It used to be easy. The more electricity the public consumed, the brighter the utility's profit picture. Conversely, if the utility sold less electricity, its profits would fall. So, until relatively recently, almost all the regulatory incentives in place were directed at rewarding utilities for selling more electricity year-on-year.

This concept was built into rate-making procedures, resulting in state utility regulators effectively creating incentives for the ongoing growth of electricity usage as well as capacity generation. Now, however, the environmental, business, and social setting in which electric utilities operate has changed significantly.

In simple terms, the American regulatory process has generally worked in this fashion: In return for a regulatory body permitting an electric utility to operate as a monopoly, the utility agreed to its prices being set by state level regulators (i.e. public utility commissions). Prices were determined by taking a utility's cost of providing service into consideration and then providing for a “reasonable return” on the firm's total investment. Because prices were set at the time a rate-making decision was made, the primary way a utility could increase profits (until the next rate-making decision) was by increasing sales.

“This phenomenon is often characterised as the utility's throughput incentive [and] because of the utility's financial structure, this is quite a powerful incentive,” says Wayne Shirley, a director of the Regulatory Assistance Project (RAP), a non-profit group of former utilities regulators who now advise state regulatory commissions.

Further exacerbating the need to increase (and certainly not suffer a decrease) in revenue are two financial characteristics of utilities. Shirley continues: “First, a utility's cost structure is, in the short-term, relatively fixed, so reduced sales are not generally offset with reduced expenses. Likewise, increased sales are generally not accompanied by increased costs.” Shirley is well placed to comment as he served as chair of the New Mexico Public Utility Commission from August to December 1995 and before that as the State's chief consumer advocate. “This means that virtually every dollar gained from increased sales translates into a dollar of increased profits – and virtually every dollar lost to reduced sales translates into a dollar of reduced profits.”

High fixed expenses

A second characteristic relates to the fact that utilities generally have high fixed expenses and are highly leveraged, with profits amounting to a small percentage of revenues. “Thus, a utility with US$1 billion in revenues may have only a few tens of millions of dollars of profits in the US$50 million range,” Shirley says. “A seemingly small one percent change in total revenues may represent as much as a 20% change in profits.”

When these factors are combined, we can see why utilities historically have not been willing participants in energy efficiency programmes. It simply was not in their best financial interest.

Decoupling profits from sales

One regulatory concept aimed at addressing this situation is known as “decoupling,” a regulatory tool that separates utilities' profits from sales. “Specifically, decoupling takes aim at one of the critical barriers to increased investment in cost-effective energy efficiency – the potentially deleterious impacts that such investment can have on utility finances under traditional cost-of-service regulation,” Shirley and two colleagues, Jim Lazar and Frederick Weston, wrote in a recent report to the Minnesota Public Utilities Commission.

“Decoupling, in which the mathematical link between sales volume and revenues is broken, eliminates the throughput incentive and focuses a utility's attention on its customers' energy service requirements and the economic efficiency of its own operation,” the report explained. “It renders revenue levels immune to changes in sales.”

Looked at another way, under decoupling any marginal increased profits associated with sales growth are “returned” to electricity buyers. On the other hand, any reduced profits resulting from a decrease in sales are “shouldered” by electricity buyers. In the context of decoupling, in order to increase profits, a utility will need to increase its own operating efficiency, so the link between increased revenues and increased profits is thereby broken.

While not yet widely accepted, decoupling is beginning to find its way into State regulators' “toolboxes” all over the nation. In California, Idaho, Maryland, New York, Utah, and Vermont, utility regulators have adopted some form of decoupling. For example, the approach taken in California encourages utilities to pursue efficiency initiatives while at the same time protecting them from decreases in electricity usage. Moreover, the recently-enacted Obama Administration's economic stimulus bill initially included a provision directing electricity regulators to develop incentives for decoupling – before it was taken out of the final legislation.

However, support for the concept is far from universal. The Electricity Consumers Resource Council, a trade group for large industrial electricity consumers, argues that decoupling “promotes mediocrity” in utilities' management practices. “The attractiveness of revenue decoupling to many utility executives is that it will immunise the company's earnings or revenues from sales fluctuations. This can only promote mediocrity and indifference to the utility's core business, a situation that would not be in the best interests of either advocates of selling or unselling the energy product.”

Similarly, other consumer advocates such as the Ohio Consumers' Council, a State-level office that bills itself as “your residential utility consumer advocate”, has voiced significant reservations about decoupling. In Ohio, the consumer council has said that if utilities suffer declines in earnings, then they should simply file amended requests with the public utility commission to address the situation.

What these objections indicate, perhaps more than anything else, is some groups' unrelenting faith in traditional regulation, Wayne Shirley says. “They've not actually run the numbers to understand the value to customers of stabilising utility companies' revenues,” he says.

Likely introduction of cap-and-trade

Despite the mixed feelings about decoupling, the concept seems destined to increase in importance as the US moves closer to some type of greenhouse gas emissions cap-and-trade system. Assuming that by this time next year the US has a system in place – either by legislation or through EPA promulgation of a cap-and-trade regulation – utilities that rely on fossil-fuel based generation will face the challenge of how best to reduce emissions, serve their customers, and maintain profits. Under this scenario, decoupling may well be embraced by regulators and the power generating industry as the cheapest way to reduce carbon emissions.