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The new utility economics: managing the demand side.

It may seem improbable for a profit-maximizing electrical utility to pay its customers to use less electricity. But, motivated by the need to conserve energy resources, utilities across the country are doing just that. The Pacific Northwest region in particular, has been a pioneer in this conservation effort.

Our article discusses several key ideas at work in the new utility economics, and reviews some of the current forces affecting energy resource decisions. We examine strategies used by the Northwest's investor- and consumer-owned utilities, and outline related marketplace challenges. It's a complex topic, to be sure, but one in which all the region's citizens have a clear stake.

Energy Supply and Demand

In the utility world prior to conservation, energy needs were met by increasing energy supplies. Typically, increasing supplies meant building another dam, coal plant, or nuclear plant, or purchasing electricity from another utility.

However, in the 1970s, thanks to the thinking of Amory Lovins and others, another approach to energy resources surfaced. Basically, the new thinking suggested that we don't need energy or kilowatt-hours per se, we need light and heat in our homes, mechanical work done in our factories, and water pumped on our farms.

This shifting emphasis spurred development of a new analytical framework known as Integrated Resource Planning (IRP). The central idea is that utility planners integrate resources from both sides (supply and demand) of the energy market to help meet customer service needs at the least possible cost.

From the supply side come the traditional sources of energy: dams, coal and nuclear plants, etc. These are acquired by the utility and delivered to the customer through the electric meter. Energy resources are available from the demand, or customer, side as well--in the form of efficiency measures like weatherization, more efficient lighting, high efficiency motors, and so on.

Managing energy use on the customer side of the meter is called Demand-Side Management (DSM), another key term in the new utility economics. In addition to conservation measures, DSM activities can also include other tactics such as shifting electricity use from peak to off-peak times, and providing incentives for customers to switch fuels (i.e., from electric heat to a gas-fired furnace). These new tools and tactics can minimize total economic and environmental costs, while at the same time, allow utilities to reliably meet their customers' energy service needs.

Utilities in Our Region

The Pacific Northwest region, as defined in the 1980 Northwest Power Act, includes Washington, Oregon, Idaho, the western third of Montana, and fringes of Wyoming, Nevada, Utah, and California. Some 130 electrical utilities serve a population of over 9 million people throughout this region.

The region's utilities fall into two distinct categories: investor-owned and consumer-owned. The former are owned by shareholders, their stock is publicly traded, they have certain monopoly franchise rights granted by the states, and their rates are regulated by the state regulatory commissions. Our region has six investor-owned utilities, including the Montana Power Company, and they account for just under half the region's electricity sales and generation.

The Pacific Northwest is served by more than 120 consumer-owned utilities as well, and these purchase some or all of their power at a special "priority firm" rate from the Bonneville Power Administration (BPA). This group includes municipally owned enterprises, public utility districts, and rural electric cooperatives. This group accounts for about half the region's electricity sales and generation.

The region's utilities serve an annual load of about 20,000 average megawatts (aMW) of energy. Over half comes from hydropower. The rest comes, in declining order, from coal, out-of-region purchases, nuclear, gas-fired turbines, co-generation, and renewables (such as wind, solar, and geothermal).

Conservation Plans

Northwest utilities routinely speak of regional planning. But it is important to note that no single entity in the region has the authority to make all power resource decisions. As the regional planning entity, the Northwest Power Planning Council forecasts demand, examines the full range of supply options, adopts a least-cost resource plan, and consults extensively with regional interests through its public involvement process. The Act gives the Council explicit authority with regard to Bonneville's acquisition of resources, but at the individual utility level, the Council influences decisions more through its analysis and persuasion.

Thus, despite our efforts to coordinate planning, electric power decisions in the region are made through a diverse, decentralized, somewhat un-mapped and constantly evolving milieu, which reflects the independence and diverse interests of many players. Authority derives from federal, state, and local laws, from the various patterns of utility ownership and management, and from the interests and concerns of those who have a stake in what happens.

The Northwest has long enjoyed some of the lowest electric rates in the nation. Historically, rates have been comparatively low because most of our electricity has come from hydropower rather than the more expensive thermal plants that supply most of the nation. Energy efficiency provides a relatively inexpensive way to "stretch" the hydropower from our rivers without building more expensive plants or importing power from outside the region.

In its 1991 Northwest Conservation and Electric Power Plan, the Power Planning Council set resource acquisition targets for the region's public and private electric utilities. The plan directs the regional power system to acquire over 2,300 aMW of new resources for the decade, including over 1,500 aMW of conservation and efficiency resources. Figure 1 shows the conservation resources called for in the 1991 Power Plan, including the contribution of both public and private utilities.

Conservation: Incentives & Coalitions

Many of the region's utilities recognize that conservation is the lowest-cost, most flexible, most environmentally responsible source of new power. They also appreciate the value of energy efficiency as part of a broader strategy to retain businesses in their communities.

Typically, utility commercial and industrial customers are in competition with other businesses from outside the region. If the utilities fail to keep energy service costs as low as possible, their customers will be less competitive. And if its customers are less competitive, the utility also becomes less competitive.

Energy efficiency may be an obvious idea, but providing incentives for it is not. Conserved energy reduces consumer energy purchases, thus reducing utility revenues. Under traditional regulatory treatment where profits are maximized by maximizing sales, the investor-owned utility has no financial incentive to successfully conserve.

To address this problem, regulatory commissions in each Northwest state now have legal mechanisms that allow private investor-owned utilities to recover conservation expenses. The Montana Public Service commission, for instance, can award a bonus of up to 2 percent additional return on conservation investments in the rate base established for the Montana Power Company, PacifiCorp, or the Montana-Dakota Utilities Company.

Unlike the rates of investor-owned utilities, public utility rates do not require regulatory commission approval. Public utilities are owned by customers, who elect the policy-making board. If the customers or board determine that pursuing energy efficiency makes sense, utility staffs can be expected to find a way to make it happen.

The Bonneville Power Administration, the region's largest energy wholesaler, has committed to working with consumer-owned utilities to save 660 aMW (nearly half the overall regional goal) by the end of the decade. Seattle City Light's planned savings of 100 aMW represents a significant share of this target. Other major municipally owned utilities, such as Tacoma City Light and Eugene (Oregon) Water and Electric Board, have also made conservation their primary new resource choice. To these utilities, the ability to develop conservation resources hinges on Bonneville's financial support--which, as the sidebar explains, is somewhat unsure.

Large public power utilities aren't the only ones aggressively pursuing conservation. The Conservation and Renewable Energy System (CARES) represents a group of smaller public utility districts in Washington state. CARES can issue tax-exempt revenue bonds for joint participation in conservation and renewable energy resources.

Western Montana's eight public utilities, together with the Western Montana Generation and Transmission Cooperative, Inc., have proposed an "umbrella energy efficiency contract" with BPA to implement their ten-year conservation plan. The eight Montana utilities plan to pool resources and create a team approach to address common needs for program design, training, advertising, promotion, and other aspects of conservation program implementation.

New Competitive Challenges

After generations as a legal monopoly, the electric utility industry is now facing serious new competitive challenges. Among these are emerging technology, cheap natural gas, and a national trend toward deregulation.

* Emerging generation and conservation technologies. A new type of natural gas fuel cell promises clean and efficient electricity production, at a competitive price, at the location of the end user. In Japan, utilities are committed to buying 1,000 MW of fuel cell energy over the next ten years. With fuel cells, the business or even home of the future may put more power into the system than it takes out.

Another promising new technology integrates digital electronics with electric utility distribution systems. "Intelligent transmission networks" provide precise real-time feedback and control of power-using components, thus boosting effective capacity without heavy capital investment in new distribution systems. "Direct digital control" software integrates lighting, heating, ventilation, air conditioning, fire, and safety systems for complex commercial buildings; it can halve energy use and operating staff requirements while improving occupant comfort.

* Natural Gas. Currently, energy suppliers are offering to sell power from natural gas-fired combustion turbines much cheaper than coal or nuclear power. In some cases, the price is very competitive with conservation. The Clinton administration is very pro gas.

* Deregulation. The Federal Energy Regulatory Commission recently ordered the natural gas transmission pipeline industry to make its services available in an open competitive market. Thus, major industrial customers compete directly with smaller local gas distribution companies for the same supplies coming through major pipelines.

If electricity transmission were similarly deregulated so that a retail customer could buy from a competitor of the local monopoly utility, many fear that chaos would ensue. "Retail wheeling," as this is called, generates visceral interest when utilities discuss the future.

Marketplace Barriers

Unlike the top-down managed coal plant, a conservation "power plant" requires that all consumers of electricity help manage the resource. That, in turn, requires widespread understanding and acceptance of energy-efficient technologies and practices throughout the energy marketplace. Several key challenges remain. These include:

* An underdeveloped conservation infrastructure among designers, contractors, installers, realtors and other trade allies.

* A scarcity of consumer capital for investment in conservation measures. Energy-efficient technologies typically involve a higher initial cost than less efficient alternatives--even though total life-cycle costs are often lower. Many consumers lack capital to purchase the more efficient options up front.

* The short payback that most customers desire from investments in energy efficiency. For most consumers, an investment in energy conservation has lower priority than many competing options.

* A variety of institutional barriers that prevent the customer from participating even if reasonable financial incentives are available. In a classic example, residential or commercial property owners are responsible for retrofit and maintenance decisions, while tenants are responsible for paying the utility bill.


Conservation and energy efficiency programs are a key part of the integrated resource plans of Pacific Northwest electric utilities and the 1991 Northwest Power Plan. But, as with any other energy resource, conservation costs money and effort. Paying for it can drive up rates. Unlike supply-side resources, conservation reduces customer use of electricity, thereby helping to lower energy bills, even though rates may go up. Also unlike supply-side resources, utilities and participating customers may share costs of conservation measures because each benefits directly. Conservation can be a win-win arrangement for both the individual customer and the utility as a whole.

Because conservation resources are produced on the customer's side of the meter, they may require rate adjustments or other regulatory treatment to ensure that the utility's least-cost plan is also its most profitable course of action. This challenge may be the most complex of all.


Jeffrey R. Hammarlund, "Working With Trade Allies for Successful Demand-Side Management Programs," Home Energy Magazine, Vol. 10, No. 5, September/October 1993.

David O. Jermain, "Technology Innovation and its Role in the Restructuring of the Electric Utility Industry," presentation to the Northwest Power Planning Council, Hood River, Oregon, August 11, 1993.

Armory B. Lovins, Soft Energy Paths: Towards a Durable Peace (Cambridge, MA: Ballinger Publishing Co., 1977).

David Moskovitz, "Decoupling vs. Lost Revenues," presentation at the National Association of Regulatory Utility Commissioners Fourth Annual IRP Conference, Burlington, Vermont, September 14, 1992.

Northwest Power Planning Council, "1991 Northwest Conservation and Electric Power Plan," Volume I and Volume II, Parts I and II, Publication numbers 91-04 and 91-05.

Northwest Power Planning Council, "Regulatory Policies to Encourage Conservation - the Puget Regulatory Experiment," Publication number 93-1, February 17, 1993.

Northwest Power Planning Council, "The Green Book; Tracking Pacific Northwest Electric Utility Conservation Achievements, 1978-91," Publication number 93-2, February 17, 1993.

Puget Power's Decoupling Experience

"Decoupling" is one of several new demand-side management tools being considered by Montana (and other state) regulatory commissioners. Puget Sound Power and Light Company's recent experience of it may be instructive.

In October 1991, the Seattle-area utility began basing revenues and earnings on the number of customers served, rather than the number of kilowatt-hours sold. This "decoupling" of revenues from sales is meant to remove disincentives that undermine conservation.

Washington state regulators also allowed Puget Power to include, at the same time, two new cost recovery clauses. One clause offset the costs of extra power purchases in a low water year--a risk utilities had traditionally absorbed. Another clause granted recovery of the utility's cost of acquiring the conservation resource.

In addition, state regulators granted an incentive bonus to utility shareholders, based on the amount of conservation Puget Power was able to acquire. If the utility could acquire over 17 aMW, shareholders could divvy up $5 million. But if the utility acquired only 8 aMW, it would be penalized $4 million.

This highly innovative rate treatment was to continue for three years, with increases or decreases, as appropriate, managed by an annual periodic rate adjustment mechanism (PRAM).

The first PRAM aroused very little controversy. But PRAM 2 created a real storm of negative publicity. Over the year 1991-92, Puget Power had produced about 17.5 aMW of conservation savings, which triggered the incentive bonus to shareholders. However, uncooperative weather forced the utility to purchase more power than expected, driving down revenues and increasing power purchase costs. Puget's total revenue adjustment request came to nearly $100 million. Finding the attendant 9 percent rate hike unacceptable, state regulators approved only $66 million, deferring the rest to the next general rate case.

The Northwest Power Planning Council analyzed this important test case, and concluded that about one-fourth of Puget Power's increased revenue requirement in PRAM 2 came from decoupling. Most, said the Council, was due to resource costs, unrelated to decoupling. The shareholder bonus accounted for the remainder--about 7 percent--of the increase.

Though yet unfinished, the Puget Power experiment does suggest an important policy lesson. New rate treatments like decoupling can "incentivize" conservation. But if we try to achieve too many new and complex objectives at once and rates skyrocket, our innovations may fail the all-important "front page test."

Public Power's Mid-Life Crisis

A mid-life crisis always hits when you can least afford the extra complication. So it is with Bonneville Power Administration (BPA), the region's giant power marketing agency. Established in the 1930s to transmit and market electricity from the Federal Columbia River Power System, and now squeezed by both industry-wide changes and regional pressures, BPA is painfully restructuring its priorities.

At the core of this process are several related questions, no less arduous for the fact that many agencies and entities are suffering through a similar crisis. Is BPA a government agency or a business? And how, in the era of "reinventing government" so it assumes a more business-like focus on market and customers, do these categories overlap? Can the agency become more competitive by developing business plans, market strategies, new product lines? Does it make sense to decentralize authority from headquarters to field offices; how much and what kind of authority should move down the line and out into the field?

In its search for new answers, BPA is partaking of nearly a dozen different quests, including internal reviews, outside audits, and citizen forums. Each of these, we hope, will contribute to a wise future for this important agency.

Meanwhile, what happened to precipitate this identity crisis? For one thing, the money well went dry. A multi-year drought cut power production of BPA dams, and forced repeated purchases from higher cost suppliers.

Compounding BPA's financial woes was a sustained drop in aluminum prices. Rate levels for aluminum company customers--major power users--varied according to the world price of aluminum. When the price dropped, so did the power rate, forcing BPA to sell below its own cost of purchasing replacement power.

In addition, new fish and wildlife obligations required new outlays, as did the acquisition of new conservation resources. By 1993, BPA had nearly exhausted its financial reserves, and risked missing a $750 million payment to the U.S. Treasury. To stem the financial hemorrhage, the agency has raised rates to customer utilities and the aluminum companies by about 15 percent. In addition, BPA has cut back on discretionary programs, including fish and wildlife restoration and energy conservation.

The agency expresses a commitment to cost-effective conservation programs, and to capturing "lost opportunity" resources. But in all likelihood, more cuts will be required to ensure BPA's financial health.

While BPA asks fundamental questions about its identity and viability, its customers, partners, competitors, and client groups watch and wait--sometimes with great anxiety.

No group has a greater stake in BPA's future than the region's 120 or so consumer-owned utilities, who have been dependent on BPA for half a century. How will they fit into the new scheme of things? Likewise, generating utilities wonder what BPA's new transmission policies and prices will do. Utilities banking on conservation wonder whether they will be penalized or rewarded under future rate designs.

To a large extent, BPA has fulfilled its original mission--to help electrify the region and serve public power. And given the uncertainty facing BPA and the industry in general, some public utilities may decide to leave the comfortable shelter of socially conscious BPA and step out on their own as independent players.

Other utilities fear being kicked out of the nest before they can fly. But even if they stay, it seems likely the rules will change. Utilities allied with BPA may be required to pay all or most conservation program costs out of their own revenues. If BPA grants large retail customers access to its transmission, the small public utility may lose an important local industry as a customer. And if BPA "unbundles" services and sets new product prices based on actual costs, it may charge the small rural utility a lot more for its power.

In short, the deregulation of regional utilities may be a mixed blessing. Montana airline travelers know what deregulation of that industry did to reduce services and raise fares.

James H. Nybo is a conservation analyst with the Northwest Power Planning Council; Jeffrey R. Hammarlund is principal analyst with Hammarlund Energy Services. Both reside in Portland, Oregon.
COPYRIGHT 1993 University of Montana
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Title Annotation:The New Energy Economics in Montana & the Region
Author:Nybo, James H.; Hammarlund, Jeffrey R.
Publication:Montana Business Quarterly
Date:Sep 22, 1993
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