Robert J. Michaels

I. Compounding the Inefficiencies of Regulation

Erroll Davis, the former CEO of Wisconsin Electric Power (now a unit of WE Energies) was a rare utility executive. As competitive power markets evolved in the 1990s his low-cost company was ready to move aggressively. And well it should, thought Davis. Almost all utilities enjoyed regulated terrritorial monopolies and state public utility commissions almost invariably allowed them to recover all of their costs in rates to captive consumers. On top of costs, those rates allowed investors who supplied capital to the utility to earn a “fair” return on their funds after considering risk and other market factors. Economical service required large powerplants and transmission systems, but larger was often better. A larger pool of profits became available while executives at bigger companies usually enjoyed bigger incomes. Regulation in effect rewarded higher capital spending because regulators allowed almost all of its durable assets into “rate base,” where it could earn the allowed return. Davis understood the incentives. He once told a journalist “your new desk goes into the rate base. This is the only industry I’ve ever seen where you can increase your profits by redecorating your office.” (Fortune, Nov. 13, 1995)

Utilities were not totally riskless. Bad weather or incompetent operation might leave them short of their allowed profits, but regulators allowed investors returns high enough to reflect at least some of these risks. Intrinsically unstable costs like generator fuel were automatically passed to ratepayers. Beginning in the 1980s, environmental politics brought new opportunities and new risks. The opportunities came as a recasting of utilities’ business missions – they would change from providers of power to sellers of “electric services,” investing in both production facilities and energy efficiency. They would provide power users with services and equipment that facilitated reductions and time shifts in consumption. Smart meters could allow real-time tracking of costs, while other plans allowed utilities to curtail customers at peak hours (in return for discounted rates). Some regulators allowed utilities to fund rebates on energy-efficient appliances with revenue from ratepayers.

Risks would materialize if the programs were successful – selling less power meant smaller revenues to cover ongoing costs of past investments, along with the threat that investors would not earn their allowed returns. Regulators in some states (California was first, in 1983) responded with “decoupling” rules that allowed utilities to recover all of their authorized revenues even if consumption fell. In the event of a shortfall the utility would calculate a “true-up” amount and build it into future rates. Decoupling keeps investors whole and possibly makes executives more receptive to demand-limiting regulations. By eliminating much downside risk, however, it might also lead executives to care less about efficient operation. A few other states (including Maryland, Massachusetts, Idaho and New York) also introduced it, but others (Oregon, Washington) turned it down. Maine abandoned its flawed program in the mid-1990s after it caused small customers’ bills to increase while their consumption fell.[1] California reinstituted its program in 2002 after briefly abandoning it during its ill-fated experiment with competition.

II. The Incentives and Performance of Decoupled Systems

Decoupling alone does not encourage utilities to emphasize demand management over production. It only makes them indifferent between selling power and selling conservation. In the late 1980s New York policymakers allowed a “natural experiment.” Four of its utilities that decoupled saw conservation-related expenses rise by 370 percent, but the four that did not saw higher increases. Decoupling in practice appears to keep investors whole but not to deliver on promises to engage in more demand-side activities.[2]

Decoupling without additional incentives and threats insulates shareholders and management from the few risks their companies still face. (Some programs require “weather normalizations” that also protect against low revenues due to abnormally favorable weather.) Without decoupling, regulation throws most utility risks onto consumers, and with it they bear still more. Users, however, are less well-positioned than shareholders to bear these risks. Consumers cannot choose among competing utilities and all but the largest of them are are unable to hedge power prices. Shareholders of all sizes can choose their risk exposures by holding diversified portfolios or shares of mutual funds. If potential undercollection of revenue increases investor risk, regulators could more easily respond by accounting for it in a higher authorized return.

Decoupling can also encourage perverse consumer behavior and result in inequitable treatment. A user that has invested in efficiency will end up paying higher prices for each kilowatt-hour consumed (including prorated conservation expense) while one that does not conserve will pay relatively less for more kilowatt hours consumed. Such problems can be alleviated by still more regulation, such as California’s policies that charge large customers more per kilowatt-hour than small ones. Decoupling can also distort competition for customers in states that allow it. Even if all suppliers must invest in efficiency, unregulated competitors do not enjoy the same revenue stability as regulated utilities.

III. Decoupling Goes to Congress

Some scholars argue that the American regulatory system works well because states can individually experiment and learn from one another. A federal rule appears inappropriate since the logic of decoupling is weak and observed outcomes are at best mixed. Nevertheless such a rule was included in the economic stimulus bill.

Turning decoupling into a federal matter is itself dubious, since it is part of “retail” ratemaking (i.e. for sales to final users) explicitly delegated to states under the Federal Power Act and subsequent legislation. The bill conditions a state’s eligibility for certain efficiency-related funds on its governor’s notifying the Secretary of Energy that it will seek to implement decoupling practices. It is not clear what “seek” means here, or how DOE will determine whether the governor tried hard enough. A state commission that accedes to the request must decouple “each electric and gas utility, with respect to which [it] has ratemaking authority.” This provision exempts 25 percent of U.S. power consumption because only a handful of state regulators have jurisdiction over municipal and cooperative utilities.[3] Corporate utilities serving New York, Chicago and Philadelphia will be decoupled, but municipal operations in Los Angeles (home of House Energy and Commerce Committee Chairman Waxman), Seattle and San Antonio will be exempt.

State policies must “ensure that utility financial incentives are aligned with helping their customers use energy more efficiently and that provide timely cost recovery and a timely earnings opportunity for utilities associated with cost-effective measurable and verifiable efficiency savings, in the way that sustains or enhances utility customers’ incentives to use energy more efficiently.” If interpreted literally the language takes important powers away from states and may limit their powers to design rates as they prefer.

IV. What Does the Expansive Language Mean?

As a preview, one can look at some adjustment provisions and balancing accounts that already exist at the California Public Utilities Commission. Pacific Gas & Electric’s “Public Purpose Programs Revenue Adjustment Mechanism” allows
decoupling for efficiency-related programs, but also sets up accounts for Low Income Energy Efficiency (which includes transfers as discounted rates), research and development programs, and other renewable energy programs. [4] “California Alternative Rates for Energy” account adjusts revenue for low income assistance rates.[5] The “Procurement Energy Efficiency Revenue Adjustment Mechanism” ensures recovery of certain costs in procurement programs.[6] There is also a “Distribution Revenue Adjustment Mechanism” (that includes an allowance for franchise fees and uncollectibles).[7] There are also automatic adjustments for the “DWR Power Charge Collection Balancing Account,” and the “Utility Generation Balancing Account.” Adding the amounts requested for these accounts, PG&E (annual electric sales approximately $9 billion) has asked the commission for the right to automatically recover $322.9 million extra in 2009.[8]

The preceding list may numb most peoples’ minds, but probably excites those in Congress. The expansiveness of the bill’s language means that it can accommodate extremely broad definitions of assets and expenses that get automatic recovery. This regulation will make state regulators unable to protect ratepayers from being billed for social programs that Congress might never be able to fund from taxes. The range of automatic adjustments already existing in California only hints at the potential scope of further federal interventions in state regulation.

Decoupling rests on the false assumption that consumers use too much electricity and cannot figure out their own ways to conserve. As any of us who have turned off a lamp or put on a sweater know, consumers who want to conserve or save money on electricity have a variety options. This policy is a perfect illustration of unnecessary government intrusion into both the marketplace and American people’s homes.


[1] Leslie Hudson et al, “Maine’s Electric Adjustment Mechanism: Why It Fizzled,” Electricity Journal 8 (Oct. 1995), 74-83.

[2] The Keystone Center and U.S. EPA, State Clean Energy-Environment Technical Forum, Dec. 13, 2007, Conference Call Summary.

[3] Municipal systems (“public power”) account for 15 percent of total retail sales and cooperatives for 10 percent.





[8] California Public Utilities Commission, Agenda Draft Resolution E-4217 These must be netted against FERC-related adjustments of -$41.8 million

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