The Obama Administration’s 2010 budget, the American Recovery and Reinvestment Act (ARRA) economic stimulus plan and certain state policies envision a transformation of how Americans will use electricity. Key elements include energy efficiency measures and related rebates, demand response programs that will reduce power usage in response to price signals, and “smart meters” that facilitate more granular and dynamic pricing information to inform usage behavior. Energy efficiency (EE) mandates to reduce electricity use pose potential credit quality and profitability risks for investor-owned utilities (IOU), particularly in today’s economic environment. Such risks could slow the deployment of EE measures despite intense pressure to scale up such programs.
IOUs have already seen notable sales volume erosion as the recession has reduced energy demand. The continued push for greater consumer access to EE measures, and dynamic retail pricing and enhanced metering technology to facilitate those measures, create an investment dilemma. In the eyes of many investors, without a change in cost recovery, a utility helping its customers reduce their usage would be like an auto manufacturer encouraging people to carpool so they could buy fewer cars – a strong argument against purchasing the auto company’s shares.
The other side of the equation is the utilities’ continuing investment needs to upgrade aging infrastructure and address decreasing generation reserves. Government mandates for meeting renewable portfolio standards and greenhouse gas reduction targets also will require additional IOU capital investment and the assumption of new technology and regulatory risk. The result combines an irresistible force and an immovable object: upward pressure on revenue requirements and retail rates in a tough economic climate. Utilities have less usage volume by which to earn a return (a situation EE will exacerbate), at the same time costs and risks are increasing.
How do investors gauge what’s happening in this climate? If utilities invest in significant EE, will they recover those costs sufficient to maintain the utility’s financial quality? To answer such questions, investors must assess certain key factors for any IOU that pursues an EE program:
- Materiality: the impact of an EE mandate must be material compared to the utility’s overall rate base, revenues and sales volumes
- Regulatory risk: the certainty and timing of any cost recovery mechanism
- Regulatory balance: the likelihood that utility regulators (and the investment community) will do a peer comparison of return on equity performance for utilities that do and do not pursue EE, along with assessment of EE incentives and cost recovery mechanisms
- Innovation: the technology risks that a utility’s EE implementation may or may not meet expectations or targets
- Market conditions: whether EE is considered by the IOU and regulators as a long-term commitment or a temporary fix for wholesale supply scarcity
Ultimately, the investment judgment on a utility’s EE programs comes down to the IOUs’ ability to effectively use the various cost recovery tools available.
There are a number of options that IOUs often consider to provide a reasonable opportunity to earn an allowed return on equity or an incentive balanced against concerns regarding retail rate increases, credit quality and aggressive EE deployment. Each has its advantages and drawbacks, but IOUs have begun to propose them singly or in combination to address the cost recovery issue, their investment quality and thus willingness to engage in aggressive EE measures:
- Pre-approval of carrying/construction work in progress costs prior to new EE deployment (i.e., before the measure is deemed used and useful)
- Shared benefits that allow recovery of some of the net societal benefits
- Cost capitalization of program costs by allowing a “bonus” rate of return on the un-depreciated amount over part of the useful life of the EE measures
- EE performance target recovery of allowed program costs
- Recovery of lost revenue for a portion of the useful EE life
- Return on, and return of, avoided energy and capacity costs resulting from the EE measure
- Recovery of third-party EE provider service contract costs
- Shared revenues from EE bid into wholesale capacity markets
- Decoupling retail rates from volumes sales
Decoupling deserves special mention because of its impact on utility risk. One view is that decoupling does not decrease business risk, but instead simply offsets growing risk already posed by EE and conservation measures. Another view is that decoupling insulates utilities from revenue volatility caused by traditional risks like weather and economic downturns. This view could lead to calls for reduced rates of return because of reduced business risk. Decoupled utilities have not experienced much positive reaction from the stock and bond markets, while rating agencies typically do not improve ratings for decoupling, but may take a negative view for its absence. However, given the vastly increased political EE pressures, rating agencies may begin to view decoupling as a requirement for a utility to maintain its rating.
IOUs and their investors need to weigh the various cost recovery, incentive, and decoupling options together. It’s an analytical question: What single tool, or combination, will ensure appropriate IOU earnings levels to meet investor expectations and demands for a significant scale up of EE; balanced against short and long-term rate impacts on consumers? All considered, of course, under the clouds of an uncertain economy.
About the Author
Washington Watch is a regular feature of Electric Energy T&D Magazine appearing three times annually and focused on regulatory and legislative energy- and utility-centric initiatives. Gregory K. Lawrence is a partner in the Energy and Derivatives Markets Group of global law firm McDermott Will & Emery, and leads the firm’s Global Renewable Energy, Emissions and New (GREEN) Products Group. Mr. Lawrence focuses his practice on renewable power, emissions and energy efficiency project development, regulatory proceedings, compliance and investigations, transactions, and governmental affairs relating to the wholesale and retail electricity and natural gas industries.
