6. Penalty Provisions and Deadband Range
The earnings/penalties curve includes a "deadband" where neither earnings nor penalties accrue. The MPS defines one end of this deadband, and the trigger for penalties defines the other end. Parties present two conceptual approaches for establishing the penalty trigger. In the next section we discuss these approaches to establishing the penalty trigger and associated deadband range, before addressing the penalty levels.
6.1. Penalty Trigger
The utilities propose that penalties be triggered when the net benefits from the portfolio become negative (PEB < 0).30 This approach is referred to as the "cost-effectiveness guarantee," and requires that utilities pay back any negative net benefits to ratepayers, dollar-for-dollar, up to the cost of the energy efficiency portfolio.
NRDC, TURN, and DRA recommend that penalties be triggered when achieved savings fall below a certain percentage of the Commissions goals, even if that occurs when portfolio net benefits are positive. Penalties would be assessed on a per unit (kW, kWh and therm) basis, for each unit below the savings goal. NRDC and DRA would combine this approach with the cost-effectiveness guarantee so that penalties would begin to accrue when either PEB < 0 or the savings achieved fall below a certain percentage of the savings goal. The two types of penalties would be additive under their proposals.31
As indicated in Attachment 2, negative net benefits under the cost-effectiveness guarantee are generally expected to start when performance falls to 40%-50% of the savings goals. The utilities argue that as long as net benefits are positive to ratepayers, ratepayers are earning a positive return on their investment in energy efficiency, and therefore it is not reasonable to impose any other type of financial penalties on the utilities. They also point out that the Commission adopted this approach for the penalty provisions under the pre-1998 shared-savings mechanism.
We agree with the utilities, NRDC and DRA that ratepayers should be protected against the risk of portfolio losses in the form of negative net benefits, and therefore adopt a cost-effectiveness guarantee provision under today's adopted incentive mechanism. However, we do not agree with the utilities that paying back negative net benefits to ratepayers is a sufficient penalty mechanism in the context of this Commission's current resource planning and procurement priorities. Today, more than any other time in our history, we are relying on energy efficiency to produce a significant level of savings through ratepayer-funded energy efficiency programs. Establishing explicit savings goals represents a departure from our development of a shared-savings incentive mechanism prior to electric restructuring and the energy crisis in California. In the early 1990s, as we sought to revitalize energy efficiency in utility resource planning, we focused on maximizing the net resource benefits from ratepayer-funded energy efficiency and tied the MPS, the penalty provisions and the earnings rate to that single parameter. Unlike today, we did not combine the objective of maximizing energy efficiency net benefits with that of achieving and exceeding specific MW, GWh or therm energy efficiency savings levels.
Therefore, in the context of today's dual objectives for energy efficiency, it is reasonable to combine a portfolio cost-effectiveness guarantee with per-unit penalty provisions that start when the utilities miss savings goals at a level of performance below the MPS. This ensures that each end of the deadband, where penalties and rewards are triggered, is structured to reflect the performance objectives discussed above. Moreover, since 2003 we have introduced penalty provisions in other areas of resource procurement that apply if the utility fails to meet specific procurement targets or obligations.
In particular, in our Renewable Portfolio Standard proceeding, we instituted a penalty of 5¢/kWh for a utility failing to meet annual Renewable Portfolio Standard procurement targets.32 We have also adopted penalty provisions in our local and system resource adequacy proceedings tied to the performance objectives for those procurements.33 Adopting penalty provisions tied to the accomplishment of energy efficiency savings goals is consistent with this direction.
In terms of how far below the MPS these penalties should begin, TURN, NRDC and DRA each propose a 15% deadband range for the individual savings metrics under their recommended earnings/penalty curve.34 Applying a comparable 15% deadband range to our adopted minimum floors for each metric (of 80%) yields a penalty trigger at 65% of the individual savings goals. This trigger level is reasonable for the reasons discussed below.
In designing a risk/reward incentive mechanism, we seek to impose financial penalties when savings performance is substandard. At the same time, there may be significant net benefits created by the energy efficiency portfolio even when it does perform below the MPS. While some parties argue for a per-unit penalty trigger above 65%, and others for one below 65%, in our judgment, a trigger at 65% of the savings goals strikes the appropriate balance among these competing considerations. 35
The risk of incurring penalties should be one that the utility can reasonably be expected to manage. The utilities have argued in this proceeding that establishing a penalty trigger at essentially any level above 40-50% of the savings goal imposes too much risk on utilities, in particular, too much forecasting risk and market risk. However, with over $2 billion in ratepayer funding, including funding for market penetration studies and process evaluations to assess what is working and what is not in program implementation, the utilities have an unprecedented amount of resources available to manage these risks. In fact, they have the flexibility to use their authorized funding to "dig deeper" to achieve more GWh, MW and MTherm savings (whether to avoid the trigger for penalties or to meet the MPS threshold for financial rewards) even if the ratio of costs to savings increases in the process.36
Moreover, the utilities have access to over ten years of completed studies on energy efficiency load impacts, savings persistence and retention, and implementation "best practices"-many of which were conducted or managed by the utilities-to draw from in managing their portfolios. And finally, the utilities have the ability to manage market and forecasting risks through portfolio diversification, since the penalty trigger is based on the GWh, MW and MTherm savings achieved from a large portfolio comprised of a broad range of energy efficiency activities. In sum, we conclude the utilities have a reasonable opportunity to manage the risk of potential penalties under a risk/reward incentive mechanism that sets the penalty trigger at 65% of the individual savings goals.
6.2. Penalty Levels
We now turn to the level of penalties below the deadband, beginning with the cost-effectiveness guarantee. All parties agree that under this guarantee, utilities will reimburse ratepayers dollar-for-dollar for any negative net benefits up to the total ratepayer investment (i.e., the total cost of the energy efficiency portfolio), subject to any penalty limits under parties' proposals. (See Section 7 below.) Except for PG&E, all parties propose that the calculation of negative net benefits be based on the same PEB metric used for calculating positive net benefits. Only PG&E proposes an alternate calculation, which produces a lower rate at which penalties would increase up to the total amount of portfolio costs.37 For example, if the utilities only achieve 35% of the savings goals, using PG&E's calculation produces negative net benefits of $369 million whereas using the PEB definition produces negative net benefits of $510 million, for all four utilities combined. (See Attachment 2.)
As discussed above, in D.05-04-051 we established how the net benefits achieved by energy efficiency should be defined for the purpose of this risk/reward incentive mechanism. We see no reason to modify this definition on the penalty side alone, as PG&E suggests. Therefore, both positive and negative net benefits produced by the energy efficiency portfolio will be based on the adopted PEB formula.
The utilities do not propose that any penalties be assessed based on missing the savings goals, and therefore have not proposed any penalty rates for this purpose. TURN, NRDC and DRA recommend a 2-tiered structure for penalty rates when achievement towards the savings goals falls below the deadband. Tier 1 rates would start right at the lower end of the deadband, and then would be superceded by higher Tier 2 penalty rates as performance falls (as a percentage of savings goals) by another 15% to 25%, depending on the proposal. Tier 1 penalty rates proposed by these parties range from 1- 2 ¢/kWh, 10- 20 ¢/therm and 5-10 dollars/kW. Their proposed Tier 2 penalty rates are exactly double the Tier 2 rates.
In developing their original proposals, DRA, NRDC and TURN used a Tier 1 penalty rate that was generally benchmarked against supply-side costs to reflect 1/8 of the cost of a kWh, kW and therm.38 In constructing their proposed shareholder incentive mechanism, NRDC, DRA and TURN chose these penalty rates in order to balance overall risk with reward in their proposals taken as a whole. Subsequent to workshops, NRDC adjusted its per-unit penalty rates in order to present its entire proposal in pre-tax form. Accordingly, NRDC's penalty rates are double those proposed by DRA and TURN (in both tiers).
On balance, all of the other structural elements of today's adopted incentive mechanism (the MPS, the deadband range and earnings potential above the MPS) are much closer to NRDC's proposal than those recommended by TURN or DRA. Therefore, as a starting point, the per-unit penalty rates corresponding to the higher levels that NRDC proposes will better serve to balance overall risks with the reward side of the incentive mechanism. Since NRDC's proposed Tier 1 (between 55% and 70% of goals) overlaps with the deadband range under today's adopted mechanism, the Tier 2 rates are more relevant for our consideration. These rates are 4¢/kWh, 40¢/therm and 20 dollars/kW.
While representing a reasonable starting point, NRDC's Tier 2 kWh rate is still significantly lower than the per unit penalty imposed on utilities if they miss their Renewable Portfolio Standard requirement. We see no reason to impose lower per kWh penalties on energy efficiency relative to renewables, particularly since energy efficiency is "first in the loading order" under California's resource procurement priorities. Therefore, we will increase NRDC's Tier 2 kWh penalty rate from 4¢ to 5¢/kWh and adjust the other per unit rates upwards to reflect a comparable increase. Making these adjustments yields the following per unit penalty rates for performance at or below 65% of goals: 5 ¢/kWh, 45 ¢/therm and $25/kW.
Adding these per unit penalties to the cost-effectiveness guarantee, as NRDC and DRA recommend, results in penalties that would pay ratepayers back more than their full investment in energy efficiency, if left uncapped.39 Instead, we will apply the larger of the per unit and cost-effectiveness guarantee penalty provisions at performance below the deadband.
Applying these penalty rates results in estimated penalties on the order of $144 million for all utilities combined if performance falls to 65% of the goals, increasing to $238.5 million at 50% of the goals. Below 50% of goals, penalties associated with the cost-effectiveness guarantee are expected to become larger than the per-unit penalties. At that point, ratepayers will receive dollar-for-dollar reimbursement for the negative net benefits. As we discuss in Section 6.3.4, our adopted per unit penalty levels in conjunction with the cost-effectivenesss guarantee and the "reward" side of the mechanism produce a reasonable balance of potential earnings and penalties on either side of the deadband.
The total level of potential penalties will be capped at the same dollar level as the cap on earnings, as discussed in Section 7 below. These penalties are intended to compensate ratepayers for their reduced benefits or increased costs on a pre-tax basis as a result of the utilities' substandard performance.
30 There is a difference among the utilities on how the cost-effectiveness guarantee translates into their proposals for the bottom end of the deadband range, however. Under its earnings/penalty curve proposal, PG&E specifies the penalty trigger (bottom of the deadband range) as 40% percentage of savings goals, at which point the cost-effectiveness guarantee takes effect. The other utilities define the bottom of the deadband range as whenever negative net benefits start, irrespective of the percentage of goals achieved. Therefore, under PG&E's penalty proposal there could be negative net benefits, but no penalty provisions, if the utility achieves 40% or more of the savings goals.
31 CE Council proposes a fixed dollar penalty of $135 (for all utilities combined) if savings falls to any level below 50% of the Commission's goals. (See Attachment 2). However, CE does not present a basis for establishing this structure to penalty provisions, or even indicate how the $135 million in penalties should be allocated among the individual utilities. Hence, we cannot evaluate this proposal in any meaningful way, and do not discuss it any further in today's decision.
32 See D.03-06-071, pp. 50-51.
33 See D.06-06-064 at pp. 66-67, and D.05-10-042 at p. 94.
34 TURN: MPS of 100%/Tier 1 penalties start at 85%; DRA: MPS of 90%/Tier 1 penalties start at 75%; NRDC: MPS of 85%/Tier 1 penalties start at 70%. Under these parties' proposals, the deadband applies to the individual metric performance, not an average of two or more.
35 For these reasons we also reject Pacific Energy Policy Center's proposal, introduced in its comments on the proposed decision, i.e., that we eliminate the deadband altogether such that per-unit penalties would start if the utilities fails to meet 85% of their annual savings goals.
36 Under the fund shifting rules adopted in D.05-09-043, utility portfolio managers are able to shift resources among budget categories within programs, as well as across programs to manage these risks, with only a few circumstances where Commission approval is required. (See D.05-09-043, Table 8.)
37 More specifically, PG&E proposes using the results from only one of the two tests of cost-effectiveness that are weighted to produce the PEB net benefit calculations per D.05-04-051, namely, the Program Administrator Cost test. See the description of the PEB formula in Section 10 below.
38 See Response to ALJ Electronic Ruling Dated March 8, 2007 Regarding Proposed Incentive Mechanism Penalty Rates of the DRA, NRDC and TURN, March 13, 2007. As explained in that filing, these parties acknowledge that the $5/kW Tier 1 rate is lower than what a 1/8 benchmark would produce, but was agreed upon as reasonable for other reasons.
39 This can be observed in Attachment 2, where under the NRDC and DRA proposals the total penalties will ultimately exceed the $2.2 billion in ratepayer investment, if left uncapped.
