Incentivizing the Transition: Cost Recovery and EE in New Jersey

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A Blog Series Covering How the Clean Energy Act is Transforming New Jersey’s EE Landscape

By EEA-NJ Staff on October 25, 2021

Welcome back to A New Era For Efficiency: a blog series on how the Clean Energy Act is transforming New Jersey’s energy efficiency landscape.

In our last post, we looked at the core programs at the heart of New Jersey’s energy efficiency transition. Under the Clean Energy Act, utilities must achieve a 2% annual reduction in electricity usage and a .75% annual reduction in gas usage. Core and non-core programs give them a framework to achieve those goals.

These mandates create a “stick” to force utilities towards a certain level of EE investment. But do utilities also have “carrots” that incentivize energy efficiency? Historically, the answer has been no. Utilities make less money when they sell less energy. Why make investments that cut your revenue?

That’s why cost recovery mechanisms—the topic of today’s blog post—are so important. These ratemaking structures make investing in energy efficiency less financially risky and more appealing for utilities.

Cost Recovery and Energy Efficiency

Why are cost recovery mechanisms so important to energy efficiency and a clean energy transition? To understand, it’s best to start with how utilities function without EE-based cost recovery mechanisms.

Utilities make more money when they sell more energy. Yet, a large portion of utility business costs don’t have a direct volumetric link to the amount of energy generated in a day. Instead, many costs stem from significant one-time infrastructure investments such as new power lines. These costs don’t shrink when demand goes down, and higher demand helps utilities recover them faster.

The resulting marketplace incentivizes utilities to create and sell as much energy as possible. Maximizing energy generation has serious drawbacks for our communities, such as air pollution and climate change. And using clean energy to reliably meet demand is challenging when utilities are incentivized to make that demand as high as they can.

Consumers can still make meaningful energy efficiency choices on their own, without changes to the ratemaking structure. Improving your home’s insulation, for example, cuts your energy use and your energy bill.

But significant energy savings will get left on the table. Up-front financing requirements mean that many consumers can’t afford energy efficiency investments on their own, even when those investments pay for themselves over time. Utilities face no incentive to help multi-family property owners and renters overcome the “split incentive” challenge, where owners pay for EE improvements but don’t enjoy the immediate savings. And utilities also face little incentive to improve efficiency in any “in front of the meter” areas of the grid that consumers don’t directly control.

There will always be costs associated with generating and distributing energy—and utilities need a way to recover those costs. The challenge for decision-makers is creating a rate structure that protects consumers and incentivizes energy efficiency while ensuring utilities stay financially healthy.

What cost recovery mechanisms can help utilities strike this balance? Let’s take a closer look:

Lost Revenue Adjustment Mechanisms (LRAMs)

Under a Lost Revenue Adjustment Mechanism, or LRAM, utilities are entitled to recover some or all of the revenue they lose when energy sales decrease because of energy efficiency improvements. While other policy levers (such as the mandates of the Clean Energy Act) push utilities towards EE investments, LRAMs mitigate the financial impact of compliance.

LRAMs are useful for getting reluctant utilities to the table when it comes to energy efficiency. But they have several drawbacks compared to more robust cost recovery programs.

At the end of the day they still create a marketplace where utilities earn more money when they sell more energy. Accurately distinguishing losses from energy efficiency programs versus losses from other factors is complicated and time-consuming. And while LRAMs don’t punish energy efficiency, they do little to encourage it.

Conservation Incentive Programs (CIPs)

In their 2007 review of utility incentives for energy efficiency, the EPA stated:

“One important test of a cost recovery and incentives policy is its impact on corporate culture. A policy providing cost recovery is an essential first step in removing financial disincentives associated with energy efficiency investment, but it will not change a utility’s core business model.”

Conservation Incentive Programs (CIPs) can contribute to that fundamental shift in corporate culture. That’s because they introduce a “carrot” to reward companies for exceeding energy efficiency standards, not just a “stick” to punish them for non-compliance.

Utilities participating in CIPS receive incentive payments for participating in energy efficiency programs, just like utilities using LRAMs. Unlike LRAM cost recovery, however, CIP incentives scale upwards as utilities invest more in energy efficiency. While the incentive to sell more energy and make more revenue still exists, there is now a counter-incentive to maximize energy efficiency and CIP incentives.

A large portion of NJ’s gas industry has been regulated through Conservation Incentive Programs (CIPs) for over a decade. Most of the state’s gas utilities opted for a CIP cost recovery mechanism when filing their settlements with the BPU, indicating the popularity of this more robust incentive program.

Full Symmetrical Decoupling

LRAMs and CIPs both weaken the connection between energy sales and revenue. Only full symmetrical decoupling, however, severs it. Because complete decoupling removes the incentive to sell as much energy as possible, it’s the most powerful foundation for building an effective energy efficiency program.

Under full decoupling, utilities and regulators forecast how much power the utility will need to provide to their service area in a year. They also estimate how much revenue the utility needs to earn over the year to cover costs. Using that data, the regulator and utility reverse-engineer the rate consumers should pay for each kilowatt or therm.

While a perfect forecast will result in the utility generating exactly the amount of energy they predicted, that’s usually not what happens in the real world. So decoupled utilities undergo a regular “truing-up” period to change their rates, accompanied by a refund or surcharge to consumers that reflects earlier mis-forecasts. These adjustments are usually small. A recent study of decoupled US utilities found that most annual adjustments were less than 1%.

Removing the incentive to sell as much energy as possible is especially important in conjunction with another important policy under the Clean Energy Act—building electrification. Building electrification can be a powerful decarbonization tool when it’s accompanied by investments in efficiency and renewables.

Without decoupling, however, utilities face a strong incentive to maximize sales related to electrification demand on the grid. That incentive can result in expensive, inefficient, and polluting investments such as companies building new power plants or encouraging homeowners to install wasteful resistance heaters. With decoupling, utilities face no penalties for making efficient and cost-effective improvements, such as weatherizing buildings. Those savings get passed onto consumers, and demand on the grid becomes lower and easier to meet through renewables.

Complete symmetrical decoupling is a means to an end—using less energy—and not a policy goal in and of itself. That’s why good program design remains important. A well-designed program will actively encourage energy efficiency, not simply provide utilities with guaranteed revenue. A well-designed program also allows for financing structures that recognize the lifetime benefits of energy efficiency investments.

The Future of Cost Recovery in New Jersey

Most NJ utilities have opted for a more progressive CIP cost recovery mechanism over the less powerful LRAM. While that’s a heartening fact, it still leaves runway for more progress towards complete symmetrical decoupling. As utility cultures shift more and more towards viewing energy efficiency as a positive good, rather than a neutral or negative one, energy efficiency advocates will continue pushing for (well-designed) complete symmetrical decoupling.

Cost recovery mechanisms will be one of the many topics up for revisitation during the new programs’ triennial review. This review, which is coming up in less than three years, will be an opportunity to advocate for further decoupling.

Want to get involved right now? Anyone can join regular meetings of the NJ Clean Energy Program’s energy efficiency stakeholder group. Register to join the next virtual meeting, which takes place on October 27 at 1pm.

EEA-NJ sits on the BPU’s Equity and Workforce Development Working Groups, where we advocate for our members’ interests as the Groups oversee program rollouts. Working Group meetings are closed-doors, but EEA-NJ members can hear updates and provide feedback for the Groups by attending our regular ad-hoc committee meetings. The next meeting will be held November 12. Contact Policy Counsel John Kolesnik at jkolesnik@eeaofnj.org for an invitation link.

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