Utility Ratemaking for Racial Justice

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Performance-based ratemaking could help lessen racial inequities in energy burdens.

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The NAACP has long emphasized the importance of environmental and climate justice to marginalized communities, including issues in the energy sector. People of color and low-income people in the United States have higher energy burdens, live in less energy efficient homes, and have less access to distributed energy generation such as rooftop solar. Traditional cost-of-service ratemaking provides perverse incentives that have exacerbated racial inequity in energy.

Performance-based ratemaking methods, by contrast, present opportunities to remove these incentives, but their full potential to promote equity remains untapped.

Private investor-owned utilities (IOU) serve 75 percent of energy consumers in the United States. Generally speaking, IOUs’ retail rates are set based on rate cases—hearings held once every few years by a state’s energy regulator where IOUs demonstrate their historical costs and project future expenditures and where interested parties, including consumer advocates, can show contrary evidence.

After the hearing, the regulator uses a formula to set a “revenue requirement”—the amount of money an IOU is entitled to based on its costs and investments. Actual retail rates are then set based on projected energy use to meet the revenue requirement.

Although the regulation of energy is complex and split between federal and state actors, states have the ultimate say in setting retail energy rates. Traditionally, states have set rates using a cost-of-service model, which promises utilities compensation for all costs plus a return on capital investments. Under this model, if sales exceed projections, then the IOU makes more than the revenue requirement.

In addition, states have automatic adjustment mechanisms that allow rate changes between rate cases based on certain triggers; most notably, states have a fuel adjustment clause or other attritional adjustment clause that passes on any increase in the price of fuel to customers.

Cost-of-service ratemaking has been widely panned for decades because of the perverse incentives it creates. For example, because fuel and operations costs are almost perfectly passed on to consumers, IOUs always make more money for each additional unit of energy that gets put through their wires, regardless of whether that unit is providing useful power or being lost due to inefficiency. This phenomenon is known as the throughput incentive: IOUs with cost-of-service rates will never benefit from a reduction in energy distribution, whether from energy efficiency upgrades, demand management, or distributed energy generation.

These incentives have obvious implications for global challenges such as managing climate change, but they have significant distributional effects as well.

Low-income households, especially households of color, are disproportionately likely to suffer from higher energy burdens—meaning that their energy bills create disproportionately high financial pressures. People of color are also more likely to live in older, less energy efficient housing. They are also more likely to rent their homes. This arrangement poses a problem for improving efficiency because most landlords pass on utility costs to tenants.

Some states have adopted performance-based ratemaking in place of the cost-of-service model. In performance-based ratemaking, utility revenue is decoupled from total sales to eliminate the throughput incentive. Instead, IOUs are presented with revenue adjustment mechanisms (RAMs) that adjust their revenue caps, the most significant being performance-incentive mechanisms (PIMs).

PIMs increase or decrease an IOU’s revenue requirement if it meets a certain benchmark or fails to meet a certain standard. Other RAMs include fuel adjustment clauses, but also earnings-sharing mechanisms, under which the earnings or costs of programs are shared between IOUs and consumers. For example, a 2017 Hawaii earnings-sharing program allowed utilities to recoup 20 percent of the savings that customers made by increasing energy efficiency.

Performance-based ratemaking has taken many forms and has received its fair share of criticism. Regulation without “negative” PIMs––that punish bad outcomes––could actually encourage severe cost-cutting with guaranteed profits. But poorly designed “positive” PIMs—those that reward desired outcomes—could reward IOUs for ridiculously little investment. Still, performance-based ratemaking has tremendous potential for achieving public policy goals.

PIMs and RAMs have been designed to encourage reliability, customer satisfaction, energy efficiency, and distributed energy capacity among other goals. But usually, they are not concerned with distributional impacts. That is, PIMs do not require IOUs to target the households that need the most help.

More thoughtful ways of designing these mechanisms could go a long way toward combating racial inequities in energy burdens. And because racial disparities are so stark, these PIMs would not need to target race to improve equity, so regulators are unlikely to run afoul of constitutional requirements for equal protection of the law.

One possible negative PIM that could tackle the high energy burden would focus on non-weatherized homes. This PIM would require household-level or neighborhood-level data about energy burdens and energy use intensity, a measure of how much energy it takes to heat or cool an area per square foot.

With such data, a regulator can set a threshold energy use intensity and set a shrinking percentage of IOU customers that can fall below the threshold before the IOU’s revenue requirement is cut. For example, if 30 percent of a utility’s customers fall below the threshold during a study period, the regulator could say that at the end of year one, the regulator will penalize the utility if more than 27 percent of its customers still fall below the threshold, then 24 percent in year two, and so on.

To avoid unnecessary delay, where IOUs can achieve greater improvement, the PIM could also be “symmetrical,” meaning the utility would also be rewarded if it reached higher targets—such as a 5 percent reduction in a year, instead of the 3 percent required to avoid penalization.

Because homes with the highest energy burden are disproportionately households of color, low energy use intensity will help relieve racial injustice in energy burdens.

And this is only one of many possible mechanisms for promoting racial equity in energy burdens.

Well-designed utility regulation can target inequality while synergizing with policies such as renewable energy credit markets, energy efficiency credit markets, and pay-as-you-save financing programs. Through forward-thinking design of existing regulatory tools, states can build a brighter and more just energy future.

Joseph A. Ingrao

Joseph A. Ingrao is an incoming fellow at the Clean Air Council in Philadelphia.