Topic Area: Demand-Side Management of Electricity
Geographic Area: Massachusetts, Rhode Island and New Hampshire, USA
Focal Question: Do shared savings incentives promote demand-side management?
Sources:
(1) Eto, Joseph; Alan Destribats and Donald Schultz. 1992. "Sharing the Savings to Promote Energy Efficiency," in Regulatory Incentives for Demand-Side Management, Steven M. Nadel, Michael W. Reid and David R. Wolcott, eds. Washington, D.C.: American Council for an Energy-Efficient Economy. 1992. pp. 97-124.
(2) Rowe, John. 1990. "Making Conservation Pay: The NEES Experience." The Electricity Journal 3. December.
(3) Rowe, John. 1990. "A Do-it-yourself Editorial; Incentives for Conservation and Load Management Programs." Electric Utility Executives' Forum 125:11. May 24. P.108.
(4) Shenon, Philip W. 1980. "Many Electric Utilities Suffer as Conservation Holds Down Demand." Wall Street Journal. Oct 9, p1.
Reviewer: Aran F. Ryan, Colby '96
Review:

The Regulatory Dilemma:

Regulated electric and gas utilities dominate the energy sector. This context of regulated monopolies presents both complex regulatory issues and the opportunity for a radical reorientation of the existing regulatory structures to a utility's twin responsibilities: least-cost supply and financial profits for shareholders.

Under traditional ratemaking, regulated utilities receive a set rate of profit, based on fixed costs, for each unit of electricity sold; variable costs are passed on to the ratepayer. Once the rate is set for a time period, it is in the profit-maximizing interest of the utility to sell as many kWh's as possible. The traditional structure presents substantial barriers to conservation-minded demand-side management (DSM) regulations. The end run approach has two parts:
1) Regulatory reform to "decouple" profits from sales, removing the clearest disincentive to conservation,
2) Creation of incentives for DSM
The case reviewed below is an example of reformed regulation which hits both chords.

Background: A Conservation Minded Utility
The principles which have guided New England Electric System (NEES), a Massachusetts-based utility holding company, to its position as a national leader in DSM were fostered by the energy crises of the 1970s. During the late 1960s and early 1970s, while other utilities were busy constructing additional plants to serve the forecasted growth in electricity demand, NEES hesitated. Chairman Guy W. Nicholas was quoted as sensing that something "was going to go wrong" with oil supplies. The Arab oil embargo in 1973 and the ensuing energy crisis sparked conservation efforts which slashed forecasts for annual growth of electricity demand to 2 -3% from 7%. NEES weathered this shakedown much better than its industry counterparts such as Northeast Utility of Connecticut whose capital intensive build-up led it to forecast an excess capacity in 1980 of 40.3% on its peak-use day. NEES had indeed taken a risk; increasing demand could have caught it unprepared. Instead its ratepayers benefited from minimized overhead, and its shareholders were rewarded when NEES received high financial security ratings. NEES had learned the valuable lesson that capacity did not ensure profits, opening it to the perspective that DSM was not a trojan horse and could instead create value for its shareholders (Shenon, 1980).

The NEES Shared-Savings Proposal:
In September 1989 NEES submitted a plan to the regulatory authorities in Massachusetts, New Hampshire, and Rhode Island which proposed that NEES receive a portion of the "savings" resulting from DSM programs it was prepared to institute. CEO John Rowe outlined an aggressive agenda by which NEES would spend $65 million, approximately 4% of revenues, on DSM - effectively reducing the amount of electricity NEES could sell. The proposal, which had been developed in cooperation with the Conservation Law Foundation of New England (CLF), a Boston-based environmental advocacy group, was approved by mid-1990 by all three states with varied minor adjustments.

Shared-savings programs aim to break the link between profits and sales by rewarding the utility with a fixed portion of the estimated consumer surplus, calculated in terms of net present value, generated by using cost-effective demand-side measures to avoid costs. The reward structure is designed so that the utility has the opportunity to increase profits by earning a reward greater than the cost of lost sales. In the case of two of NEES's utilities this was achieved as follows:
1) The expected net benefit is determined: The net consumer surplus, or net resource value, is equal to the total avoided supply costs (fixed and variable) minus the total cost of the DSM programs.
2) DSM costs are recovered: To reduce the risk of implementing DSM programs the total cost of the programs was to be recovered by the utility at the end of the year incurred.
3) The reward: A portion of the net benefit is distributed to the utility. For both Narragansett Electric (NE) and Granite State Electric (GSE) the reward incentive was 10% of the net resource value (to encourage cost-effective DSM) plus 5% of the total avoided cost (an incentive to pursue all DSM opportunities, and not just "cream-skimming" those offering the greatest marginal net value). NE was allowed to earn the incentive on all savings beyond 50% of the goal net resource value. GSE on the other hand earned the incentive on all savings, not just those in excess of 50%, but only once a threshold was exceeded.
4) Lost Revenues: By definition DSM reduces the growth of sales. In the case of NEES the revenue lost through decreased sales volume was accounted for in the wholesale rates set by the Federal Energy Regulatory Commission (FERC) which allowed NEES a reasonable return on investment.

Initial 1990 Program Results (1990 Mil$)
NE
GSE
Avoided utility supply costs
42.3
4.4
Utility DSM program expenditures
14.7
1.7
Estimated customer contribution
1.8
0.2
Net resource value
25.8
2.5
Shared-savings incentive
1.6
0.2
Other incentives
1.3
0.2
Total incentive
2.9
0.4
DSM expenditures as a percent of utility revenues
0.6%
0.1%
Total incentive as a percent of DSM program expenditures
20%
24%
Total incentive as a percent of utility program cost and customer contribution
18%
21%
Source: PG&E, 1991; and Hutchinson, 1991; within Eto, Joseph; Alan Destibats and Donald Schultz, 1992.


Analysis and Conclusion:
In this case the shared-savings program was profitable - NE and GSE earned an estimated 18 and 21% rate of return, respectively, on program costs. The total incentive return to NEES was approximately 12% of costs. Both NE and GSE generated a positive net resource value representing a cost avoided by society. This is an applied example of shared-savings functioning as a positive incentive to DSM, decoupling profits from sales in a performance based system which created benefits for ratepayers and utilities.

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