Is the US form of ‘decoupling’ (ie breaking the link between energy saving and reduced revenues) transferable to GB?
Catherine Mitchell, IGov Team, 18th July, 2014
There is an implicit incentive in traditional economic regulation which compels utilities (meaning the main components of energy systems (producers/generators, transmitters, distributors and retail / supply) to encourage consumption rather than to reduce energy use. Utilities make more money selling energy than they can when encouraging an efficient use of it. This is at odds with current energy policy and is sometimes known as the throughput incentive. Many utilities in the US have dealt with this problem by ‘decoupling’ utility revenues from throughput incentives, and this is talked about in a short-hand way as decoupling. The energy system structure and its regulation is different in the US than in GB. GB already has some regulation which is meant to ‘decouple’ the incentive to supply from revenues. The question is whether US decoupling regulation is preferable and/or better to that in place in the UK?
In a regulatory context, decoupling is the breaking of the link between (1) setting a level of revenue that a regulated gas or electric utility will be allowed to collect (allowed revenue) and the amount of energy sold; with (2) the actual allowed revenue collected by the utility. The ‘decoupling’ occurs by an adjustable price mechanism which makes the utility indifferent to selling less / passing more energy across their wires, because their revenue will be the same if they sell more or pass less energy across their wires . This does have a cost to consumers, but a very small one and the question is whether by implementing this incentive, utilities would focus more strongly on energy efficiency thereby bringing customer energy usage down, thereby resulting in lower bills overall for customers despite the additional regulatory cost of decoupling.
This type of revenue regulation does not change the way in which a utility’s allowed revenues are calculated. A revenue requirement is based on a company’s underlying cost of service and the means of calculating it relies on long standing regulatory methods. What is innovative about revenue regulation and decoupling is how a defined revenue requirement is combined with decoupling to (hopefully) eliminate sales-related variability in revenues (thereby not only eliminating weather and general economic risks facing the company and its customers) but also potentially adverse financial consequences flowing from successful investment in end-use energy efficiency – i.e. reduced sales. Thus, while traditional regulation sets prices, then allows revenues to float up and down depending on how much is sold; decoupling sets revenues per customer based on actual use. This does not mean getting rid of competition. Rather it moves the focus of competition from price to service, since companies still compete for customers, and a customer can still switch but on the basis of the service they get. In the US, this decoupling can be set in a number of ways i.e. by equalising kWh costs (as shown in the Table below) but it can also be set as revenue per customer.
Decoupling should eliminate a strong disincentive to invest in energy efficiency. By itself however decoupling does not provide the utility with a positive incentive to invest in energy efficiency but it does remove the antagonism to their impacts on short run returns. If, in addition to decoupling, which removes the ‘bad’ incentive for companies to sell more energy, you introduce a ‘good’ incentive for companies to sell energy efficiency services you should end up with companies competing and innovating on the best way to offer and do energy efficiency.
The Regulatory Assistance Project (RAP), based in Vermont, has written a very detailed explanation of decoupling. Utility expenses can broadly be divided between non-production and production costs in the US. Non-production costs (i.e. all those expenses related to the delivery of energy) are usually recovered through a combination of a customer charge plus one or more volumetric rates (i.e. KWh, KW). There are various ways that decoupling can be implemented (full, partial, and limited), and the report shows which of the 23 or so States in the US which have decoupling have used which model. It also provides utility case studies and an in-depth analysis of the costs and impacts of decoupling on different customer groups. While the table below shows the decoupling adjustment reverting to the utility, there are many methods, including shared savings of the decoupling adjustment or combinations of decoupling with innovative rate design.
|Decoupling Example: Revenue Requirement Calculation|
|Net Equity Investment||$100,000,000|
|Allowed rate of return||10.00%|
|Total Revenue requirement||$115,384,615|
|Actual Sales (kWh)||990,000,000|
|Decoupling Price ($/kWh)||$0.1166|
From a British perspective, the questions are (1) whether the British version of decoupling currently on transmission and distribution networks is adequate?; and (2) whether such a decoupling model applied to suppliers in Britain (which currently do not have a decoupling incentive) would be viewed as detrimental to competitive retail goals and/or whether the US decoupling method would be the regulated mechanism of choice to break the link between sales and revenue?
With respect to the latter question: in Britain, supply is separated from the transmission and distribution functions, and is considered competitive. This is unlike the US where distribution and supply (retail) tends to be linked within the same company. In the US model, it is easier for such things such as time of day tariffs, peak tariffs, rising step tariffs etc to be implemented because the benefits to the network of customers reducing their energy flow directly to reduce distribution network costs (for example, through avoided infrastructure replacement etc) and to customers, who pay less via a regulated allowable revenue. A DNO in Britain could implement measures to improve their, or customer’s, efficiency of use, but they will not necessarily be paid for it because of the lack of a mechanism to do so. This is the so-called problem of the broken value chain (see M. Lockwood, IGov Working Paper on networks, forthcoming). Thus, capturing the value of decoupling is easier in the US than in Britain.
Nevertheless, it is the suppliers in Britain who are the executives of the Government’s energy efficiency programs. In general, one can expect suppliers to want to grow their volume sales, and at the very least not to shrink them. However, if they could make more incremental income from efficiency measures than from additional energy sales, then they should not mind reducing their energy sales. Such an incentive is not in place in the UK at the moment; not least because in theory it is retail competition which is meant to provide that incentive to suppliers to differentiate – potentially as a supplier which provides services rather than sells units – thereby attracting customers. While this works to some degree at the industrial and commercial level it is minimal at the domestic customer level.
About a decade ago, there was a regulatory attempt to ‘book-end’ the obligation to supply renewables and increase energy efficiency by putting in place a matching obligation to reduce carbon per customer. The only way to do this was to either supply a greater proportion of low carbon or to reduce energy use per customer. This measure however was blocked in its final stages of discussion. There are therefore various possible approaches to decoupling sales and revenues on suppliers.
With respect to the first question, up until 2010, electricity distribution company income did depend on total energy throughput over networks, but in the latest DPCR5 (2015-2023) this driver has been removed. Similarly, since 2013, the transmission operator should also be indifferent to throughput. In theory, companies are now allowed to collect the revenue necessary to operate the network, regardless of electricity used. If less electricity is transmitted or distributed, per unit charges would simply go up.
However, there are some incentives to do with the Regulatory Asset Value (RAV). Broadly, the more electricity transmitted/distributed at peak hours, the larger the network needs to be, and the larger the capital expenditure (CAPEX) additions to the RAV, which some informed people do think still matter for companies. This link is somewhat weakened under RIIO, because it is no longer actual CAPEX that is directly added to the RAV but rather 70% of projected spend, but the broad principle remains true. In addition, companies seek to bid up the initial allowed revenue as much as possible, because they can outperform on costs more easily the bigger the allowance. They are then allowed to keep a proportion of those under-used allowed revenues. This implies that companies would not be very happy about falling (peak) demand, as it puts downward pressure on allowed spend. Overall, therefore, it does not seem that full decoupling has been achieved in networks in Britain.
Decoupling, in the US sense, is a fundamentally sensible and useful incentive. US decoupling is of course possible in GB networks and it (or some other regulatory mechanism) should also, of course, be possible in a competitive retail setting. As is becoming clear in the US, a combination of decoupling with innovative rate design can be very beneficial to the success of demand side policies.