2. Introduction and Summary1

Energy efficiency is the best choice for meeting the energy needs of California's citizens and its economy, while protecting the environment. Producing "nega-watts," "nega-watt hours" and "nega-therms" of energy by using limited energy supplies more efficiently is smart business, smart for California's ratepayers and the least-cost way to address climate change. Today we adopt a risk/reward incentive mechanism designed to extend California's commitment to making energy efficiency the highest energy resource priority. This action builds upon Assembly Bill 32, the Low Carbon Fuel Standard and other initiatives that California has taken to aggressively reduce greenhouse gases (GHG).2 It also reinforces our commitment to ensuring that overall per capita electricity consumption in California holds steady, and declines in the future for the investor-owned utilities we regulate.

By aligning shareholder and consumer interests through today's adopted incentive mechanism, we create a "win-win" regulatory framework for energy efficiency-one that provides both a meaningful level of shareholder earnings and an estimated return of over 100% on ratepayers' investment in energy efficiency as the utilities reach towards and exceed our 2006-2008 energy savings goals.3 This return represents the substantial cost savings created by displacing more expensive supply-side alternatives with energy efficiency, resulting in lower utility revenue requirements and lower customer bills.

If our savings goals for 2006-2008 are met, we estimate that energy efficiency will create $2.7 billion in net ratepayer benefits (resource savings minus investment costs), enabling California to avoid the equivalent of three giant (500 megawatt) power plants over the current three-year program cycle. In addition, the cumulative energy savings will reduce global warming pollution by an estimated 3.4 million tons of carbon dioxide in 2008, equivalent to taking about 650,000 cars off the road.4

Success in achieving the benefits of energy efficiency requires a sustained, long-term commitment to energy efficiency on the part of the utilities we regulate. To achieve this commitment, we recognize what the Energy Action Plan5 and past Commission decisions have duly noted: There is an inherent utility bias towards supply-side procurement under cost-of-service regulation, namely, that investor-owned utilities can generate earnings for shareholders when they invest in "steel-in-the-ground" supply-side resources, but not when the utilities are successful in procuring cost-effective energy efficiency.

Ensuring sustained and successful commitment to energy efficiency is best accomplished by moving away from a cost-of-service compliance regulatory framework, to one that will create a "win-win" alignment of shareholder and ratepayer interests. Today's decision creates incentives of sufficient level to ensure that utility investors and managers view energy efficiency as a core part of the utility's regulated operations that can generate meaningful earnings for its shareholders. At the same time our adopted incentive mechanism protects ratepayers' financial investment, ensures that program savings are real and verified, and imposes penalties for substandard performance.

We achieve this alignment of shareholder and ratepayer interests, in the following ways:

· The level of potential earnings under the adopted incentive mechanism represents a meaningful opportunity to earn for utility shareholders based on consideration of supply-side comparability and other factors.

· However, earnings to shareholders accrue only when utility portfolio managers produce positive net benefits (savings minus costs) for ratepayers.

· These earnings begin to accrue only as the utilities reach to meet and surpass the Commission's kWh, kW and therm savings goals.

· Earnings are greatest when savings performance is superior, not just "expected."

· All calculations of the net benefits and kW, kWh and therm achievements are independently verified by the Commission's Energy Division and its evaluation, measurement and verification (EM&V) contractors, based on adopted EM&V protocols.

· Ratepayers receive the vast majority of economic benefits, since they pay for all the energy efficiency portfolio costs.

· The shareholder "reward" side of the incentive mechanism is balanced by the risk of financial penalties for substandard performance in achieving the Commission's per kW, kWh and therm savings goals.

· Ratepayers are protected against financial losses on their investment in energy efficiency. If portfolio costs exceed the verified savings from that portfolio, shareholders are obligated to pay ratepayers back dollar-for-dollar for those negative net benefits.

· The overall level of potential earnings and penalties is capped in a manner that symmetrically limits both ratepayers' and shareholders' exposure to risks, while still encouraging superior performance.

Figure 1 illustrates the risk/reward incentive mechanism we adopt today. As this figure shows, earnings begin to accrue at a 9% sharing rate if the utility meets 85% of the Commission's savings goals. If portfolio performance achieves 100% of the goals, the earnings rate increases from 9% to 12%. Each earnings rate is a "shared-savings" percentage. This means, for example, if the combined utilities achieve 100% of the 2006-2008 savings goals and the verified net benefits (resource savings minus total portfolio costs) at that level of performance is $2.7 billion, then $2.4 billion (88%) of those net benefits goes to ratepayers and $323 million (12%) goes to utility shareholders.6

If utility portfolio performance falls to 65% of the savings goals or lower, then financial penalties begin to accrue. There are two penalty provisions, and the greater of the two applies when savings fall to (or below) the 65% threshold. The "per unit" penalties are 5¢ per kilowatt-hour (kWh), 45¢ per therm and $25 per kilowatt (kW) for each unit below the savings goal.7 The "cost-effectiveness guarantee" obligates shareholders to pay ratepayers back dollar-for-dollar for negative net benefits.

Applying these penalty provisions to the current 2006-2008 utility portfolios results in estimated penalties on the order of $144 million for all utilities combined, if performance falls to 65% of the goals. Estimated penalties increase to $238.5 million when performance falls to 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 negative net benefits under the cost-effectiveness guarantee.

As shown in Figure 1, there are no earnings or penalties within the "deadband" range of performance, i.e., greater than 65% and less than 85% of goal achievement. In order to provide reasonable limits to the risks and rewards under the incentive mechanism, penalties and earnings are capped at $450 million (all four utilities combined) for each three-year program cycle.

Table 1 presents the potential shareholder earnings and penalties at various levels of portfolio performance for all four utilities combined, based on the 2006-2008 savings goals and portfolio costs.8 Table 1 also presents the level of net benefits that accrue to ratepayers (their "return on investment") at each level of performance, after accounting for shareholder earnings or penalties. All amounts are in pre-tax dollars.

Figure 1: Adopted Incentive Mechanism Earnings/Penalty Curve

TABLE 1

Ratepayer and Shareholder "Share" of Verified Net Benefits

Under Adopted Shareholder Risk/Reward Incentive Mechanism

(Based on 2006-2008 Portfolio Costs and Savings Goals

Verified Savings % of Goals

Total Verified Net Benefits

Shareholder Earnings

Ratepayers' Savings

         

125%

$3,919

$450

cap

$3,469

120%

$3,673

$441

  

$3,232

115%

$3,427

$411

  

$3,016

110%

$3,181

$382

  

$2,799

105%

$2,935

$352

  

$2,583

100%

$2,689

$323

  

$2,366

95%

$2,443

$220

  

$2,223

90%

$2,197

$198

  

$1,999

85%

$1,951

$176

  

$1,775

80%

$1,705

$0

  

$1,705

75%

$1,459

$0

  

$1,459

70%

$1,213

$0

  

$1,213

65%

$967

($144)

  

$1,111

60%

$721

($168)

  

$889

55%

$475

($199)

  

$674

50%

$228

($239)

  

$467

45%

($18)

($276)

  

$258

40%

($264)

($378)

  

$114

35%

($510)

($450)

cap

($60)

         

As indicated above, potential earnings for the 2006-2008 program cycle start at $176 million if all four utilities achieve the minimum performance threshold of 85%, which in turn would deliver approximately $1.9 billion in net benefits. That is, if the utilities actually produce net benefits of $1.9 billion (based on verified costs and resource savings) when they reach 85% of the savings goals, then their shareholders will receive $175 million of those net benefits under the shared-savings structure we adopt today. The vast majority of the net benefits--$1.775 billion--goes to ratepayers.

Some parties to this proceeding argue that because shareholders do not put up their capital to finance energy efficiency, and therefore do not incur the associated financial risks, it would not be "fair" to ratepayers to award more than minimal shareholder earnings under the risk/reward incentive mechanism. This perspective ignores the performance risks imposed by the penalty provisions of the incentive mechanism, which are far from minimal, as well as the inherent biases that exist in favor of supply-side resources to the detriment of achieving our energy efficiency objectives.

More importantly, in considering what is fair to ratepayers, we observe that ratepayers "invest" in both supply-side and energy efficiency resources, irrespective of who puts up the initial capital. The only difference is that for steel-in-the-ground investments (generation, transmission, distribution) ratepayers have to pay not only the cost of the facilities, but also the financing costs (debt service, return-on-equity, and associated taxes) to compensate those that put up the initial capital. In contrast, since energy efficiency expenditures are expensed and reflected in rates immediately, energy efficiency saves ratepayers substantial financing costs. Those cost savings are magnified because a dollar of energy efficiency can displace far more than a dollar of supply-side investment to meet the same amount of kWh, kW and therm energy needs.

The magnitude of these cost savings produces a staggering potential return on investment for ratepayers. As discussed in today's decision, for the 2006-2008 program cycle alone, the $2.2 billion in energy efficiency investments is projected to produce over $2.7 billion in net benefits (resource benefits minus portfolio costs). This benefit is only a "potential" return on ratepayers' investment because realizing it requires portfolio management that must be more innovative, aggressive and motivated to "mine deeper" for cost-effective energy savings than ever before in California's history.

What is fair to ratepayers? We believe that it is to make sure that this large return on their investment, the kW, kWh and therm savings goals and the large reductions in GHG emissions, are actually realized with the funds authorized. By aligning shareholder and ratepayer interests, today's adopted incentive mechanism serves to ensure this result. In doing so, this mechanism produces a return in excess of 100% on ratepayers' investment in energy efficiency as the utilities achieve and surpass our 2006-2008 savings goals.9

By today's decision, we also establish the earnings claim and recovery process: There will be two interim claims during each three-year program cycle that are "progress payments" towards total expected earnings, and one final true-up claim after the program cycle is completed. We hold back 30% of the expected earnings in each interim claim to provide a margin for error in expected earnings. 10 Authorized earnings will continue to be recovered in electric distribution and gas transportation rates, pursuant to D.98-03-063.11

Each earnings claim will be based on the savings and net benefits verified in Energy Division's interim and final EM&V reports, and each claim will be submitted via compliance Advice Letter by the utilities. We establish procedures that provide numerous opportunities for the utilities and interested parties to participate, both procedurally and substantively, in the development of the draft and final EM&V reports prepared by Energy Division and its EM&V contractors. We do not restrict the final true-up process, as some parties propose. Ratepayers will only be required to share net benefits with shareholders to the extent that those net benefits actually materialize, based on Energy Division's EM&V results.

In addition, today we resolve two issues related to how energy efficiency cost-effectiveness calculations will be performed. First, we direct that the costs of shareholder incentives be included both when evaluating the cost-effectiveness of program plans submitted during the program planning cycle, as well as when conducting a cost-effectiveness review of portfolio performance in hindsight. Second, we clarify how the "free rider" adjustment should be applied to the cost side of the equation in conducting cost-effectiveness evaluations or in calculating the net benefits to be shared under the adopted incentive mechanism.12

Finally, we establish a schedule for revisiting today's adopted risk/reward incentive mechanism, after we have gained experience with implementation. We direct Energy Division to prepare an evaluation report for Commission consideration by February 1, 2011. This will enable us to consider any recommended modifications to the incentive mechanism in time for the 2012-2014 program cycle. More generally, in a concurrent phase of this proceeding we have embarked on a state-wide, strategic planning effort for our utility energy efficiency programs. This effort focuses on developing long-term programs and saving goals that extend beyond our three-year planning cycles. Today's decision, combined with our long-term planning efforts, lays a strong foundation for making energy efficiency an integral part of "business as usual" in California.

1 Attachment 1 describes the abbreviations and acronyms used in this decision.

2 Assembly Bill 32 (Stats. 2006, ch. 488) requires that statewide GHG emissions be reduced to 1990 emission levels by 2020. On January 18, 2007, Governor Schwarzenegger established the Low Carbon Fuel Standard by Executive Order S-01-07. This standard will be implemented as an "early action measure" under Assembly Bill 32 to reduce the carbon intensity of all transportation fuels in California.

3 We use the term "the utilities" to refer collectively to the utility respondents in this rulemaking: Pacific Gas and Electric Company, Southern California Edison Company, San Diego Gas and Electric Company and Southern California Gas Company.

4 D.05-09-043, mimeo., p. 3.

5 California's principal energy agencies, including this Commission, joined to create the Energy Action Plan in 2003. This plan identifies specific goals and actions to ensure that adequate, reliable and reasonably-priced electrical power and natural gas supplies are achieved and provided through cost-effective and environmentally sound strategies. A copy of the Energy Action Plan is posted on the Commission's website at http://www.cpuc.ca.gov/static/energy/electric/energy+action+plan/index.htm.

6 We fund energy efficiency programs over a three-year funding cycle, also referred to as a three-year "program cycle." We also establish annual and cumulative savings goals for each program cycle. Earnings and penalties are based on cumulative achievements.

7 As discussed in Section 5.2, we adopt this level of per-unit penalties for energy efficiency to be consistent with the penalty levels we have established under the Renewables Portfolio Standard program.

8 See Attachment 8 for a breakdown of potential earnings and penalties (and caps) by utility.

9 See Table 1 above: If 100% of the goals are achieved, the ratepayer share of net benefits is $2.366 billion, which is 107.5% of the $2.2 billion in ratepayer investment. At higher levels of performance, the return (net benefits) associated with the same level of portfolio investment will increase.

10 As discussed in this decision, we also permit the utilities to book any amounts of the progress payments that might need to be paid back to ratepayers at the final true-up claim, despite this hold-back amount, against a claim for positive earnings in the next program cycle.

11 Changes to Commission rate recovery and cost allocation procedures are beyond the scope of Phase 1, as we discuss in Section 12 below. However, we encourage the Assigned Commissioner, in consultation with Energy Division staff, to consider how cost allocation issues may be raised for Commission consideration in the future, in the appropriate procedural forum and with proper notice to all interested parties.

12 In the context of energy efficiency, "free riders" are those program participants who would have undertaken the energy efficiency activity in the absence of the program. We adjust program savings to remove the effect of free riders because their participation would have happened anyway, and therefore the savings associated with their actions cannot be considered a benefit of the program. Today we clarify that participant costs should also be adjusted to account for free riders, unless those costs represent program expenditures (utility revenue requirements).

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