20110321Hirsh Rebuttal.pdf

Benjamin Otto (ISB No. 8292)
710 N 6th Street
PO Box 844
Boise,ID 83701
Ph: [phone] x 12
Fax: [phone]
botto~idaoconservtion.org
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Attorney for the Idao Conservtion Leage, the NW Energ Coalition, and the Snake River Allance
BEFORE THE IDAHO PUBLIC UTILIES COMMISSION
IN THE MA'IER OF IDAHO POWER )
COMPANY'S REQUEST TO MODIFY )
RECOVERY OF INCENTIVES PAID TO )
SECURE DEMAND-SIDE RESOURCES )
CASE NO. IPC-E-I0-27
REBUTtAL TESTIMONY OF THE CONSERVATION PARTIES
NANCY HIRSH
March 18, 2011
1 Q. Are you the sae Nancy Hirsh tht submitted diect testimony in th ca on March 4,
2 2011?
3 A. Yes I am.
4
5 Q. Are you replying to the diect testimony of al paties?
6 A. No. I am only replyig to the testimony of the Industrial Customers of Idao Power and Staff
7 of the Puc. The direct testimony fied by Idao Power and the comments of CAPAI correctly
8 express the substance and spirit of the stipulation.
9
10 Q. Wil the stpulation increas the revenue colleced to cover DSM program expenditures?
11 A. Yes it wiL. Tht has been clear from the begining of this case. But increasing DSM funding
12 is no reason to reject the stipulation. The rider is just one tool that can be used to collect revenue
13 to pay for energy effciency and demand response programs. Includig progr expenses into the
14 PCA and into genera rates are two additional ways to cover progr expenditures and support
15 DSM. Maitaining the rider level in order to reduce the negative balance is an important outcome
16 of this case. But the priar focus of this stipulation is to better align the goals of the varous
17 DSM progrs with the goals of the company whie stil maintaiing the focus on capturg al
18 cost effective energy savigs.
19 Moreover, the DSM progrs covered in this stipulation are the most cost effective in
20 Idao Power's portfolio. Going forward, all paries wi have amble opportunities to review the
21 prudency of DSM spendig regardless of the fundig mechaism in annua PCA fiings, general
22 rate cases and, most immediately, in Idao Power's recently fied DSM prudency review for 2010.
23
24 Q. Do you believe increas fundig for DSM is reanable, prudent, and in the public interest?
1 Hirsh, Reply
Conservation Paries
1 A. Yes as long as the fundig goes towards verifiable, cost effective programs that provide
2 measurable energy savigs. That is clearly the cas here as the progrs at issue in the stipulation
3 are the most cost effective and largest of Idao Power's entire DSM portfolio. The prudency of
4 spending on these programs is not an issue in this case.
5 Beyond reasonable and prudent, increasing DSM fundig is essential for Idaho Power to
6 comply with this Commission previous orders to purue al cost effective DSM. It so happens that
7 even at 4.75% of base revenues the Company has found and acquied additional cost effective
8 DSM. The conservtion paries agreed to the stipulation because it represents a creative, yet
9 pragmatic and modest, method to asist the Company is pursuig cost effective DSM.
10 ICIP seems to argue that the Company should only acquie DSM up to the amount of
11 funding in the rider. I believe this does not comport with this Commission's prior orders and
12 should be rejected. The proper measurg stick for acquiring DSM is cost effectiveness, not an
13 arbitra percentage of base revenues. An arbitra fundig cap would dissuade Idao Power from
14 puruing least cost resources thereby raising power rates for all customers, ICIP included.
15
16 Q. ICIP argues on pages 7 and 8, that th Commison has "shown a reluctance to increas the
17 EE rider for Idao utilties above the 5% leveL." Do you agree with th interpretation?
18 A. No. Whe this Commission has declined to increase Rocky Mountai Power's rider level
19 beyond 5%, I understand these decisions to be based on factors not applicable to this stipulation.
20 Whe I was not engaged on that case, one of my fellow Conservtion Parties, ICL, was. ICL has
21 explained to me that RMP's DSM portfolio included an irgation load control progr that
22 seemed to provide benefits to ratepayers in five other states, and a under performing Agrcultural
23 Energy Servce program. Those issues are not present in the cae here.
24 The stipulation before you today deals with two areas of progrs that are the most cost
25 effective in Idaho Power's DSM portfolio. These programs are evdence of Idao Powers' success
2 Hirsh, Reply
Conservtion Parties
1 in developing and promoting DSM measures that deliver real benefits to Idao ratepayers. And as
2 I explained above, the metric for acquig DSM progrs should be their cost effectiveness, not
~..3 an arbitra fundig liit.
4 ICIP also points to Avista's rider level of 3.98%. As you know, the Commission approved
5 this amount because that is what the Company requested wa necessa to acquie all the cost
6 effective energy savigs identified in its IRP. Order No 30918, A VU-E-09-o6 (October 7,2009).
7 Nothig in that case supports, or even considers, a supposed 5% fundig cap. Rightfuly so this
8 Commission has taken a case-by-case approach to the rider leveL. The increase for DSM fundig
9 arsing from this stipulation is for progrs with a long track record of cost effectiveness.
10
11 Q. ICIP also questions the theory of incentivizg an electric utity to pursue demand side
12 resource programs. Do you agree with ICIPs asssent of the theory?
13 A. No. ICIP provides an incomplete explanation of the theory and then misapplies it to Idao
14 Power. On page 15 ICIP refers to the Averich-Johnson (A-J) effect and refers to their
15 "discussion" of this in case IPC-E-09-09. I hesitate to ca this a discussion since ICIP dedicated a
16 single paragrph to this complex economic priciple. See Comments and Protest of ICIP at 6,
17 IPC-E-09-09 (March 1,2010). More troubling to me though is the incomplete nature of this
18 dicusion. Despite the statements of ICIP, the impact of A-J effect depends on the specifics of
19 the utilty.
20 The A-J effect argues that utilties have an incentive to put lare capital projects into their
21 rate base if the allowable rate of return exæeds the cost of capital. I emphaize this second clause
22 becaus this is essential to understandig if the A-J effect applies to Idao Power. The incentive
23 occurs because given a fixed rate of retur that exceeds the cost of capital; shareholders ear more
24 on a $1 million investment than a $1 investment. But as explaied by Steve Kih in When
25 Revenue Decoupling Wil Work. . .and When it Won't: "If a reguator keeps allowed rates of retur
3 Hirsh, Reply
Conservation Paries
1 close to a utilty's cost of capital, increasing the eared rate of retur wi be the primar drver of
2 the utilty's stock price." See Kihm at 1, Attachment 1. ICIPs ((discussion" of the A-J effect
3 neglects to provide this ful explanation and does not attempt to examine Idao Power's rate of
4 retur relative to their cost of capital.
5 ICIP next describes the "reduced projections for demand side progr achievement in its
6 IRP process. . .." Whe we too have concerns about the company's DSM plans in the IRP, we
7 believe a varety of factors drve this. Not the least of these factors is that curently Idao Power
8 has no opportunity to ear a retur on DSM - an obvious disadvatage compared to supply-side
9 resources that this stipulation would begin to address. Whe we may agree that the term ((equa
10 footing" may not be a completely accurte way to describe the impact of these recovery chages,
11 they certaily do begin to provide a more robust business case for the company to purue demand-
12 side resources. The Conservtion Paries support this stipulation because it addresses one of the
13 primary factors inhibiting greater puruit of demand-side resources in the IRP process.
14
15 Q. ICIP argues the Commison should reject the stipulation because the parties have not
16 agreed to a metod of alocating demand respnse incentives in the cost of service study. Do
17 you agree?
18 A. No. ICIPs concerns seem to be based on the potential for shifting costs between customer
19 classes. The Conservtion Paries share this sae concern, but acknowledge the stipulation
20 includes a mechanism to ensure no cost shifting occurs until the next genera rate case. The
21 Stipulation preserves all of the rights and options of al paries, and this Commission, to address
22 and resolve the cost allocation issue in the next rate case. ICIPs concern about cost shifting is
23 unwarted at this time.
24
4 Hirsh, Reply
Conservtion Paries
1 Q. ICIP also argues the Commison should reject the stipulation because it does not diuss
2 how the costs of the Custom Efficiency program wi be alocted in the general rate cas. Do
3 you agree?
4 A. No. Lie ICIP, the Conservtion Paries are concerned about the proper method to allocate
5 the Cusom Efficiency costs going forward But we also recognize that this issue does not need to
6 be resolved now. The stipulation asks the Commission to approve the capitalization of Custom
7 Efficiency incentive costs. It does not alocate any of these costs to any customer. Approving the
8 capitalization of Custom Effciency payments is a completely separte question of which
9 customers wi pay for these costs. ICIPs concerns about this issue are premature.
10
11 Q. ICIP's tesimony addresss the carrying chage on the back balance of the rider. Would you
12 lie to address th ise?
13 A. Yes. The stipulation clearly states the Company wi continue to use a 1.00% carg charge
14 on the back balance. The Conservation paries do not support increasing the carrg charge on
15 the back balance regdless of the outcome of this case.
16
17 Q. In the Direct Testony of PUC Staff, witness Randy Lobb states tht the current Schedule
18 91 percentage wi be reduced eventualy. Do you agree with thi statement?
19 A. No. The stipulation is deliberately silent on the issue of future chages to the Schedule 91
20 tariff rider. Paries to the stipulation agreed to disagree on the level of the rider and agreed to take
21 this issue up in a future proceedig. Changing the Schedule 91 percentage depends first and
22 foremost on the level of fundig necessa to acquire avaiable and cost effective energy savigs.
23 Prejudgg the level of fundig necess to meet future opportunities is not appropriate for this
24 docket at this time.
25
5 Hirsh, Reply
Conservation Paries
1 Q. Does thi conclude your reply comments?
2 A. Yes. Thank you.
6 Hirsh, Reply
Conservtion Paries
BEFORE THE IDAHO PUBLIC UTILITIES COMMISSION
IN THE MA'IER OF IDAHO POWER )
COMPANY'S REQUEST TO MODIFY )
RECOVERY OF INCENTIVES PAID TO )
SECURE DEMAND-SIDE RESOURCES )
CASE NO. IPC-E-1O-27
ATtACHMENT 1
Ki, Steve Whn Revenue Decoupling Will Work. . .and When it Won't
(October 2009)
Attachment 1
Hirsh, Reply
Conservation Paries
\
~
ENERGY CENTER
OF WISCONSIN
BY
Steve Kihm
Research Director
skihmcgecw.org
When Revenue
Decoupling Will Work...
and When It Won't
Published in the October
2009 issue of The Electricity
Journal October 2009
www.ecw.org : ' ,',' ' ~., '
~
Overview
Revenue decoupling wil be highly effective in removing the disincentive for utilities to promote
energy effciency in certin situtions, but completely ineffective in other. Since the
effectiveness of decoupling depends on paricular details, it is best viewed as a tactical tool to be
used for some utilities rather than a strategic instrment that can be used effectively on all
utilties.
· When Decoupling Wil Work: If a regulator keeps allowed rates of return close to a utility's
cost of capital, increasing the earned rate of return wil be the primary driver of the utility's
stock price. Decoupling mechanisms prevent energy effciency activities from lowering
the earned return and prevent sales promotion from increasing it. Under this condition,
decoupling will make the utilty largely indifferent between sales promotin and energy
effciency.
· When Decoupling Won't Work: If a regulator sets rates of return in excess of a utility's
cost of capital, increasing investment scale wil be the primary driver of the utilit's stock
price. In that case its investors wil prefer an expanding rate base to a more-stable one,
even if the utilty earns the same rate of return on both. Decoupled or not, a utility
operating under this condition wil prefer to promote sales because so doing will increase
its investment scale more rapidly over time.
1. BACKGROUND
The Financial Foundation of Revenue Decoupling
Under trditional ratemakng practices, when a utility promotes energy effciency, the revenue it
loses is greater than the varable cost it avoids. This lost net revenue affects the utility's bottom
line, reducing its eared rate of return. Revenue decoupling mechansms are ratemaking devices
that restore those lost net revenues to the utilty. Many suggest that in so doing, decoupling
mechanisms necessarily eliminate the disincentive for the utility to promote energy effciency.
The decoupling concept rests on the notion that a utilty's investors are indifferent between
alternatives that produce the same rate of retu. Yet, a basic tenet of finance is that any rate of
return or profitability index fails to reflect the all-important differences in investment scale
across the varous expansion paths, as Higgins notes in Analysis for Financial Management:
The problem with the PI (profitabilty index) and the IRR (internal rate of return) is basically
that they are insensitive to the scale of investment. 1 (Emphasis added.)
Finance textbooks are full of examples demonstratig that investors wil be better off if the firm
selects a large-scale investment with a low rate of retu over a small-scale investment with a
high rate of retu.2 As Higgins puts it rhetorically, but convincingly:
Would you rather earn an 80 percent return on $1, or a 50 percent return on $1 millon?3
Note that you would not need $ 1 milion of idle cash to take advantage of the second option. As
long as you can raise capital at a cost rate that is less than 49.99992 percent, you wil prefer the
investment with the larger scale. Similarly, as long as a utilty is allowed to earn a retu that
exceeds the cost rate at which it obtains capital, its present investors, too, wil be better off if the
utility invests in large-scale capital assets rather than smaller ones. The fact that the utility must
issue new shares of stock to expand its system does not change that conclusion, nor does the fact
that its rate of retur might be the same across the varing expansion paths.
The Fair Rate of Retur
Setting the fair rate of retu is a public policy decision. I use the modifier "fair" in the previous
sentence because that is how the U.S. Supreme Court labeled the rate of retu in Smyth v. Ames:
What the company is entitled to ask is a fair return upon the value of that which it
employs for the public convenience.4
While economics and finance can inform us about the cost of capital, those fields have little to
say about fairness as set forth in legal constrcts, as financial expert freely admit. 5 Therefore,
we should not expect economic concepts, such as the cost of capital, to be the regulators'
exclusive guide in setting fair rates of retu.
As noted at the outset, whether the regulator sets the rate of retu at the cost of capital plays an
important role here because it determines whether the foundation exists for an effective
decoupling mechanism. In abstract neoclassical economic theory, a case can be made for setting
the rate of retu equal to the cost of capitaL. As Kahn notes, however, in a dynamic institutional
environment, the cost of capital can be viewed only as a "bottom limit" for the fair rate of
retu.6 In a pragmatic sense, regulators can set the rate of retu at the cost of capital or higher.
It is not surrising then to find that some regulators set allowed retus above the utilties' costs
of capitaL.
This is more than an academic discussion. For example, consider the following 2007 decision
from the Wisconsin commission:
The cost of equity, which is the minimum acceptable return, is a starting point. It would
drive utility market values to book value, which eliminates the economic incentive for
utilities to expand their systems. Under normal economic conditions, the fair return on
equity lies above that minimum rate.7
In this decision, the regulator found the cost of equity to be 9.0 percent; it set the retu on equity
at 10.8 percent in order to achieve a multitude of public policy objectives. It is well-reasoned
regulatory decisions like this one that nevertheless make decoupling mechanisms ineffective.
If such a utilty can raise capital at a cost rate of 9 percent, but is allowed to earn close to 1 1
percent returns on all invested capital, it can deliver gains to its present investors by adding
capacity. As I wil demonstrate, those gains flow to the present investors, even though the
present investors supply none of the new capital necessar for that expansion. The utility doesn't
have to ear a retu higher than 11 percent to generate those gains; it just has to expand the
investment base to which that 11 percent retu wil apply.
A decoupling mechanism would not eliminate this incentive to expand. It would, in fact,
reinforce it. By drving the earned rate of return to the allowed level, the decoupling mechanism
ensures that this utilty wil ear a return in excess of its cost of capitaL. That sends a clear signal
to the utility to expand.
2
The Importce of Investment Scale in the Utilty Industr
The notion that regulators often set rates of retu in excess of the cost of capital, and that such a
condition creates the incentive for the utility to expand, is not a new one. In 1962, A verch and
Johnson published a seminal piece in the American Economic Review setting fort what most
regulatory economists consider to be the overarching utilty incentive strctue. Their well-
known conclusion, shown below, has since that time been referred to as the A-J effect:
The firm has an incentive to acquire additional capital if the allowable rate of return
exceeds the cost of capitaL. 8
Note that the A-J incentive strctue suggests nothing about increasing the rate of retu-it
assumes that the rate of retu is fixed at the allowed leveL. Just as we discussed above, to create
wealth for its present investors, the utilty merely needs to get larger, and that alone propels its
stock price upward. As Gordon notes, to take full advantage of the A-J effect, the utilty, as a
regulated entity, must create a need to expand its capacity:
Stockholders benefit if the allowed rate of return exceeds the firm's cost of capital and if
an expansion of capacity is required to meet demand.9 (Emphasis added.)
A utility creates a need for capacity expansion by encouraging customers to use more energy, not
less.
Empirical Evidence of the A-J Effect
Finance principles can help us determine whether the A-J effect holds for a paricular utilty. If
investors expect that a utilty wil be allowed to just ear its cost of capital, no more or no less,
there wil be party between its stock price and its book value:
If the return on book equity is pushed back toward the cost of capital, then the stock price
will be pushed back to book value.1o
Conversely, if the expected rate of retu is in excess of the cost of capital, the utilty's stock
price wil trade above its book value. This relationship is typically expressed via the stock-price-
to-book-value ratio, or market-to-book ratio. A result in excess of 1.00 indicates that the A-J
effect holds.
Over the past half centu, on average, the tyical utility stock has traded at a substatial 50
percent premium to its underlying book value (i.e., the long-ru average market-to-book ratio
equals 1.50).11 Even in today's challenging financial markets, about half of the electric utilities
followed by the Value Line Investment Survey have stock prices trading signifcantly in excess of
their book value. 12
Utilities subject to the A-J effect wil tend to have higher expected rates of retu than their
counterparts. We see a strong relationship between a utility's expected rate of retu and its
market-to-book ratio in Figure 1.
3
Fig. 1
Value Line Electric Utilities
2.00
\
3.00
2.50
The A-J effect does not hold
for utilties with market-to-book
ratios near 1.00 or below that leveL.
.
..
o
~-"
glD 1.50
~
~~ 1.00
. .... ...
The A-J effect holds for utilities
with market-to-book ratios
noticeably in excess of 1.00.
0.50
0%5%10%15%20%25%
Projected Return on Equity Over Next 3 to 5 Years
Even though the A-J effect does not influence all utilities today, it does affect a large number of
them, and we need to be cognizant of its powerfl impact on those companies. Some of the
utilties operating under the influence of the A-J effect suggest that the preferred path to a low-
carbon futue is one that involves building large-scale nuclear generating units.13 Without
prejudice as to the public policy implications of such a choice, from a financial perspective that
proposal makes sense.
If the utilities that ear high rates of retu can successfully implement this nuclear strtegy, they
wil deliver greater per-share stock price gains to their present investors than they would under
any other resource strategy. The rate-of-retu incentive is firmly in place for those utilities;
questions about the financial risk of such a strtegy have been mitigated to a large extent by
recent governent loan guarantees.14 Whether nuclear power represents the best resource choice
for ratepayers or for the public in general is a matter of disagreement. A discussion of that issue,
however, is beyond the scope of this article. We are focusing here on corporate finance.
If the A-J effect holds, the utility has a strong incentive to proceed along this path, and it is not
surrising to see such utilties headed in that direction. As I wil demonstrte in a moment,
decoupling such utilities wil have no effect on their expansion plans because they are attempting
to increase their stock prices primarily by creating a need for greater investment scale, not by
earning higher rates of return.
4
lI. FINANCIAL ANAL YSIS
Maximizing Market Value for the Present Investors
To determine whether an action is good or bad for utility shareholders, we need an explicit
objective function. Gordon provides one. It is the standard perspective in corporate finance:
The objective of a utilty management in its investment and other decisions is to serve the
company's owners-its present stockholders.15 (Emphasis added.)
Put another way, the objective of utilty management is to maximize the market value of the
utility stock held by the present investors.
Gordon's dividend discount model (DDM) can be used to ilustrte the key points that bear on
this issue. It determines the stock price by calculating the net present value of cash flows to the
present investors, which is the standard financial constrct. He develops several variants of the
DDM with differing degrees of complexity, but which all reflect the same fudamental financial
concept. Readers interested in a thorough treatment of utility finance should refer to his classic
text, The Cost of Capital to a Public Utilty.
The version of the model that allows us to demonstrate the point in question in the most
straightforward maner is the following. It assumes an all-equity financed firm that pays out all
of its eamings as dividends. This makes the analysis more transparent without any loss of
mathematical generality:
P= NBx+(x-p)INp
In the model, P is the stock price per share, N is the number of shares held by the present
investors, B is the book value per share, x is the rate of retu, p is the cost of capital, and I is the
amount of new investment that the utilty wil finance.
Let us use Gordon's model to demonstrte first that expanding investment scale is attactive to
the present investors when the rate of retu exceeds the cost of capital, i.e., when the A-J effect
holds. Then let us use it to show that such is not the case if the rate of retu equals the cost of
capital, i.e., when the A-J effect is absent. Finally, we can use it to show how decoupling would
affect the utilities in both scenarios.
Case 1: The Rate of Retu Exceeds the Cost of Capital (A-J Effect Holds)
Assume that our hypothetical utility has 1,000,000 shares of stock in the hands of its present
investors. Its book value is $20.00 per share. Its allowed retu is 12 percent, and its cost of
capital is 10 percent. At this point it has no plans to add capacity. Its stock price is then:
p = (1,000,000)($20.00)(0.12) + (0.12 - 0.10)($0) = $24.00
(1,000,000)(0.10)
5
Because the utility ears a rate of retu that exceeds its cost of capital, its stock price lies above
its book value. Next we consider two expansion alternatives. The first requires $10 milion of
new capital; the second requires $30 millon of new capitaL.
Since the utilty pays out all of its earings as dividends, and since the utility uses only equity
financing, it must issue new shares of stock to finance this expansion. These new shares wil
have an effect on the per-share stock price. Where, though, in Gordon's model is the variable
that represents the new shares to be issued? His model is the solution to a series of equations that
solve simultaneously for not only the stock price, but also for a host of other varables. The
number of shares to be issued is determned not only along with the new stock price, but the new
book value per share, and the new earnings per share, as well. The interested reader should refer
to Gordon's text for a full discussion of this comprehensive simultaeous financial solution.
Retuing to the example, let us calculate the new stock prices that would result if the utility
made the $10 milion or the $30 milion capital investments:
P. - (1,000,000)($20.00)(0.12) + (0.12 - 0.10)($10,000,000) $26.00$IOM - (1,000,000)(0.10)
P. - (1,000,000)($20.00)(0.12) + (0.12 - 0.10)($30,000,000) $30.00$30M - (1,000,000)(0.10)
What happens to the present investors when the utility expands? Note that those investors did not
supply any of the new capital. They stil hold their original 1,000,000 shares. So under the three
possible scenarios, the market value of their investment is:
No New Investment
MVpresent-investors = 1,000,000 x $24.00 = $24,000,000
New Investment = $10 Milion
MVpresent-investors = 1,000,000 x $26.00 = $26,000,000
New Investment = $30 Milion
MVpresent-investors = 1,000,000 x $30.00 = $30,000,000
The market value of the present investors' stock increases as this utility adds capacity, which is a
manifestation of the A-I effect. As the firm moves from a no-new-investment position to a $30
milion new investment, the present investors provide no new capital, yet the market value of
their holdings increases by $6 million (from $24 millon to $30 millon). Not a bad result for
putting no new money into the game.
6
If this looks like a windfall gain to the present investors, it is. Myers makes that very point:
Note that an opportunity to invest in a project offering more than the cost of capital
generates an immediate capital gain for investors. This is a windfall gain, since it is
realized ex ante.16
New investors canot act fast enough to captue any of the excess retu (that is why it is an ex
ante gain), making expansion quite attractive to the present investors. This critical point is
missed by some who analyze utility incentives. Rate base expansion is not done for the benefit of
the new investors who provide the capitaL. Those investors enter into a business traction in
which they supply fuds in exchange for shares of stock, operating at ans' length to the utility.
Utility managers want those new investors to pay as much as possible for a share of stock.
Managers expand the utility to create gains for the present investors. It would be asking a lot of
utility managers operating under the A-J effect-maagers whose primary responsibility is to
represent the interests of the present investors-not to pursue such opportities.
Case 2: The Rate of Retu Equals the Cost of Capital (A-J Effect Absent)
Now let us retrace our steps, retaining all assumptions from the prior example, except that we
wil set the rate of retur equal to the cost of capitaL. When we do, we find that for the no-
investment scenario, the stock price drops to book value, as it should according to fmance
priciples:
P. = (1,000,000)($20.00)(0.10) + (0.10 - O. 10)($0) = $20.00$OM (1,000,000)(0.10)
Now let us calculate the new stock prices that would result if the utility made the $10 million or
the $30 milion capital investments. When we do, we observe an interesting result:
P. = (1,000,000)($20.00)(0.10) + (0.10 - 0.10)($10,000,000) = $20.00$IOM (1,000,000)(0.10)
P. = (1,000,000)($20.00)(0.10) + (0.10 - 0.10)($30,000,000) $20.00$30M (1,000,000)(0.10)
If the rate of return equals the cost of capital, a utility looking out for its present investors has no
inerent incentive to expand. The stock price remains at the $20.00 book value per share in all
cases. So under the three possible scenaros, when the rate of retu equals the cost of capital, the
market value of the present investors' stock is the same-$20 million. If the rate of retu equals
the cost of capital, from the perspective of the present investors, we are in a growth-for-growt's
sake situation. Under this condition, the present investors obtain no benefits from expansion.
Energy Effciency, Decoupling, and the A-J Effect
Instead of holding the earned rate of retu constant across all expansion paths, we introduce the
following relationships:
7
1. Strategy I-Encourage energy effciency: For the utility to avoid makg a new
capacity investment, it must promote energy effciency aggressively. If it does,
without decoupling its earned rate of retu wil decline by 50 basis points relative
to its allowed rate of retu.
2. Strategy 2-Business as usual: If the utility continues on its business-as-usual
path, it wil need to build the $ i 0 milion facilty. It will earn its allowed rate of
retu.
3. Strategy 3-Promote sales: If the utilty promotes sales, without decoupling it wil
increase its eared rate of retu by 50 basis points relative to its allowed rate of
retu. It wil need to build the $30 millon facility.
In the case where the allowed retu is 12.00 percent (i.e., where the A-J effect holds), this
produces earned rates of retu of 11.50, 12.00, and 12.50 percent, respectively. Let us calculate
the utility stock prices under the three scenarios:
p = (1,000,000)($20.00)(0.1150) + (0.1 150 - O. 10)($0) $23.00encourage-EE (1,000,000)(0. 10)
P, = (1,000,000)($20.00)(0.1200) + (0.1200 - 0.10)($10,000,000) = $26.00BAU (1,000,000)(0. 10)
p = (1,000,000)($20.00)(0.1250) + (0.1250 - O. 10)($30,000,000) = $32.50promote-sa/e., (1,000,000)(0. 10)
With no decoupling mechanism in place, the utility's present investors are best off if the utility
promotes sales. This is manifested by the higher per-share stock price. Now, let us decouple the
utility. That restores the rate of return to 12.00 percent in all cases, but does not affect the
investment scale changes, as merely implementing decoupling does not prevent the utilty from
pursuing any strategy it wishes. This wil then retu us to the prices we calculated initially for
this utility. Table 1 presents the results:
Table 1
Impact of Decoupling on Utility Stock Prices
Rate of Return:; Cost of Capital (A-J Effect Holds)
No Decoupling With Decoupling
Eared Rate Stock EamedRate Stock
Strategy of Retu ""Prce of Retu "Price
Encourage Effcienèy 11.50%"-$23.00 12.00%"\$24.00
Business as Usual 12.00%..$26.00 12.0010 1l $26.00
Promote Sales 12.50%(optimal result) $32.50 12.00%(optimal result) $30.00
Table 1 shows why, in a strategic sense, the presence or absence of a decoupling mechanism is
irrelevant when the A-J effect holds. With or without decoupling, sales promotion is the optimal
strategy. Even though under decoupling the earned rate of retu is the same under all scenaros,
since the A -J effect is operating, the stock price varies directly with the change in investment
scale.
8
Capitalizing Energy Efficiency Invegtments Won't Help if the A-J Effect Holds
Since energy effciency deprives the utility of investment scale, why not allow the utility to
create some scale by capitalizing energy effciency investments? Say the regulator of our
hypothetical utility allows it to capitalize $5 milion of energy effciency expenditues. Assume
that is the level of spending required to elimiate the need for the utility to constrct either
supply-side facility.
Under decoupling, the rate of retu is restored to 12 percent, and the utility now gets to add $5
milion to the rate base. Under these conditions, the stock price wil be:
p = (1,000,000)($20.00)(0.1200) + (0.1200 - 0.10)($5,000,000) = $25.00encourage-EE (1,000,000)(0.10)
By allowing the decoup1ed utility to also ear a retu on its energy efficiency expenditues, we
add one dollar to the stock price. Nevertheless, this falls far short of the $30.00 per share stock
price that we expect to obtain if the decoup1ed utility avoids energy effciency altogether,
promotes sales, and builds the large supply-side facility.
This has extremely negative consequences for those of us interested in encouraging all utilties to
pursue energy effciency opportities. If the utilty is operating under the A-J effect, and if
promoting energy effciency programs would allow the utility to avoid a $10 bilion nuclear
plant, if we decouple the utility, what level of energy effciency expenditues would we then
need to allow the utility to capitalize just to make its present investors neutral to energy
efficiency?
The answer is $10 bilion! If the A-J effect holds, anything less leaves the present investors
worse off than they would be if the utility built the nuclear plant.
Where Decoupling Works
If the A-J effect is absent, which is the case for some utilities, then decoupling alone will make
the utility indifferent between promoting energy effciency and promoting sales. Retuing to our
hypothetical utility, recall from our earlier discussion that if the utility promotes energy
efficiency aggressively, without decoupling it lowers its eared rate of retu by 50 basis points;
if it operates under business-as-usua1 conditions, it ears its allowed rate of retu; and, if it
promotes sales, without decoupling it increases its eared rate of retu by 50 basis points
relative to the allowed retu. The new investment requirements are again $0, $10 millon, and
$30 milion, respectively, for these scenaros. If the allowed rate of retu is 10 percent, then
without a decoupling mechanism in place, we obtain the following stock prices under the various
scenaros:
p = (1,000,000)($20.00)(0.0950) + (0.0950 - 0.10)($0) $19.00encourage-EE (1,000,000)(0.10)
P. = (1,000,000)($20.00)(0.1000) + (0.10000 - 0.10)($10,000,000) = $20.00BAU (1,000,000)(0.10)
9
p = (1,000,000)($20.00)(0.1050) + (0.1050 - 0.10)($30,000,000) = $22.50promote-sales (1,000,000)(0. I 0)
Again, it is not surrising that absent decoupling, the utility's stock price is the lowest if it
promotes energy effciency aggressively, and the highest if it promotes sales. Implementing a
decoupling mechanism restores the eared rate of retu to 10 percent in all cases, and restores
the stock prices to their former leveL. Recall that when the rate of retu equals the cost of
capital, expansion creates no additional value for the present investors. The stock price is $20.00
in all expansion scenarios under that condition. Table 2 shows this result.
Table 2
Impact of Decoupling on Utilty Stock Prices
Rate of Return = Cost of Capital (A-J Effect Does Not Hold)
No Decouoling WithDecou~--
EamedRate Stock Earned Rate / Stock ..
)
Strtegy of Return "-Price of Retu Prce
Encourage Effciency 9.50%""$19.00 10.00%optimal result $20.00
Business as Usual 10.00%..$20.00 10.00%ootimal result $20.00
Promote Sales 10.50%(ootimal result) $22.50 1000%"' optimal result $20.00--
The result in Table 2 is the one that decoupling advocates intend. When the rate of retu equals
the cost of capital, under decoupling, the utility management that looks out for its present
investors is trly indifferent between promoting energy effciency aggressively and promoting
sales. The problem is that not all utilities operate under this condition.
The Uphil Climb for Energy Efficiency under the A-J Effect
So what can we do if we want a utility to make energy effciency its preferred resource option
when the A-J effect holds? If we take rate-of-return policy as a given, as I do in this article, in
terms of ratemaking adjustments, not much can be done. Decoupling won't help; nor wil
capitalizing energy effciency expenditues, unless we match the scale of the avoided supply-side
assets on a dollar-for-dollar basis, a policy that in many ways would be self-defeating.
A strctural approach may be more productive. One option that some states have implemented is
to have independent third parties deliver statewide energy efficiency programs. This allows the
utility to focus on the supply-side, which it likely wil do anyway if the A-J effect holds. That
proposal, though, raises its own set of issues, a discussion of which is beyond the scope of this
article. It might be appropriate in some instances, but not in others.
If we step back for a moment and use history as our guide, we can see that the big drvers of
utility resource policy could be external factors (e.g., changes in macroeconomic conditions,
state and Federal initiatives, fuel availability). If we reflect upon what happened during the
previous nuclear constrction cycle, it was cost escalation that led to the cancellation of many
plants. Notwithstanding the curent governent loan guarantees, the cost of nuclear power today
may rise to a level where a utility cannot make a reasonable case to build such a facility. In
addition, if recent events are indicative of changing public attitudes, it may be quite difficult to
site coal-fired units, even those that include carbon captue technology. If nuclear plants are too
10
.
expensive, and utilities can't site coal-fired plants, the list of resource options sta looking quite
short. That may leave energy efficiency as a much more attactive resource option, if by default
if nothing else.
If such external events do not obtain, however, as long as the A-J effect continues to hold, which
it likely wil for many utilties, I see little possibilty of encouraging many of those utilities to
abandon large-scale supply-side constrction plans in favor of aggressive promotion of energy
effciency. The incentive to add plant is simply too strong when the A-J effect holds.
Since decoupling mechanisms do not address energy-effciency-related investment scale impacts,
implementing such devices cannot alleviate this concern. Implementing decoupling mechanisms
for utilities not subject to the A-J effect is likely to be more productive. Those utilities focus
heavily on the eared rate of retu, which is the taget of the decoupling concept.
i Robert C. Higgins, Analysis for Financial Management, Itwn (Homewood, Ilinois), 1988, p. 231.
2 Stephen A. Ross, Randolph W. Westerfeld, and Bmdford D. Jordan, Fundamentals of Corporate Finance, Irwin
(Homewood, Ilinois), 1991, p. 214.3 Higgins, p. 231.
4 Smyth v. Ames, 171 U.S. 361 (1898)
5 Stewar C. Myers, "The Application of Finance Theory to Public Utility Rate Cases," The Bell Journal of
Economics and Management Science, 1972, p. 79.
6 Alfred Kahn, The Economics of Regulation, Vol. 1, MIT Press (Cambridge, Massachusett), 1988, p. 42.7 Wisconsin Public Service Commission, Re: Application of Madison Gas and Electric Companyfor Authority to
Change Electric and Natural Gas Rates, Final Decision, Docket 3270-UR-115 December 14, 2007, p. 27.
8 Harey Averch and Leland Johnson, "Behavior of the Firm Under Regulatory Constrint," American Economic
Review, Volume LII (1962).
9 Myron J. Gordon, The Cost of Capital to a Public Utilty, Michigan State University (East Lansing, Michigan),
1974.
10 Stewar C. Myers and Lynda S. Borucki, "Discounted Cash Flow Estimates of
the Cost of Equity Capital: A Case
Study," Financial Markets, Institutions & Instruments, 1994.
11 Steven G. Kihm, "The Proper Role of the Cost-of-Equity Concept in Pmgmatic Utility Regulation," The
Electricity Journal, December 2007..12 Market-to-book mtios are as ofJune 19,2009.
13 For example, see Southern Company, 2008 Summary Annual Report. p. 11.
14 Morningsta, "Southern Company: U.S. Offers Nuclear Loan Backing," June 18,2009.
15 Gordon, p. 3.
16 Myers, p. 80.
11
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