'Dancing backward in high heels': examining and addressing the disparate regulatory treatment of energy efficiency and renewable resources.

• Author: Scott, Inara

1. INTRODUCTION II. UTILITY REGULATION AND RATEMAKING A. The Regulated Utility B. Utility Rate Setting III. PARALLEL DEVELOPMENT: SEPARATE, BUT NOT EQUAL A. Energy Efficiency B. Renewable Resources IV. DANCING BACKWARD: DIFFERING TREATMENT OF RENEWABLE RESOURCES AND ENERGY EFFICIENCY, AND THE OBSTACLES THAT RESULT A. Ratemaking Differences in the Treatment of Energy Efficiency and Renewable Resources B. The Challenge of Measuring Efficiency 1. Evaluating Energy Efficiency and Renewable Resources 2. Obstacles Created by Cost Effectiveness Limits C. A Need for Customer Participation V. UNLEASHING THE POTENTIAL OF ENERGY EFFICIENCY A. Meeting the Challenge of Utility Rate Structures B. Setting Hard Targets for Energy Efficiency C. Streamlining Cost-Effectiveness Tests D. Addressing Market Barriers VI. CONCLUSION I. INTRODUCTION

   When public utilities plan the resources they will use to meet their customers' load requirements, they have a variety of options from which to choose. (1) An electric utility might elect to obtain supplies from a natural gas-fired generator, a coal plant, or a wind farm. A natural gas utility in the Pacific Northwest might choose from natural gas supplied by producers in the Rocky Mountains or Canada. These options are known as supply-side resources; (2) that is, they are alternatives the utility can use to serve existing load. Utility programs aimed at reducing demand or modifying demand patterns are known as demand-side management programs, or DSM. (3) Energy efficiency is a DSM resource.

   Energy efficiency lowers consumers' energy bills, reduces environmental impacts from energy use, stabilizes the electrical grid, decreases the need for expensive infrastructure improvements, and often costs less than supply-side alternatives. (4) As energy production is responsible for the vast majority of greenhouse gas emissions in the United States, (5) energy efficiency can play a key role in national efforts to address global warming. (6) New methods of extraction, including hydraulic fracturing (tracking), may have extended the available supply of fossil fuels, but they have also created new environmental concerns. (7) Energy efficiency decreases the need for additional fossil fuel resources, without requiring additional resources in its stead. This range of benefits--with little to no downside--may be why politicians, academics, and regulators have lined up to support energy efficiency, often establishing it as a first priority resource. (8)

   As a supply-side option, renewable resources are quite different from energy efficiency resources. Rather than decreasing demand, these resources meet demand--they simply do it in an environmentally preferred way. Renewable resources offer benefits similar to energy efficiency. Renewables diversify a utility's portfolio away from fossil fuels, reduce U.S. dependence on foreign imports, mitigate environmental harms, and create new market opportunities for U.S. businesses. (9) Renewable resources are essential to our world's long-term energy future; even with the best technological advancements, a utility's supply-side options cannot all be met with energy efficiency. On the other hand, renewable resources may increase the strain on the electric grid, require additional investments in transmission and distribution infrastructure, or create undesired environmental hazards. (10)

   Given the balance of costs and benefits offered by the two resources and the importance ascribed to increasing energy efficiency, one might expect that renewable and efficiency resources receive, at a minimum, comparable regulatory treatment. However, this is not the case. In 2009, renewables constituted 76% of all energy tax incentives, while energy efficiency only constituted 3%. (11) Twenty-nine states have now adopted renewable portfolio standards (RPS) requiring utilities to serve a percentage of their load from renewable resources (12)--even when those resources are more expensive than other alternatives--while states mandating efficiency adoption explicitly cap targets to only "cost-effective" energy efficiency. (13) Utility rate structures deter utilities from making cost-effective energy efficiency investments, while incentivizing utilities to invest in large-scale renewable resource projects. (14)

   The disparate treatment of energy efficiency operates on many levels, from the utility regulator to the individual customer. Thousands of utility customers choose a "green energy" option that adds to their monthly bills, (15) yet they must be offered financial incentives to engage in energy efficiency projects that provide significant long-term energy savings. A variety of sources have identified a significant "efficiency gap" (16) between readily available, cost-effective energy efficiency policies and their adoption rate by utilities and consumers, even while above-market voluntary renewable resource programs continue to grow. (17) In states with an RPS, utilities are required to expend above-market costs for renewable resource projects. Many go even further and establish feed-in tariffs or special set-aside requirements to jump start non-cost effective renewable technologies, including solar photovoltaics and geothermal power generation. (18) Yet in some of the very same states, utilities are only permitted to fund cost effective energy efficiency programs that cost the same or less than fossil fuel alternatives. (19) In short, support for energy efficiency is strictly tied to its ability to save customers money, while renewable resources receive support even in the face of cost disparities.

   The purpose of this Article is to illuminate key differences in the regulatory treatment of energy efficiency and renewable resources, and to provide concrete recommendations for enhancing energy efficiency programs by creating a more balanced regulatory treatment. Part II provides an overview of the utility industry, along with a background on utility regulation and ratemaking that are essential to understanding the incentives provided by differing regulatory regimes. Part III considers the parallel development of energy efficiency and renewable energy programs. Part IV contrasts the two, and highlights the way regulatory differences have impeded the deployment of energy efficiency programs. Part V suggests policy changes to level the playing field between the two resources and lessen the regulatory burden placed on implementing energy efficiency programs. As Part VI concludes, addressing the regulatory and market barriers to energy efficiency investment could transform the nation's energy portfolio, to the benefit of both utilities and their customers.

2. UTILITY REGULATION AND RATEMAKING

   Understanding the disincentives to investment in energy efficiency requires an explanation of the complex, and occasionally archaic, world of utility regulation and ratemaking. This Part provides a brief background on the utility industry and describes cost-of-service ratemaking.

   1. The Regulated Utility

      The utility industry includes a variety of participants, from small power producers and federal power agencies, to power marketers. Within the retail market, however, customers are served primarily by investor-owned utilities (IOUs), cooperatives, and publicly owned utilities (publics). Approximately 70% of retail customers are served by IOUs, (20) which are regulated by state and federal agencies, including state public utility commissions and the Federal Energy Regulatory Commission (FERC). (21) Publics and cooperatives face significantly different regulatory structures than IOUs. (22) Many are exempt, in whole or in part, from state and local regulatory jurisdiction, and may be governed by private boards or local government entities. The focus of this Article is IOUs, because they are subject to overarching regulatory structures regarding both renewable resources and energy efficiency, and because they constitute the majority of the utility market. Also, unlike publics and cooperatives, which do not have a profit motive, IOUs are uniquely sensitive to profit margins and regulatory incentive mechanisms.

      Extensive state and federal regulation of electric utilities began in the 1920s with the determination that utility service constituted a "natural monopoly." (23) This conclusion resulted from the belief that providing utility service required a significant capital investment, and that as a result, duplication of services and industry competition would ultimately result in higher, not lower, prices for customers. Government regulators believed that granting utilities exclusive service territories--i.e., creating regulated monopolies--would result in lower prices and more reasonable rates for customers. (24) In addition, by granting a monopoly, regulators could demand in return that utilities agree to serve all customers. This bargain became known as the "regulatory compact": utilities agreed to serve all customers within their service territory on a non-discriminatory basis; in return, regulators agreed to provide the utility with an exclusive service territory and allow the utility to set rates so as to earn a reasonable rate of return on its capital investments, consistent with similarly-situated businesses. (25)

      At the same time, the separate functions of generation, transmission, and distribution became increasingly "vertically integrated" within the same entity. (26) Thus were formed the prototypical utilities of the twentieth century: large, privately-owned entities that controlled the entire supply chain related to providing utility service, with government entities overseeing a cost-based rate setting process.

      The energy crises of the 1970s provided the first challenge to this traditional model of utility service. (27) Recognizing a need to diversify the nation's energy supply portfolio and begin to transition away from fossil fuels, (28) Congress passed the Public Utility Regulatory...