- Email: [email protected]
Time to face FACs: How fuel clauses undermine energy efficiency
Time to-Face FACs: How Fuel Clauses Undermine Energy Efficiency Fully reconciledfuel adjustment clauses remove incentives for energy @&my on both sides of the meter The Energy Policy Act of 1992 provides a logical opportunity to re-examine!both their design and appropriateness. Richard E. Morgan
A
Rick lilorgan is manager of the Utility Regulate y Program in the Acid Rain Division of the U.S. Environmental Protection Agency. Previously he worked on regulatory matters for the Public Service Commission of the District of Columbia and the Environmental Act ion Foundat ion. The views expressed here are solely those of the author and do not necessarily reflect policies of the US. EPA.
mong the administrative actions that President Bill Clinton took during his first few months in office was to commit the United States to a timetable for reducing greenhouse gas emissions to 1990 levels. Achieving this goal will be no small undertaking for a nation whose economy has depended on ample supplies of cheap energy and is by far the world’s largest emitter of carbon dioxide (C@), the greatest contributor to global warming. Clearly a major focus of our nation’s emission reduction strategy must be the electric utility industry which alone is responsible for a third of U.S. C@ emissions and 7.5% of the worlds. The industry’s own Electric Power Research
Institute (EPRI) has estimated that through efficiency gains alone it is technically possible to reduce our electricity use by 24% to 44%, with a commensurate drop in CO2 emissions. It is no secret that the way we regulate our electric utilities creates barriers to energy efficiency For example, under the traditional ratemaking formula which fixes base rates, utilities find that successful conservation efforts reduce revenues and depress earnings. Regulators are beginning to counter this disincentive toward conservation with innovative ratemaking devices such as shared savings mechanisms and decoupling of profits from sales.
I
34
The Electricity Journal
Another significant, yet largely unrecognized, barrier to energy efficiency can be found in the ubiquitous automatic fuel adjustment clause (FAC). That is the subject of our attention here. Fuel adjustments discourage energy efficiency in several ways. First, they shift risks in a way that can bias utilities against investments that increase supply-side efficiency Second, by flowing through all changes in fuel expenditures, a fuel clause deprives the utility of some of the economic advantages of energy conservation. Finally FACs insulate utilities from certain risks associated with fossil-fuel based resources at the expense of “green” technologies such as efficiency and renewables. The enactment of the Energy Policy Act of 1992 (EPAct) provides an opportunity for state public utility commissions (WCs) to m-examine the fuel clause as it relates to energy efficiency Section 111 of EPAct mquires state PUCs to consider regulatory policy alternatives with regard to both demand-side and supply-side efficiency And as we shall see, regulators have a number of policy alternatives ranging from outright elimination of the FAC to redesign of the adjustment clause formula. I. A Review of the FACs Although the fuel adjustment clause has been around for almost a century its nearly universal ap plication is a fairly recent phenomenon. Traditionally,FACs were invoked to address fuel price fluctuations in wartime or
emergency situations, allowing utilities to pass sudden changes in fuel prices through to consumers. They were often repealed once prices stabilized. The public paid little attention to fuel clauses until the latest wave, which began with the Arab Oil Embargo in 1973. For utilities, FACs were indispensable, with fuel prices doubling in a single year. Angry consumers saw their electric rates increase by 20 percent or more almost overnight.
Fuel adjustments shift risks in a way that can bias utilities against investments that increase supply-side 6fJicieny.
cluded that FACs were a necessary evil during that era of volatile energy prices. Fears of fuel price fluctuations remain today among utilities and regulators, and more than 40 states provide for some sort of automatic fuel adjustment for major electric utilities.’ A variety of FAC designs persisted as late as the 197Os,including clauses that tracked prices or Btu consumption instead of total fuel expenditures? By the late 198Os,however, all remaining clauses could be characterized as a single type: the “cents per kWh” method which fully reconciles actual fuel expenditures with base rates. The move toward fully reconciled FACs reflected regulators’ desire to account for every penny utilities spend on fuel, although it may have inadvertently sacrificed operating efficiencies on both sides of the meter, as we shall see. II. Sacrificing Supply-Side Efficiency
Frequent nuclear plant outages aggravated the situation,as FACs shifted to billpayers the burden of high-cost replacementpower. Moreover,several documented abuses in utilities’purchasing practices helped “fuel” the controversy Critics railed against the FAC, labeling it the “fool adjustment clause” or the “nuclear unreliability clause.” Public pressure led to numerous inquiries into fuel adjustments by federal and state officials. Congress even mquired all state PUCs to review their fuel adjustment policies in 1978. In the end, most policymakers con-
“Whenratessimplytrackcosts, thriftbringsno reward,and wasteincursno pei~lty”~ This simple statement highlighted the Maine Public Utilities Commission’s plea to its state legislature in 1991 for authority to abolish the fuel adjustment clause. This argument is hardly news to anyone who has ever regulated a utility - or even to utility officials themselves. But the PUC aptly describes the effect of a fully reconciled FAC on a utility’s incentive to operate its facilities efficiently
I-
October2993
35
Under such a regime, about all a regulator can do is keep a close eye on how utilities purchase fuel and run their plants, and hope any sources of inefficiency haven’t been overlooked. Several state commissions have established reward/penalty mechanisms for power system efficiency as a substitute for the efficiency incentive that exists when fuel expenditures are subject to regulatory lag.4At best there is scant evidence that such programs have any positive impact, and at worst they encourage gaming which may be counterproductive.5 not that utilities are being devious. They are simply responding to the regulatory signals that WCs are sending them. Consider the example of a utility that has an opportunity to save $2 rnillion a year on coal by spending an extra $1 million on maintenance at a power plant. Any business operating in a free market would be foolish to pass up such a deal. But not a utility with the protection of a fuel clause! Depending on its rate case cycle, it might never recover that extra $1 million spent on maintenance. But it will surely recover every penny spent on fuel through its fully reconciled FAC. In effect, the fuel adjustment clause shifts all costs associated with fuel to the consumer, while the utility remains accountable for cost variations that are not covered by the clause. With such a mechanism in place, it is difficult for a utility to remain indifferent (as it should) between expenditures on fuel and maintenance.
t is I
36
There is compelling evidence that utilities could improve the efficiencies of their power supply systems substantially. EPRI cites potential cost-effective heat rate improvements of 2% to 4% at most fossil-fired generators.6 Further savings can be achieved through installation of amorphous metal core distribution transformers, which can cut line losses by 70% - yet they comprise only one of every ten newly installed transformers.7 Accord-
It is not that utilities are being devious. They are simply responding to the signals that PUCs are sending them.
ing to one estimate, supply-side efficiency improvements could reduce utility carbon emissions by 7%.8 There is empirical and anecdotal evidence to support the contention that fuel clauses affect the efficiency of utility system operations. A controversial 1982 FERC study of the effects of automatic adjustment clauses which gave utilities a clean bill of health on fuel purchasing practices was not so reassuring about supply-side efficiency The study linked FACs to a “tendency to use excessive fuel relative to other inputs/ not-
ing that “the dollar amounts . . . can be substantial.“’ “In most states, utilities have no direct financial interest in the use of fuel,” argues former Nevada regulator Stephen Wiel. “They are simply reimbursed dollar for dollar for what they’ve spent. They don’t have the same enthusiasm for system efficiency as if it directly affected their bottom line.“‘OIn Missouri, commission staff members believe the elimination of the FAC “lit a fire under the utilities” in terms of both system efficiency and fuel procurement. The lack of a fuel clause, they argue, has encouraged Missouri utilities to more aggressively pursue improving heat rates and reducing forced outages, while driving harder bargains for fuel as well.” Surely utilities with automatic fuel clauses aren’t totally oblivious to what they spend on fuel. After all, many are active players in wholesale markets, and they care about the effects of prices on retail consumption as well. But the yoke of discipline that regulatory lag places on a utilitys operations is substantially removed by a reconciled fuel clause, and regulators have found no effective substitute. III. Undercutting Demand-Side Efficiency “A utility’s most powerfulincentive for sellingmoreelectricityis hidden in its regulatory fuel adjustment cla~se.“~~
As former Maine regulator David Moskovitz argues here,
The Electricity Journal
automatic fuel adjustments create barriers to energy efficiency on the customer’s side of the meter as well. One such disincentive has to do with the way utilities dispatch their generation systems in order to minimize operating costs. The typical utility system includes many different generating facilities with a variety of cost profiles and sources of fuel. When kilowatt-hours are saved, the most costly supply resources tend to be backed out first, usually the least efficient generating units and the most expensive to fuel. Moreover, because T&D line losses are a geometric function of load (i.e., losses increase as the square of the current), conservation produces disproportionate savings there too. he fact that “marginal” fuel cost savings due to demandside programs tend to be higher than a utility’s average fuel cost is one of the benefits of saving energy: When a kilowatt-hour is saved through energy efficiency, savings on fuel expenses will usually be greater than the fuel cost for that kilowatt-hour. In theory, the value of this fuel savings could serve as a “cushion” to help offset some of the utilities’ DSM costs, such as program costs or foregone revenues. But what happens to this benefit if the utility has a fuel adjustment clause? Every penny of savings is flowed through to customers when the clause is reconciled with base rates. None of the benefits of the fuel cost savings remain with the utility to offset
T
October 1993
other DSM costs. Thus, the fuel clause removes a potential “sweetener” that might have helped to offset the bitter financial pill that most utilities must swallow when they pursue energy conservation. There is a “flip side” to this argument as well, which relates to sales promotion Growing sales tend to increase a utility’s fuel expenditure per kWh for the same reasons that saving energy reduces it - likely increases in line losses and heat rates. Thus, for
FACs remove a “sweetener” for the bitterfimncial pill that most utilities must swallow when they pursue conservation.
many utilities, there may be significant costs associated with sales growth. By passing through all variations in fuel costs, the fuel clause effectively insulates the utility from this cost premium on incremental sales. The magnitude of the FACrelated disincentive toward energy efficiency may not be as large as other disincentives such as lost base revenues and absence of cost-recovery treatment for DSM. The extent of this lost opportunity to offset DSM costs could vary greatly among utilities, depending upon system con-
figuration, but for many utilities it could be a significant barrier to energy efficiency The shifting of risk that occurs through the fuel clause may further dampen utility enthusiasm for saving energy Energy efficiency is a resource that offers utilities reduced risks associated with fuel price volatility This attribute is one of the great advantages of fuel-free resources, including many renewable energy technologies as well as energy conservation.13 The fuel clause, however, shifts fuel price risks from the utility to the consumer, thereby holding the utility harmless for price fluctuations. Renewables advocates argue that FACs thus diminish the perceived value of dispersed fuel-free resources in the eyes of utilities. IV. The Fully Reconciled FAC Formula Before we explore some solutions to the apparent conflict between FACs and energy efficiency, let’s review the operation of the traditional fuel clause. The purpose of a fully reconciled FAC is to pass through to consumers all changes in fuel expenditures per kWh, relative to base rates. Variation in any factor that affects fuel cost per kWh is flowed through the clause, including changes in fuel price, variations in generation or T&D efficiency,changes in system configuration, or the availability of a nuclear unit. It makes no difference whether a jurisdiction has a simple adjustment clause that addresses fuel costs alone or a broader one that
37
includes purchased power and perhaps other energy costs as well. Nor does it matter whether the clause tracks all fuel costs or just the variance from the fuel component of base rates established in the most recent rate proceeding. And it doesn’t matter if fuel costs are estimated or averaged over a period of months and later trued up. As long as fuel costs are ultimately reconciled, or trued up to reflect actual costs (as virtually all FACs do), the clause will pass through every penny of fuel cost changes. The general formula for a fully reconciled FAC looks like this:14
where
FEa= fuel expenditure, actual FEb = fuel expenditure, base The total fuel cost is the sum of
the base fuel expenditure plus the FAC adjustment. In some jurisdictions, no fuel costs are included in base rates, so all fuel costs are included in the FAC. The effect of this formula is the total pass-through to consumers of any deviation in fuel expenditures (per kWh sold) from the amount contained in base rates. The rate adjustment reflects not only changes in fuel price and fuel mix, but also variations in system efficiency,including such factors as unit heat rates, generation mix, and line losses. Moreover, since maintenance expenditures which could help to conserve fuel generally are not covered by an adjustment clause, the utility may
38
actually have a perverse incentive to avoid making fuel savings investments. Even a clause that permits only a partial pass-through of cost changes (as has been utilized in New York and California) goes only part way toward addressing disincentives toward saving energy V. Can FACs Foster Energy Efficiency? FACs can be designed in a way that eliminates most of the disincentives toward energy efficiency described above. The key to de-
With FACs, utilities may have a perverse incentive to avoid making fuel savings investments.
signing efficiency into a fuel clause is to use a formula that assumes a fixed fuel efficiency factor, such as system heat rate, instead of actual efficiencies, as is implicit in a fully reconciled FAC. This is not a new concept, but rather an old one that was still in practice in a few states until quite recently In his 1980 book Automatic Adjustment Clauses: Theory and Application, Michael Schmidt describes a FAC formula that tracks “cents per million Btu” and was in use in six states at the time.15,16In effect, this FAC formula used a fixed system heat rate, regardless of the ac-
tual heat rate experienced on the utility’s system. According to !Schrnidt,“It has been widely used to provide the utility with an incentive to use its most efficient . . . generator units for a given load.“17 The following formula for a “fixed heat rate FAC” illustrates -“. one way that a fuel clause could be designed to encourage heat rate improvements: (FE@) Fuelac@stment=
- FEN
k&hsales
where
HRr= heat rate, fixed HRa= heat rate, actual Heatrate= Btu/kWh Under such a clause, if the utility can increase its generation efficiency above the fixed heat rate, it may keep any savings until its next rate proceeding. Conversely if its system heat rate deteriorates, the utility must absorb the added fuel costs. This formula can be ap plied on a system or plant-byplant basis.18 sadly, the fixed heat rate FAC has all but died out due to the controversy in the 1970s regarding over- and undercollections, which are inevitable (if very small) without a fully reconciled clause. Perhaps the only remaining such clause is a feature in Puget Power’s periodic rate adjustment mechanism (PRAM), which the Washington [Utilities and Transportation] Commission adopted in 1991.19The PRAM, which contains a decoupling feature as well as fuel cost recovery fixes the heat rates for several coal-fired plants
The EkctricityJournal
as an incentive for Puget to maximize system efficiency Regulators can take another step toward energy efficiency by using a fixed line loss factor instead of actual line losses in the FAC formula. Here, the utility would absorb any deviation in line losses. The utility can also retain the benefits of T&D system efficiency improvements up until its next general rate case. At least one jurisdiction, New York, uses a fixed line loss factor in its fuel clause.” The following generalized formula for a “fixed efficiency FAC” is designed to encourage improvements in both heat rates and line losses:21 FE
a Fuel adj. =
x HRr
jgxa
u
-ml
kWh sales
where
latory lag. A fixed efficiency FAC would protect the utility from fuel price volatility, but would leave the utility at risk for variations in system efficiency” For a wellmanaged utility such a clause would provide an opportunity to improve its financial performance. because they are not fully reconciled, the fixed efficiency and fixed heat rate FAC models do not guarantee that customers will ultimately pay precisely what their utilities spent on fuel. While some might perceive the differ-
SaVed.
Costs related to sys tern @kiency should not be exempted porn the rigors of regulatory lag.
LLf = line loss factor,fixed Line lossfactor= kwh to load/kWhmetered.
factors could be based on historical data, or they could be based on engineering estimates or good industry practice in order to serve as targets that the utility would try to achieve. The fixed efficiency FAC addresses one of the criticisms often made of fuel clauses: that automatic adjustments should be limited to costs that are outside the control of the utility’s management. Costs related to system efficiency are squarely within a utility’s control and should not be exempted from the rigors of regu-
October2993
fuel adjustment formulas shown above are intentionally generalized and do not account for inputs other than fossil fuel, such as hydro or nuclear generation or purchased power. The generalized formula could be modified to reflect the proportion of a utility’s “kWh to load” that is generated internally by fossil fuels. To further encourage efficient system operations, this pmportion could be fixed in the clause so that the utility is held accountable for changes in fossil and nuclear unit availabilityz4 The
LLa = line loss factor, actual
The fixed heat rate and line loss
These alternative FAC models remove disincentives toward energy efficiency on the demand side as well as the supply side. Under such [models], efficiency factors that contribute to the gap between average and marginal fuel costs would no longer be lumped together in rates. With system heat rate8’ and line losses fixed in the clause formula, these variations would no longer flow through the FAC. That means the utility keeps most of the difference between average and marginal fuel costs when a kWh is
ence as an over- or undercollection, it is more properly viewed as a reward or penalty associated with changes in the utility’s system efficiency To the extent that a utility is able to significantly improve its system efficiency under a fixed efficiency FAC, it can keep the resulting fuel savings until its next general rate case. New base rates, once they are set, should reflect this savings and should therefore pass on the reduced fuel expenditures to consumers in the long run. Decreases in system efficiency would be similarly shared between the utility and its customers.
VI. Energy Policy Act
Implications enactment of the Energy Policy Act of 1992 provides a logical opportunity for regulators and interested parties to examine the impact of automatic fuel adjustments on energy efficiency. One provision in the Act requires PUCs to review the effects of their ratemaking policies on supplyside efficiency which strongly The
39
suggests a review of fuel clause procedures. Section 111 of EPAct directs PUCs and nonregulated utilities to consider three voluntary ratemaking standards related to energy efficiency It does so by amending the Public Utility Regulatory Policies Act (PURPA), a 1978 law that required WCs to consider several other voluntary ratemaking standards in the late 1970s. The first of the new PURF’Astandards requires PUCs to consider implementation of integrated resource planning (IRP). The second requires PUCs to consider policies to make investments in conservation and demand management profitable for utilities. While this standard focuses on lost revenues resulting from utility conservation programs, it could also address demand-side efficiency disincentives related to FACs. The third new PURPA standard relates most directly to fuel adjustment clauses. It requires consideration of regulatory measures to encourage “energy efficiency investments in power generation and supply” as follows: “Therateschargedby any electric utility shall be such that the utility is encouraged to make investments in, and expenditures for, all cost-effective improvements in the energy efficiency of power generation, transmission and distribution. In considering regulatory changes to achieve the objectives of this paragraph, State regulatory authorities and nonregulated electric utilities shall consider the disincentives caused by existing ratemaking policies, and practices, and consider incen-
40
tives that would encourage better maintenance, and investment in more efficient power generation,
transmission,and distribution equipment”
The Conference Report on EPAct further describes the supply-side efficiency standard as “rate changes that encourage investment in efficiency measures in generation, transmission and distribution of power.“= This suggests that PUC actions short of rate incentives (such as careful monitoring of system efficiency) would not satisfy these criteria.
PURPArequires that PUCs and nonregulated utilities commence proceedings to consider the ratemaking standards within two years, hence by October 24,1994, for the three new standards, two years after enactment of EPAct. Proceedings should be completed within three years of enactment unless an extension has been obtained from the Department of Energy Any state that has recently addressed a standard may be exempted.% In the next few years, both the supply-side and demand-side efficiency implications of fuel clauses should be subject to a thorough review in any jurisdiction that has a fully reconciled FAC. Funding for the required PUC proceedings is authorized by Section 112 of EPAct, and the administration’s proposed budget for fiscal year 1994 includes $3.5 million for this purpose. ith both billpayers’ dollars and the worlds climate on the line, it is time for PUCs to take a good, hard look at fuel adjustment clauses. Where regulators find that a FAC is necessary the mechanism can be designed in ways that minimize incentives for perverse behavior while promoting regulatory goals such as energy efficiency. ReguIators may also choose to limit adjustment clauses to factors that are clearly outside the utility’s control, such as hydro capability while leaving the utility at risk for other factors that it has the ability to manage. Even if increased risk for utility shareholders results in a higher cost of capital, consumers
W
Advocates of the new PURPA standards argue that fuel clause reform is a primary objective of the supply-side efficiency standard. In fact, when the original version of EPAct was introduced in the House, it specifically cited fuel clauses with reference to the supply-side efficiency standard. The reference to FACs was ultimately deleted from the bill so as not to single out a particular approach to supply-side efficiency,but the standard remains.
The Electricity Journal
may be better off in the long run. If regulators are convinced the fuel clause is still needed at all, they should make sure it is not working at cross purposes with their energy efficiency goals. 1 Endnotes 1. States that currently have no automatic fuel clause for major electric utilities include Arizona, Kansas, Missouri, Montana, Oregon, Texas, Vermont and Wisconsin. 2. The actual mechanics of fuel clauses can vary greatly and still have the same effect on incentives for energy efficiency. FACs may include adjustments for purchased power, or they may be part of a comprehensive energy cost adjustment clause. Some operate prospectively while others are retrospective. As long as variations in fuel expenditures are ultimately trued up to base fuel expenditures, the disincentives described herein should be of concern.
TION(Pub No. 373), IEE, Birmingham, England, May 1993 at 5.24.1. 8. S. Nadel, Improving Supply-Side Efficiency, American Council for an Energy Efficient Economy document (Jul. 27,1993) (briefing to NARUC Conservation Committee). 9. Federal Energy Regulatory Commission, Automatic Adjustment Clauses in Public Utility Rate Schedules (Feb. 1982), at 36-37. 10. Personal communication with Stephen Wiel (June 1993). 11. Personal communication with Martin Turner and John Renken, Missouri Public Service Commission (May 1993).
4. R.E. BURNS,M. EIFERT,ANDPA. NAGLER,CURRENTFAC ANDPGA PRACTICES:I~~I~LIC.~TI~NS FORRATEMAKING IN COMPETITIVE MARKETS,VOL. II: SURVEY RESPONSES,417-22 (Nat’1 Reg. Res. Inst., 1991).
6. S. Gehl, Improving the Efficiency of Fossil Power Plants, Electric Power Res. Inst. document (Jul. 27,1993) (briefing to NARUC Conservation Committee). 7. W.J. Ros, T.M. Taylor and H. Ng, Amorphous Metal Transformer Cores Save Energy and Capacity Investment, in PROCEEDINGS OFINSTITUTION OF ELECTRICALENGINEERS12~~ INTERNATIONAL CONFERENCE ON ELECTRICAL DISTRIBU-
October 1993
17. Schmidt, supra note 15, at 61. 18. If the formula is applied on a plant-by-plant basis, an adjustment would be necessary to account for changes in generating mix from the base period. 19. A similar mechanism was proposed by San Diego Gas & Electric in 1992. 20. N.Y. Pub. Serv. Comm., Opinion No. 80-24, Case No. 27137, June 18, 1980, at 31-32. 21. The author acknowledges the assistance of Neil Talbot and Bruce Biewald of Tellus Institute in developing this formula. 22. System efficiency incentives in the FAC could be combined with incentives that encourage efficient utility fuel procurement practices by linking cost recovery to a price index or benchmark. Examples include New York’s oil price indexing mechanism (N.Y PSC Opinion No. 91-19) and the “fixed weight” FAC proposed in Burns, Eifert and Nagler, supra note 4, Vol. I.
3. Maine Public Utilities Commission, Maine’s Fuel Cost Adjustment for Electric Rates, Apr. 2, 1991.
5. Most of the 13 states which reported having incentive mechanisms in the NRRI survey, supra note 4, either felt they were not working well or provided no evidence of their effectiveness.
1
16. Schmidt, supra note 15, identified Colorado, Delaware, Hawaii, North Dakota, Vermont and Wisconsin as states utilizing a Btu per kWh FAC.
12. D. MOSKOVITZ,PROFITSAND PROGRESSTHROUGHLEAST-COSTPLANNING (Nat’1 Ass’n of Reg. Utility Comm’rs Nov. 1989) at 4. 13. According to economist Shimon Awerbuch of the University of Lowell (Mass.), when such resources are evaluated using risk-adjusted approaches, they look more favorable relative to fossil fuels. 14. This generalized formula can be modified to account for purchased power and nuclear or hydro generation.
23. While there is a tendency for system heat rates to improve as energy is saved, this is not the case in every instance because of the complex nature of utility systems. 24. It may be appropriate to retain an adjustment clause that varies with hydro production, a factor that is clearly outside the utility’s control. 25. Energy Policy Act of 1992, Conference Report to Accompany H.R. 776, at 382. 26. FAC reform was actually one of the original PURPA standards in 1978, although most PUCs focused their required fuel clause proceedings on fuel procurement and management practices rather than supply-side efficiency
15. M. SCHMIDT,AUTOMATIC ADJUSTMENTCLAUSES:THEORYAND APPLICATION (1980) at 60-63,78-79.
41
A
Rick lilorgan is manager of the Utility Regulate y Program in the Acid Rain Division of the U.S. Environmental Protection Agency. Previously he worked on regulatory matters for the Public Service Commission of the District of Columbia and the Environmental Act ion Foundat ion. The views expressed here are solely those of the author and do not necessarily reflect policies of the US. EPA.
mong the administrative actions that President Bill Clinton took during his first few months in office was to commit the United States to a timetable for reducing greenhouse gas emissions to 1990 levels. Achieving this goal will be no small undertaking for a nation whose economy has depended on ample supplies of cheap energy and is by far the world’s largest emitter of carbon dioxide (C@), the greatest contributor to global warming. Clearly a major focus of our nation’s emission reduction strategy must be the electric utility industry which alone is responsible for a third of U.S. C@ emissions and 7.5% of the worlds. The industry’s own Electric Power Research
Institute (EPRI) has estimated that through efficiency gains alone it is technically possible to reduce our electricity use by 24% to 44%, with a commensurate drop in CO2 emissions. It is no secret that the way we regulate our electric utilities creates barriers to energy efficiency For example, under the traditional ratemaking formula which fixes base rates, utilities find that successful conservation efforts reduce revenues and depress earnings. Regulators are beginning to counter this disincentive toward conservation with innovative ratemaking devices such as shared savings mechanisms and decoupling of profits from sales.
I
34
The Electricity Journal
Another significant, yet largely unrecognized, barrier to energy efficiency can be found in the ubiquitous automatic fuel adjustment clause (FAC). That is the subject of our attention here. Fuel adjustments discourage energy efficiency in several ways. First, they shift risks in a way that can bias utilities against investments that increase supply-side efficiency Second, by flowing through all changes in fuel expenditures, a fuel clause deprives the utility of some of the economic advantages of energy conservation. Finally FACs insulate utilities from certain risks associated with fossil-fuel based resources at the expense of “green” technologies such as efficiency and renewables. The enactment of the Energy Policy Act of 1992 (EPAct) provides an opportunity for state public utility commissions (WCs) to m-examine the fuel clause as it relates to energy efficiency Section 111 of EPAct mquires state PUCs to consider regulatory policy alternatives with regard to both demand-side and supply-side efficiency And as we shall see, regulators have a number of policy alternatives ranging from outright elimination of the FAC to redesign of the adjustment clause formula. I. A Review of the FACs Although the fuel adjustment clause has been around for almost a century its nearly universal ap plication is a fairly recent phenomenon. Traditionally,FACs were invoked to address fuel price fluctuations in wartime or
emergency situations, allowing utilities to pass sudden changes in fuel prices through to consumers. They were often repealed once prices stabilized. The public paid little attention to fuel clauses until the latest wave, which began with the Arab Oil Embargo in 1973. For utilities, FACs were indispensable, with fuel prices doubling in a single year. Angry consumers saw their electric rates increase by 20 percent or more almost overnight.
Fuel adjustments shift risks in a way that can bias utilities against investments that increase supply-side 6fJicieny.
cluded that FACs were a necessary evil during that era of volatile energy prices. Fears of fuel price fluctuations remain today among utilities and regulators, and more than 40 states provide for some sort of automatic fuel adjustment for major electric utilities.’ A variety of FAC designs persisted as late as the 197Os,including clauses that tracked prices or Btu consumption instead of total fuel expenditures? By the late 198Os,however, all remaining clauses could be characterized as a single type: the “cents per kWh” method which fully reconciles actual fuel expenditures with base rates. The move toward fully reconciled FACs reflected regulators’ desire to account for every penny utilities spend on fuel, although it may have inadvertently sacrificed operating efficiencies on both sides of the meter, as we shall see. II. Sacrificing Supply-Side Efficiency
Frequent nuclear plant outages aggravated the situation,as FACs shifted to billpayers the burden of high-cost replacementpower. Moreover,several documented abuses in utilities’purchasing practices helped “fuel” the controversy Critics railed against the FAC, labeling it the “fool adjustment clause” or the “nuclear unreliability clause.” Public pressure led to numerous inquiries into fuel adjustments by federal and state officials. Congress even mquired all state PUCs to review their fuel adjustment policies in 1978. In the end, most policymakers con-
“Whenratessimplytrackcosts, thriftbringsno reward,and wasteincursno pei~lty”~ This simple statement highlighted the Maine Public Utilities Commission’s plea to its state legislature in 1991 for authority to abolish the fuel adjustment clause. This argument is hardly news to anyone who has ever regulated a utility - or even to utility officials themselves. But the PUC aptly describes the effect of a fully reconciled FAC on a utility’s incentive to operate its facilities efficiently
I-
October2993
35
Under such a regime, about all a regulator can do is keep a close eye on how utilities purchase fuel and run their plants, and hope any sources of inefficiency haven’t been overlooked. Several state commissions have established reward/penalty mechanisms for power system efficiency as a substitute for the efficiency incentive that exists when fuel expenditures are subject to regulatory lag.4At best there is scant evidence that such programs have any positive impact, and at worst they encourage gaming which may be counterproductive.5 not that utilities are being devious. They are simply responding to the regulatory signals that WCs are sending them. Consider the example of a utility that has an opportunity to save $2 rnillion a year on coal by spending an extra $1 million on maintenance at a power plant. Any business operating in a free market would be foolish to pass up such a deal. But not a utility with the protection of a fuel clause! Depending on its rate case cycle, it might never recover that extra $1 million spent on maintenance. But it will surely recover every penny spent on fuel through its fully reconciled FAC. In effect, the fuel adjustment clause shifts all costs associated with fuel to the consumer, while the utility remains accountable for cost variations that are not covered by the clause. With such a mechanism in place, it is difficult for a utility to remain indifferent (as it should) between expenditures on fuel and maintenance.
t is I
36
There is compelling evidence that utilities could improve the efficiencies of their power supply systems substantially. EPRI cites potential cost-effective heat rate improvements of 2% to 4% at most fossil-fired generators.6 Further savings can be achieved through installation of amorphous metal core distribution transformers, which can cut line losses by 70% - yet they comprise only one of every ten newly installed transformers.7 Accord-
It is not that utilities are being devious. They are simply responding to the signals that PUCs are sending them.
ing to one estimate, supply-side efficiency improvements could reduce utility carbon emissions by 7%.8 There is empirical and anecdotal evidence to support the contention that fuel clauses affect the efficiency of utility system operations. A controversial 1982 FERC study of the effects of automatic adjustment clauses which gave utilities a clean bill of health on fuel purchasing practices was not so reassuring about supply-side efficiency The study linked FACs to a “tendency to use excessive fuel relative to other inputs/ not-
ing that “the dollar amounts . . . can be substantial.“’ “In most states, utilities have no direct financial interest in the use of fuel,” argues former Nevada regulator Stephen Wiel. “They are simply reimbursed dollar for dollar for what they’ve spent. They don’t have the same enthusiasm for system efficiency as if it directly affected their bottom line.“‘OIn Missouri, commission staff members believe the elimination of the FAC “lit a fire under the utilities” in terms of both system efficiency and fuel procurement. The lack of a fuel clause, they argue, has encouraged Missouri utilities to more aggressively pursue improving heat rates and reducing forced outages, while driving harder bargains for fuel as well.” Surely utilities with automatic fuel clauses aren’t totally oblivious to what they spend on fuel. After all, many are active players in wholesale markets, and they care about the effects of prices on retail consumption as well. But the yoke of discipline that regulatory lag places on a utilitys operations is substantially removed by a reconciled fuel clause, and regulators have found no effective substitute. III. Undercutting Demand-Side Efficiency “A utility’s most powerfulincentive for sellingmoreelectricityis hidden in its regulatory fuel adjustment cla~se.“~~
As former Maine regulator David Moskovitz argues here,
The Electricity Journal
automatic fuel adjustments create barriers to energy efficiency on the customer’s side of the meter as well. One such disincentive has to do with the way utilities dispatch their generation systems in order to minimize operating costs. The typical utility system includes many different generating facilities with a variety of cost profiles and sources of fuel. When kilowatt-hours are saved, the most costly supply resources tend to be backed out first, usually the least efficient generating units and the most expensive to fuel. Moreover, because T&D line losses are a geometric function of load (i.e., losses increase as the square of the current), conservation produces disproportionate savings there too. he fact that “marginal” fuel cost savings due to demandside programs tend to be higher than a utility’s average fuel cost is one of the benefits of saving energy: When a kilowatt-hour is saved through energy efficiency, savings on fuel expenses will usually be greater than the fuel cost for that kilowatt-hour. In theory, the value of this fuel savings could serve as a “cushion” to help offset some of the utilities’ DSM costs, such as program costs or foregone revenues. But what happens to this benefit if the utility has a fuel adjustment clause? Every penny of savings is flowed through to customers when the clause is reconciled with base rates. None of the benefits of the fuel cost savings remain with the utility to offset
T
October 1993
other DSM costs. Thus, the fuel clause removes a potential “sweetener” that might have helped to offset the bitter financial pill that most utilities must swallow when they pursue energy conservation. There is a “flip side” to this argument as well, which relates to sales promotion Growing sales tend to increase a utility’s fuel expenditure per kWh for the same reasons that saving energy reduces it - likely increases in line losses and heat rates. Thus, for
FACs remove a “sweetener” for the bitterfimncial pill that most utilities must swallow when they pursue conservation.
many utilities, there may be significant costs associated with sales growth. By passing through all variations in fuel costs, the fuel clause effectively insulates the utility from this cost premium on incremental sales. The magnitude of the FACrelated disincentive toward energy efficiency may not be as large as other disincentives such as lost base revenues and absence of cost-recovery treatment for DSM. The extent of this lost opportunity to offset DSM costs could vary greatly among utilities, depending upon system con-
figuration, but for many utilities it could be a significant barrier to energy efficiency The shifting of risk that occurs through the fuel clause may further dampen utility enthusiasm for saving energy Energy efficiency is a resource that offers utilities reduced risks associated with fuel price volatility This attribute is one of the great advantages of fuel-free resources, including many renewable energy technologies as well as energy conservation.13 The fuel clause, however, shifts fuel price risks from the utility to the consumer, thereby holding the utility harmless for price fluctuations. Renewables advocates argue that FACs thus diminish the perceived value of dispersed fuel-free resources in the eyes of utilities. IV. The Fully Reconciled FAC Formula Before we explore some solutions to the apparent conflict between FACs and energy efficiency, let’s review the operation of the traditional fuel clause. The purpose of a fully reconciled FAC is to pass through to consumers all changes in fuel expenditures per kWh, relative to base rates. Variation in any factor that affects fuel cost per kWh is flowed through the clause, including changes in fuel price, variations in generation or T&D efficiency,changes in system configuration, or the availability of a nuclear unit. It makes no difference whether a jurisdiction has a simple adjustment clause that addresses fuel costs alone or a broader one that
37
includes purchased power and perhaps other energy costs as well. Nor does it matter whether the clause tracks all fuel costs or just the variance from the fuel component of base rates established in the most recent rate proceeding. And it doesn’t matter if fuel costs are estimated or averaged over a period of months and later trued up. As long as fuel costs are ultimately reconciled, or trued up to reflect actual costs (as virtually all FACs do), the clause will pass through every penny of fuel cost changes. The general formula for a fully reconciled FAC looks like this:14
where
FEa= fuel expenditure, actual FEb = fuel expenditure, base The total fuel cost is the sum of
the base fuel expenditure plus the FAC adjustment. In some jurisdictions, no fuel costs are included in base rates, so all fuel costs are included in the FAC. The effect of this formula is the total pass-through to consumers of any deviation in fuel expenditures (per kWh sold) from the amount contained in base rates. The rate adjustment reflects not only changes in fuel price and fuel mix, but also variations in system efficiency,including such factors as unit heat rates, generation mix, and line losses. Moreover, since maintenance expenditures which could help to conserve fuel generally are not covered by an adjustment clause, the utility may
38
actually have a perverse incentive to avoid making fuel savings investments. Even a clause that permits only a partial pass-through of cost changes (as has been utilized in New York and California) goes only part way toward addressing disincentives toward saving energy V. Can FACs Foster Energy Efficiency? FACs can be designed in a way that eliminates most of the disincentives toward energy efficiency described above. The key to de-
With FACs, utilities may have a perverse incentive to avoid making fuel savings investments.
signing efficiency into a fuel clause is to use a formula that assumes a fixed fuel efficiency factor, such as system heat rate, instead of actual efficiencies, as is implicit in a fully reconciled FAC. This is not a new concept, but rather an old one that was still in practice in a few states until quite recently In his 1980 book Automatic Adjustment Clauses: Theory and Application, Michael Schmidt describes a FAC formula that tracks “cents per million Btu” and was in use in six states at the time.15,16In effect, this FAC formula used a fixed system heat rate, regardless of the ac-
tual heat rate experienced on the utility’s system. According to !Schrnidt,“It has been widely used to provide the utility with an incentive to use its most efficient . . . generator units for a given load.“17 The following formula for a “fixed heat rate FAC” illustrates -“. one way that a fuel clause could be designed to encourage heat rate improvements: (FE@) Fuelac@stment=
- FEN
k&hsales
where
HRr= heat rate, fixed HRa= heat rate, actual Heatrate= Btu/kWh Under such a clause, if the utility can increase its generation efficiency above the fixed heat rate, it may keep any savings until its next rate proceeding. Conversely if its system heat rate deteriorates, the utility must absorb the added fuel costs. This formula can be ap plied on a system or plant-byplant basis.18 sadly, the fixed heat rate FAC has all but died out due to the controversy in the 1970s regarding over- and undercollections, which are inevitable (if very small) without a fully reconciled clause. Perhaps the only remaining such clause is a feature in Puget Power’s periodic rate adjustment mechanism (PRAM), which the Washington [Utilities and Transportation] Commission adopted in 1991.19The PRAM, which contains a decoupling feature as well as fuel cost recovery fixes the heat rates for several coal-fired plants
The EkctricityJournal
as an incentive for Puget to maximize system efficiency Regulators can take another step toward energy efficiency by using a fixed line loss factor instead of actual line losses in the FAC formula. Here, the utility would absorb any deviation in line losses. The utility can also retain the benefits of T&D system efficiency improvements up until its next general rate case. At least one jurisdiction, New York, uses a fixed line loss factor in its fuel clause.” The following generalized formula for a “fixed efficiency FAC” is designed to encourage improvements in both heat rates and line losses:21 FE
a Fuel adj. =
x HRr
jgxa
u
-ml
kWh sales
where
latory lag. A fixed efficiency FAC would protect the utility from fuel price volatility, but would leave the utility at risk for variations in system efficiency” For a wellmanaged utility such a clause would provide an opportunity to improve its financial performance. because they are not fully reconciled, the fixed efficiency and fixed heat rate FAC models do not guarantee that customers will ultimately pay precisely what their utilities spent on fuel. While some might perceive the differ-
SaVed.
Costs related to sys tern @kiency should not be exempted porn the rigors of regulatory lag.
LLf = line loss factor,fixed Line lossfactor= kwh to load/kWhmetered.
factors could be based on historical data, or they could be based on engineering estimates or good industry practice in order to serve as targets that the utility would try to achieve. The fixed efficiency FAC addresses one of the criticisms often made of fuel clauses: that automatic adjustments should be limited to costs that are outside the control of the utility’s management. Costs related to system efficiency are squarely within a utility’s control and should not be exempted from the rigors of regu-
October2993
fuel adjustment formulas shown above are intentionally generalized and do not account for inputs other than fossil fuel, such as hydro or nuclear generation or purchased power. The generalized formula could be modified to reflect the proportion of a utility’s “kWh to load” that is generated internally by fossil fuels. To further encourage efficient system operations, this pmportion could be fixed in the clause so that the utility is held accountable for changes in fossil and nuclear unit availabilityz4 The
LLa = line loss factor, actual
The fixed heat rate and line loss
These alternative FAC models remove disincentives toward energy efficiency on the demand side as well as the supply side. Under such [models], efficiency factors that contribute to the gap between average and marginal fuel costs would no longer be lumped together in rates. With system heat rate8’ and line losses fixed in the clause formula, these variations would no longer flow through the FAC. That means the utility keeps most of the difference between average and marginal fuel costs when a kWh is
ence as an over- or undercollection, it is more properly viewed as a reward or penalty associated with changes in the utility’s system efficiency To the extent that a utility is able to significantly improve its system efficiency under a fixed efficiency FAC, it can keep the resulting fuel savings until its next general rate case. New base rates, once they are set, should reflect this savings and should therefore pass on the reduced fuel expenditures to consumers in the long run. Decreases in system efficiency would be similarly shared between the utility and its customers.
VI. Energy Policy Act
Implications enactment of the Energy Policy Act of 1992 provides a logical opportunity for regulators and interested parties to examine the impact of automatic fuel adjustments on energy efficiency. One provision in the Act requires PUCs to review the effects of their ratemaking policies on supplyside efficiency which strongly The
39
suggests a review of fuel clause procedures. Section 111 of EPAct directs PUCs and nonregulated utilities to consider three voluntary ratemaking standards related to energy efficiency It does so by amending the Public Utility Regulatory Policies Act (PURPA), a 1978 law that required WCs to consider several other voluntary ratemaking standards in the late 1970s. The first of the new PURF’Astandards requires PUCs to consider implementation of integrated resource planning (IRP). The second requires PUCs to consider policies to make investments in conservation and demand management profitable for utilities. While this standard focuses on lost revenues resulting from utility conservation programs, it could also address demand-side efficiency disincentives related to FACs. The third new PURPA standard relates most directly to fuel adjustment clauses. It requires consideration of regulatory measures to encourage “energy efficiency investments in power generation and supply” as follows: “Therateschargedby any electric utility shall be such that the utility is encouraged to make investments in, and expenditures for, all cost-effective improvements in the energy efficiency of power generation, transmission and distribution. In considering regulatory changes to achieve the objectives of this paragraph, State regulatory authorities and nonregulated electric utilities shall consider the disincentives caused by existing ratemaking policies, and practices, and consider incen-
40
tives that would encourage better maintenance, and investment in more efficient power generation,
transmission,and distribution equipment”
The Conference Report on EPAct further describes the supply-side efficiency standard as “rate changes that encourage investment in efficiency measures in generation, transmission and distribution of power.“= This suggests that PUC actions short of rate incentives (such as careful monitoring of system efficiency) would not satisfy these criteria.
PURPArequires that PUCs and nonregulated utilities commence proceedings to consider the ratemaking standards within two years, hence by October 24,1994, for the three new standards, two years after enactment of EPAct. Proceedings should be completed within three years of enactment unless an extension has been obtained from the Department of Energy Any state that has recently addressed a standard may be exempted.% In the next few years, both the supply-side and demand-side efficiency implications of fuel clauses should be subject to a thorough review in any jurisdiction that has a fully reconciled FAC. Funding for the required PUC proceedings is authorized by Section 112 of EPAct, and the administration’s proposed budget for fiscal year 1994 includes $3.5 million for this purpose. ith both billpayers’ dollars and the worlds climate on the line, it is time for PUCs to take a good, hard look at fuel adjustment clauses. Where regulators find that a FAC is necessary the mechanism can be designed in ways that minimize incentives for perverse behavior while promoting regulatory goals such as energy efficiency. ReguIators may also choose to limit adjustment clauses to factors that are clearly outside the utility’s control, such as hydro capability while leaving the utility at risk for other factors that it has the ability to manage. Even if increased risk for utility shareholders results in a higher cost of capital, consumers
W
Advocates of the new PURPA standards argue that fuel clause reform is a primary objective of the supply-side efficiency standard. In fact, when the original version of EPAct was introduced in the House, it specifically cited fuel clauses with reference to the supply-side efficiency standard. The reference to FACs was ultimately deleted from the bill so as not to single out a particular approach to supply-side efficiency,but the standard remains.
The Electricity Journal
may be better off in the long run. If regulators are convinced the fuel clause is still needed at all, they should make sure it is not working at cross purposes with their energy efficiency goals. 1 Endnotes 1. States that currently have no automatic fuel clause for major electric utilities include Arizona, Kansas, Missouri, Montana, Oregon, Texas, Vermont and Wisconsin. 2. The actual mechanics of fuel clauses can vary greatly and still have the same effect on incentives for energy efficiency. FACs may include adjustments for purchased power, or they may be part of a comprehensive energy cost adjustment clause. Some operate prospectively while others are retrospective. As long as variations in fuel expenditures are ultimately trued up to base fuel expenditures, the disincentives described herein should be of concern.
TION(Pub No. 373), IEE, Birmingham, England, May 1993 at 5.24.1. 8. S. Nadel, Improving Supply-Side Efficiency, American Council for an Energy Efficient Economy document (Jul. 27,1993) (briefing to NARUC Conservation Committee). 9. Federal Energy Regulatory Commission, Automatic Adjustment Clauses in Public Utility Rate Schedules (Feb. 1982), at 36-37. 10. Personal communication with Stephen Wiel (June 1993). 11. Personal communication with Martin Turner and John Renken, Missouri Public Service Commission (May 1993).
4. R.E. BURNS,M. EIFERT,ANDPA. NAGLER,CURRENTFAC ANDPGA PRACTICES:I~~I~LIC.~TI~NS FORRATEMAKING IN COMPETITIVE MARKETS,VOL. II: SURVEY RESPONSES,417-22 (Nat’1 Reg. Res. Inst., 1991).
6. S. Gehl, Improving the Efficiency of Fossil Power Plants, Electric Power Res. Inst. document (Jul. 27,1993) (briefing to NARUC Conservation Committee). 7. W.J. Ros, T.M. Taylor and H. Ng, Amorphous Metal Transformer Cores Save Energy and Capacity Investment, in PROCEEDINGS OFINSTITUTION OF ELECTRICALENGINEERS12~~ INTERNATIONAL CONFERENCE ON ELECTRICAL DISTRIBU-
October 1993
17. Schmidt, supra note 15, at 61. 18. If the formula is applied on a plant-by-plant basis, an adjustment would be necessary to account for changes in generating mix from the base period. 19. A similar mechanism was proposed by San Diego Gas & Electric in 1992. 20. N.Y. Pub. Serv. Comm., Opinion No. 80-24, Case No. 27137, June 18, 1980, at 31-32. 21. The author acknowledges the assistance of Neil Talbot and Bruce Biewald of Tellus Institute in developing this formula. 22. System efficiency incentives in the FAC could be combined with incentives that encourage efficient utility fuel procurement practices by linking cost recovery to a price index or benchmark. Examples include New York’s oil price indexing mechanism (N.Y PSC Opinion No. 91-19) and the “fixed weight” FAC proposed in Burns, Eifert and Nagler, supra note 4, Vol. I.
3. Maine Public Utilities Commission, Maine’s Fuel Cost Adjustment for Electric Rates, Apr. 2, 1991.
5. Most of the 13 states which reported having incentive mechanisms in the NRRI survey, supra note 4, either felt they were not working well or provided no evidence of their effectiveness.
1
16. Schmidt, supra note 15, identified Colorado, Delaware, Hawaii, North Dakota, Vermont and Wisconsin as states utilizing a Btu per kWh FAC.
12. D. MOSKOVITZ,PROFITSAND PROGRESSTHROUGHLEAST-COSTPLANNING (Nat’1 Ass’n of Reg. Utility Comm’rs Nov. 1989) at 4. 13. According to economist Shimon Awerbuch of the University of Lowell (Mass.), when such resources are evaluated using risk-adjusted approaches, they look more favorable relative to fossil fuels. 14. This generalized formula can be modified to account for purchased power and nuclear or hydro generation.
23. While there is a tendency for system heat rates to improve as energy is saved, this is not the case in every instance because of the complex nature of utility systems. 24. It may be appropriate to retain an adjustment clause that varies with hydro production, a factor that is clearly outside the utility’s control. 25. Energy Policy Act of 1992, Conference Report to Accompany H.R. 776, at 382. 26. FAC reform was actually one of the original PURPA standards in 1978, although most PUCs focused their required fuel clause proceedings on fuel procurement and management practices rather than supply-side efficiency
15. M. SCHMIDT,AUTOMATIC ADJUSTMENTCLAUSES:THEORYAND APPLICATION (1980) at 60-63,78-79.
41