Decoupling 101: Of triage and panaceas

Decoupling is all the rage. The Obama campaign has made it a key part of their plan (as David gushed here), and many states have instituted decoupling proceedings to change the way that their electric and gas utilities get paid.

The good news on decoupling is directional; utilities currently have a strong incentive to keep their customers from investing in energy efficiency, and decoupling provides a way to address that.

But decoupling is hardly a panacea. We need quick, large-scale changes in fossil energy consumption to address climate change. From my vantage point, we need a long-yardage pass play, and decoupling — while still heading down the field — is a short-yardage running play up the middle.

In all cases though, as the decoupling concept gains momentum, it is critical we understand the nuances. Here is my attempt to provide some .

First off, I must admit that I have learned almost everything I know about decoupling from the good people at the Regulatory Assistance Project. (Note to any policy-makers reading this post: If you want to institute decoupling proceedings, go directly to RAP. Do not pass go.)

Theory of Decoupling

The basic idea of decoupling is as follows: regulated utilities have to spend a lot of money on capital investment that is fixed (power plants, wires, pipes, etc.) They have to pay for this capital regardless of how much energy they sell. Meanwhile, their revenues are earned largely on a variable basis (e.g., per MWh of power consumed). As a result, a small reduction in their sales has a big impact on their profits, and therefore on their ability to return money to their shareholders. As Wayne Shirley of RAP points out here [PDF] (see p. 14 in particular), a 5 percent fall in sales for a utility can reduce their profits by 59 percent. Needless to say, this provides a strong incentive to make sure sales don’t fall.

Historically, this has led to a plethora of utility rates that stand in direct opposition to the public interest from tiered pricing schedules that depress the value (to the consumer) of a MWh of conservation to special “cogen-killer” rates that provide big industrial customers with discounts as long as they agree never to cogenerate their own power. In a competitive business, such rates would be anti-trust violations … but monopoly utilities aren’t subject to anti-trust regulations, and have therefore promulgated a century of rates and practices that create massive barriers to energy efficiency.

Enter decoupling. The idea behind it is that if you “decouple” utility revenues from their sales, you remove the implicit penalty to utility shareholders caused by efficiency.

… But It’s Tricky

As you might imagine, it’s a bit complicated. The easiest way (which amazingly, I have heard utilities ask for) is simply to convert all utility tariffs from a c/kWh charge to a $/month charge. Presto: rates are decoupled! Utilities get paid the same amount of money every month, regardless of what their customers do.

The problem with such an approach, of course, is that it also removes any incentive for the customer to conserve. (If your monthly utility bill doesn’t vary with use, there not only is no incentive to install a solar panel on your roof, but there’s also no incentive to close your refrigerator door.) The best approaches (like RAP’s) work by keeping customer rates on a $/MWh basis, but changing the way the way that these rates translate into utility revenues.

Without getting into the details, you can think of this as essentially a formula to reset utility revenue targets (and therefore c/kWh rates) on a regular basis, such that as total kWh sales change, utilities always get the same amount of money.

The good news is fairly obvious: Utilities no longer get penalized every time their customers conserve. But the bad news isn’t to be dismissed. In particular:

1. It removes a disincentive, but doesn’t actually create an incentive. To RAP’s credit, they have recognized this and recommend that decoupling be coupled with a so-called “Performance-Based Rate” that lets utilities make more money if the efficiency of their system goes up. It’s a good idea, but far from universal in the decoupling conversation.
2. It essentially transfers risks from the utility to the customer. In a pre-decoupling world, utilities are exposed to the risk of economic, weather, and efficiency-related load volatility. In a decoupled world, some or all of these risks are transferred to customers, who can now see higher rates per MWh as their MWh consumption falls. Maybe this is a net positive, but there is clearly a cost that ought to be acknowledged any time one is transferring risk to the consumer.

And now, the complicated news. Here we get into the really interesting parts and the nuance lost in much of the decoupling conversation.

1. The theory of modern utility rate design is that utility returns on capital should be commensurate with utility risk. This is a central idea of all capital budgeting, which makes perfect sense on a moment’s reflection. (If you were considering two investments, and in one of them you could lose all your money while in the other one you could never lose your money, you would be unlikely to invest in the first idea unless it had a much higher “upside.”) So since decoupling reduces the risks faced by the regulated utility, shouldn’t it also reduce their returns on equity? (In other words, shouldn’t decoupling be “coupled” to a reduction in utility rates?) The answer is an overwhelming yes, especially since decoupling is transferring that risk to the consumer, who ought to be compensated. But to the best of my knowledge, this is largely omitted from the current decoupling conversation.
2. The fact that utility profits fall disproportionately as their revenues fall also works the other way, with utilities earning massive increases in their overall profitability with small increases in revenues. As a result, the utilities that have been quickest to embrace decoupling are those with falling sales, while those who are most hostile to the concept are those with rising sales. This creates odd bedfellows and odd tensions, but most interestingly, it forces rate-makers and utilities to acknowledge a flaw in the regulatory process that has previously been easy (and convenient) to overlook.

But the biggest issue goes back to the need for a long-bomb to the end zone. The problem with modern utility regulation isn’t rate design, but the innate conflict of a for-profit company with a government-guaranteed monopoly. Such an enterprise always finds itself in a situation where the interests of its customers are directly opposed by the interests of its shareholders. Decoupling doesn’t address this problem; it simply adds a wrinkle to the rules within that framework. This “tweaking within the paradigm” has the benefit of being politically relatively easy, but when the world needs a paradigm shift, it is not sufficient.

So should we decouple? That depends on your ambition and political calculus. But in all cases, we should not confuse this short-term triage with a long-term solution.