return,or both.

9.2 The Impact o Decoupling on Weather and Other Risks

Full decoupling causes a utilitys non-production revenues to be immuneto both weather and economic risk. Once the revenue requirement isdetermined (in the rate case or via the RPC adjustment), decoupling

With traditional regulation,in economic terms, weather-driven sales changes cause a

wealth transer between theutility and its customers whichis unrelated to what the u

rap revenueregulationanddecoupling 2011 04

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