California has been a leader of conservation-promoting rate design in utilities for over 40 years. Beginning with the decoupling of gas and electric rates in the early 80s and water rates in 2008, the tradition of incentivizing conservation at the regulatory level has been a cornerstone to the functionality of California utilities, inspiring other states to adopt decoupled rates as well. However, recent decisions by the California Public Utilities Commission (CPUC) to discontinue full decoupling have jeopardized these mechanisms, threatening to redefine how utilities function in an environment plagued with record drought conditions, extreme weather, and economic hardship.
Decoupling – Why do we care?
Generally, decoupling is defined as a utility ratemaking mechanism that severs the dependency of revenues from actual sales. Across the nation, this has been executed in various ways from weather normalization mechanisms to conservation riders that provide reimbursement for lost revenue due to utility-sponsored conservation programs. California was the first to implement a more robust approach that completely divorced revenues from sales, allowing the utility to be kept financially whole while actively promoting reduced sales of its primary commodity. Additionally, this full decoupling protects the utility from other variances, such as extreme weather, drought, rolling black-outs, economic downturn, utility theft, and incorrect metering conditions, among others. Having this robust mechanism suddenly stripped away from water utilities begs the questions: 1) Will the Commission terminate full decoupling for electric and gas next? 2) Will other states follow California’s lead?
FactSet closely follows the regulatory environment of electric and gas utilities throughout the United States and has recently published a report on Differentiated Ratemaking. This report offers a comparison of ratemaking mechanisms (including decoupling) used by both gas and electric utilities as protection against a variety of necessary financial threats. However, trends in Commission policy often overlap between sectors, as decisions made for one regulated industry can sometimes predict precedents for others. FactSet believes many unique insights can be discovered from a comprehensive dataset derived not only from energy utilities, but water as well. Significant Commission decisions from a trend-setting state like California can potentially have cascading effects that permeate the nation’s regulatory industry across all sectors.
Conservation, Pilot Programs, and Water
In 2020, the CPUC voted to eliminate a decade-long pilot program originally intended to promote conservation. The pilot program weighed the merits between two styles of decoupling mechanisms. The first, which mimics the widely accepted decoupling procedure used by California electric companies to fully divorce revenues from actual sales, was the Water Revenue Adjustment Mechanism (WRAM) with a Modified Cost Balancing Account (MCBA). The second, which is still allowable by the CPUC but provides less protection for the utility, is the Monterey-Style WRAM (M-WRAM) with an Incremental Cost Balancing Account (ICBA).
Decoupling was first introduced to water utilities in 2008. As drought conditions worsened, it became necessary for water utilities to actively promote conservation. The WRAM/MCBA allows the company to collect its required revenues for fixed costs regardless of actual sales, which allows a utility to remain financially whole while actively promoting the disuse of its own product. Rates are calculated based on a sales forecast and a revenue requirement approved by the CPUC in a General Rate Case (GRC) application. Revenues from actual sales are recorded in the MCBA and any over-collection or under-collections are passed through to the customers via WRAM surcharge, which is regularly adjusted. While this effectively protects the company from lost revenues due to conservation efforts, it also shifts the risk of extreme weather conditions and economic downturn from the company to the customers.
The M-WRAM/ICBA achieves decoupling differently by setting a baseline water usage for each customer class and using a tiered rate structure to charge a premium for consumption over the baseline usage. Differences in revenues are calculated by comparing actual revenues to those which would have been collected without tiered rates.
Although M-WRAM does much less to protect the utility from lost revenues, the CPUC favored M-WRAM over WRAM, stating that there was not a noticeable difference in the level of conservation achieved between the two mechanisms and, therefore, the WRAM was not achieving its intended purpose. In the Commission’s order, water utilities were prohibited from proposing continuation of full WRAM decoupling in their next GRC application, while proposals of M-WRAM would still be considered.
Where We Are Now & What Happens Next…
The California water companies have since requested a rehearing (denied by the CPUC), petitioned the Supreme Court of California for a writ of review (petitions have been combined, but the case is still open), and even lobbied for legislation to be passed that would permanently bring decoupling back to the water companies. On August 29, 2022, the governor of California signed Senate Bill 1469, which requires the CPUC to consider authorizing water decoupling mechanisms.
California American Water (Cal-Am) requested consideration of a WRAM in its GRC application filed on July 1, 2022 (A. 22-07-001). The CPUC’s response noted that while legislation requires consideration of a WRAM, it gives the “…Commission discretion as to whether or not to grant the WRAM,” and asked Cal-Am to re-file its application to reflect WRAM as an alternative to M-WRAM.
This has since sparked commotion with other companies that have so far unsuccessfully attempted to obtain party-status in the Cal-Am GRC proceeding to weigh in on the topic.
On January 27, 2023, Cal-Am filed its updated application. Instead of comparing WRAM to M-WRAM, an argument already considered by the CPUC, Cal-Am opted to design an entirely new decoupling mechanism called the Water Resources Sustainability Plan (WRSP) with the Essential Service Balancing Account (ESBA) to manage any over/under collection of the WRSP. In addition to the ESBA, the WRSP includes various mechanisms that more frequently update the sales forecasts, adjust amortization, and allow for rate-design modifications. These various moving parts both allow the utility to promote conservation and maintain lesser over/under collected balances.
Given California’s reputation as a leader in conservation-oriented rate design, FactSet will be monitoring this case and any subsequent fallout closely.
This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.
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