The Rationale for Reforming Utility Business Models.

AuthorKopin, Daniel J.


Achieving maximal performance from minimal electricity, end-use energy efficiency is expected to appeal to electricity consumers. Nevertheless, a "gap" has emerged between actual and expected consumer investment in energy efficiency (Jaffe and Stavins, 1994; Gerarden et al., 2015). The investment gap, attributed to information problems and behavioral failures, is largely considered a societal issue warranting utility-scale education and rebate demand-side management (DSM) programs (Gillingham et al., 2006, 2009, 2014, 2018). But despite having the advantage of territorial coverage, capital access, and an established platform for delivering quality service, an electric utility loses revenue when a DSM program results in declining electricity sales (Fox-Penner, 2010; Lazar, 2016). To remove disincentives for utility DSM programs, many have argued for regulatory reforms to the utility business model (UBM) allowing a utility to recover revenue, otherwise lost due to DSM, through electric rates with a "revenue decoupling mechanism" (Moskovitz et al., 1992; Lovins, 1996; Carter, 2001; Kihm, 2009; Fox-Penner, 2010; Migden-Ostrander and Sedano, 2016).

Revenue decoupling mechanisms are components of state-level retail rate design (in contrast to federal-level wholesale rate design). Through these mechanisms, the state-level regulator allows an electric utility to recover a specified amount of revenue from its electricity customers (i.e., ratepayers) over a specified amount of time. Importantly, the specified amount of revenue is independent of the utility's actual volumetric sales of electricity. Like all components of state-level retail rate design, state-level regulators (public utility commissions) approve revenue decoupling mechanisms. Within their administrative orders, public utility commissions specify which revenue (e.g., revenue otherwise lost due to DSM) is recovered and how, when and from whom. Readers interested in learning more about revenue decoupling mechanisms in particular, and electric utility rate design in general, are encouraged to consult the Regulatory Assistance Project's (2011) comprehensive introduction to the subjects.

By 2012, 29 state public utility commissions had reformed UBMs with revenue decoupling mechanisms. (1) But while the effects of revenue decoupling on DSM investment have received considerable theoretical and empirical scrutiny, the determinants of commission decisions to reform UBMs with revenue decoupling have received far less (Eto et al., 1997; Zarnikau, 2012; Chu and Sappington, 2013; Abrardi and Cambini, 2015; Kahn-Lang, 2016; Nissen and Williams, 2016). Economic models of utility DSM investment regularly assume commissions reform UBMs with revenue decoupling primarily to remove the disincentive for utility DSM investment. Under this assumption, commissions aim to enhance social welfare by increasing avoided costs of electricity usage from a total resource perspective, including electricity generation, transmission, and environmental costs (CPUC & CEC, 2001).

Brennan (2010a, 2013a, 2013b) questions the assumption that commission decisions primarily reflect social welfare objectives. Alternatively, Brennan (2013b) suggests that commissions reform UBMs with revenue decoupling in response to political economy considerations, applying "more to the political arena than the market". Further, Brennan (2013b) offers that utility-run DSM programs induced by UBM reforms may allow states to avoid the political consequences of taxation by covering costs with "increases in electricity distribution charges set in less visible regulatory proceedings" (emphasis added). This argument echoes Joskow's (1995) perspective on the political economy of early utility-run DSM programs (see also Posner, 1971):

"The fact of the matter is that environmental activists in the United States captured the utility regulatory process in many states during the late 1980s and induced the regulators to engage in a pervasive 'taxation by regulation' program to use the public utility rate-making process to tax electricity customers as a group to pay for energy-efficiency...As long as these taxes could be hidden from the public and rationalized as being 'least cost' from some perspective, utilities represented a very important political opportunity to advance a particular agenda" (emphasis added). This paper tests whether public utility commissions reformed UBMs with revenue decoupling primarily to enhance social welfare or to respond to political economy considerations. (2) We provide a short history on the nexus between utility-run DSM programs and UBM reform with revenue decoupling mechanisms. We then present alternative hypotheses of reform. Controlling for political economy determinants, we model how commissions reformed UBMs with a revenue decoupling mechanism from 1997 to 2012. Importantly, we account for whether commission decisions on UBM reform removed disincentives for DSM programs with either a "limited" (allowing case-by-case recovery) or "full" (allowing automatic recovery) revenue decoupling mechanism. We conclude with a discussion of the implications of our results for the current wave of UBM reform, for which revenue decoupling has been described as "a foundational reform that all states should adopt, on top of which other reforms can be layered" (Cross-Call et al., 2018).


This section presents a short history on the nexus between utility-run DSM programs and UBM reform with revenue decoupling mechanisms. We follow with alternative hypotheses explaining the rationale for reform, as well as discussions of the variables we use to test the hypotheses.

2.1 A Short History of Reform

After initial growth of utility-run DSM programs during the 1980s, energy efficiency spending by utilities plummeted in the 1990s as competition was introduced into state-level retail electricity markets (Nadel and Kushler, 2000). Prioritizing electricity sales growth, utilities cut discretionary spending on DSM programs in anticipation of competition. Smeloff and Asmus (1997) observe, for example, that California utilities cut DSM program expenditures by 30 percent after the California Public Utilities Commission released its first restructuring proposal in response to the California Legislature. Beginning in 1999, some state legislatures responded by adopting Energy Efficiency Resource Standard policies, which require utilities to reduce electricity consumption. Energy Efficiency Resource Standard policies vary in terms of stringency, but share a goal of reducing specific levels of consumer demand by a target date (Palmer et al., 2013). Energy Efficiency Resource Standard policies did not, however, address disincentives for DSM investment inherent to the UBM (Palmer et al., 2013). (3)

"Additional policies and programs are required to help... address our substantial underinvestment in energy efficiency as a nation," wrote the National Action Plan for Energy Efficiency (NAPEE), a stakeholder organization of utilities, regulators, and interest groups convened by President George W. Bush's Environmental Protection Agency and Department of Energy in 2006. The NAPEE recommended that states "modify policies to align utility incentives with the delivery of cost-effective energy efficiency and modify ratemaking practices to promote energy efficiency investments," dedicating an entire report to the recommendation the subsequent year (NAPEE, 2006, 2007).

The NAPEE's recommendations on UBM reform targeted the disincentive, or "throughput incentive," under traditional regulation that allows utilities to earn more revenues with greater sales of electricity. In both traditionally regulated and restructured (i.e., deregulated) states, the throughput incentive may lead utilities to face a loss in revenue even as consumers benefit from investments in energy efficiency (Lazar, 2016). The NAPEE recommended that commissions depart from traditional regulation by allowing, through administrative rulemaking, electric utilities to either

(1) recover lost revenue, resulting specifically from DSM investments, through rates on a case-by-case basis using a "limited" revenue decoupling mechanism or

(2) recover any lost revenue, deviating from a predetermined level by the commission, through rates on an automatic basis with a "full" revenue decoupling mechanism. (4)

According to the NAPEE, reforming traditional regulation by removing the disincentive, through either a limited or full revenue decoupling mechanism, would make utility profits less sensitive to electric sales volume deviations resulting from DSM investments (NAPEE, 2007).

The NAPEE's influence was pronounced. Federal legislation succeeding the NAPEE's reports reflected their recommendations: the Energy Independence and Security Act of 2007 required commissions to consider rate design modifications removing throughput incentives and rewarding programmatic success of energy efficiency programs (Rose and Murphy, 2008). But as shown in Table 1, not all state public utility commissions reformed the UBM.

2.2 Hypotheses of Reform

Prevailing economic models of decoupling - consistent with a public interest theory of regulation - assume commissions would reform UBMs to remove the disincentive for DSM investments in order to reduce negative externalities and correct market failures, namely to reduce the social costs of electricity generation, transmission, and distribution (Bonbright, 1961; Posner, 1974; Knittel, 2006). Indeed, Energy Efficiency Resource Standard policies, NAPEE's recommendations, and successive federal legislation promoting UBM reform all relied on the assumption that benefits of utility DSM investment exceed costs. Underlying that cost-benefit analysis was the California Public Utilities Commission (CPUC) and California Energy Commission (CEC)'s seminal California Standard Practice Manual: Economic...

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