Regulation of energy companies

Regulation authorities should determine the allowed revenues of energy companies that are either natural monopolies (mainly grid companies) or are granted a monopoly of supply, such that they earn more by improving their customers’ end-use energy efficiency and not by increased energy consumption. To this end, one important element is cost recovery for energy efficiency programmes that reduce customers’ energy bills. Just as important an element is that annual revenues allowed by the regulator to the companies should not, or only to a very small extent, be based on the volume of energy or power sold or transported. By contrast, regulators should mandate that energy bills to final consumers should depend on the volume of energy or power delivered as much as possible. This will provide an adequate incentive to save energy or power.

Summary

Energy companies often earn higher revenues and profits when generating, transporting, and selling more energy. In that case, they will often loose money when their final customers save energy, be it on their own, through policy, or even through demand-side management or energy efficiency programmes by the energy companies themselves. The companies will then have a strong disincentive to run such programmes (as the photograph visualises), even if they significantly reduce their customers’ and the nation’s energy bills and total costs.Such situations may be less common in developing and emerging economy countries, in which there is high growth in energy demand, and thus, investing in cheap energy efficiency avoids or defers high costs the for expansion of grids and power plants. Still, it will depend on the regulation of such investments, whether there is an economic incentive or disincentive for energy companies to invest in energy end-use efficiency, e.g. in buildings, or whether they earn more by investing in power plants and networks. If the latter is the case, it will be a market distortion that should be removed.Regulation authorities should therefore determine the allowed revenues of energy companies that are natural monopolies (mainly grid companies) or granted a monopoly of supply in such a way that they earn more by improving their customers’ end-use energy efficiency and not by increased energy consumption.

To this end, one important element is cost recovery for energy efficiency programmes that reduce customers’ energy service bills, for energy plus energy efficiency. This will normally mean that the regulator allows energy companies to include the costs in the regulated overall revenue and hence into the energy tariffs or prices. Alternatively, the legislation can mandate a price adder (typically around 0.1 to 0.3 Eurocents per kWh) that the energy companies use to finance their energy efficiency programmes. This is common practice in many countries, particularly those that place obligations on regulated energy companies to save energy through energy efficiency programmes assisting their customers, such as in many states of the USA, in Brazil, or in Denmark. An alternative source of the cost recovery for developing countries and emerging economies could be climate finance, such as Programmes of Activities (PoA) under the Clean Development Mechanism (CDM) or Nationally Appropriate Mitigation Actions (NAMAs).
Just as important an element is that annual revenues allowed by the regulator to the companies should be based on grid length or number of customers served and should not, or only to a very small extent, be based on the volume of energy or power sold or transmitted. This decoupling of revenues from energy transmission or sales will remove the basic incentive for the regulated company to increase final energy consumption of their customers and the disincentive to operate own energy efficiency programmes. It will also remove a reason to lobby against any policy action for energy efficiency. Again, many countries have already adopted such regulation schemes, including the United Kingdom, Germany, the Netherlands, Italy, New South Wales (Australia), and many states of the USA.
The original disincentive for the regulated energy company to operate own energy efficiency programmes could also be fully converted into an incentive by offering a bonus for energy savings, either as a lump-sum – like in Italy – or as a share of the net cost savings to society – as has been California’s practice. In the USA, the National Association or Regulatory Utility Commissioners has stated already back in 1989 that “A utility’s least-cost plan for consumers should be its most profitable course of conduct” (John Rowe, foreword to Moskovitz 1989), meaning that profits allowed by regulators for energy companies investing in energy end-use efficiency programmes that reduce the consumers’ and the national bill for energy services should be higher than those allowed for investing in new power plants and lines.
In contrast to energy companies’ overall revenues, regulators should mandate that energy bills to final consumers should depend on the volume of energy or power delivered as much as possible, while fixed annual or monthly charges should be as low as possible. This will provide an adequate incentive to consumers to save energy or power.

Furthermore, countries that also regulate investments in power plants, or other energy supply infrastructure, could connect allowance to expand such an infrastructure with an obligation to show that more cost-effective energy end-use efficiency, or supply-side energy efficiency investments, have been taken first. As the above considerations show, adapting the regulation of energy companies to remove disincentives for energy efficiency and to enable them to increase, or at least not reduce their profits, when operating energy efficiency programmes is most important in combination with energy saving obligations for energy companies. However, particularly the decoupling of revenues from energy volumes will also benefit all other policies and measures for energy efficiency, as it will remove a reason for the energy companies to lobby against them. The potential impact may be quite high, but it will strongly depend on national circumstances. In principle, it can have an impact on all energy-using sectors and all kinds of energy efficiency improvement actions. If cost recovery and bonus payments for energy efficiency programmes are made conditional on cost-effectiveness, for consumers and society, of the energy savings created, cost-effectiveness will be inherently guaranteed by this regulatory mechanism.There are virtually no costs for the government associated with this regulatory instrument, as it is just another form of regulation and the costs are covered by the regulated companies. Approval of energy efficiency programmes and their costs, as well as bonus payments, may entail some effort but it can be kept quite low.

Advantages and disadvantages

Advantages

In principle, this is just a change in regulation and should be easy to introduce.
It will benefit all other policies and measures for energy efficiency, as it will remove a reason for the energy companies to lobby against them.
The cost-effectiveness of the energy savings created for consumers and society, can be inherently guaranteed by this regulatory mechanism.
There are virtually no costs for government associated with this regulatory instrument.

Disadvantages

It may be difficult to explain the matter to policymakers and the public, as the belief that energy companies have a “natural” disincentive to save energy is often deeply rooted in peoples’ minds.
Regulated companies may fear loss of profit opportunities in expansion of supply and oppose the change in regulation.

Implementation tips

Many countries in the world have already modified their energy price or network tariff regulation to provide better incentives for energy end-use efficiency to the regulated energy companies. In order to save time and avoid mistakes, policy-makers can look at these examples. Lessons learnt include:

For the full or partial decoupling of revenues from the amount of energy sold or transported to be complete, it is important to perform an ex-post correction of the allowed revenue (Politecnico di Milano et al. 2000): first, the actual revenue in the past year has to be monitored; second, the allowed revenue has to be recalculated based on the actual development of the drivers chosen (grid length, number of customers connected or supplied, capacity, energy); and third, the difference must be calculated. If the actual revenue is above the recalculated allowed revenue – be it due to weather or to a strong economy, the allowed revenues for the next period will be reduced by the difference between the two, so that the consumers will get the money back. If the actual revenue is below the recalculated allowed revenue for whatever reason – energy efficiency programmes, weather or a weak economy, the allowed revenues for the next period will be increased by the difference, so that the regulated energy company will get the money back.
Following on from these considerations, the recommended regulatory action will be more difficult to implement and less likely to achieve the desired impact on the (dis-)incentives for energy companies if regulation just continues to fix energy prices or tariffs for a certain period, instead of the overall revenue, and if no such ex-post correction of revenues is done.
All of the four types or regulatory action to remove economic disincentives for energy efficiency inherent to conventional price or revenue regulation can be performed in any kind of basic regulation scheme, be it the classical “cost-plus” or “rate-of-return” scheme or the more modern “incentive regulation” schemes.
They can also be implemented for both publicly or privately owned energy companies. Experience shows that also publicly owned energy companies are expected to make profits or at least no losses, so if increased energy sales are set as their basic driver for profits, they too will have a big disincentive to assist their customers in saving energy.
The staffing requirements for regulatory authorities to perform these actions can be kept very modest.

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Aim of policy or measure

The aim of this type of measure is that regulated energy companies should earn more by improving their customers’ end-use energy efficiency and not by increased energy consumption. Regulation authorities should therefore determine the allowed revenues of energy companies that are natural monopolies (mainly grid companies) or granted a monopoly of supply in such a way that this aim is achieved. The energy companies will thus be enabled to implement energy efficiency programmes that assist their customers with all kinds of energy efficiency improvements.

Worldwide implementation status and governance level

Worldwide implementation status
Many countries in the world have already modified their energy price or network tariff regulation to provide better incentives for energy end-use efficiency to the regulated energy companies. Very often, decoupling of revenues from energy sales or transport is found in restructured electricity and gas markets. Cost recovery for energy efficiency programmes is usually linked to energy efficiency obligations for the energy companies.

Some examples:
Among the many countries or states in the world that have already modified their energy price or network tariff regulation to provide better incentives for energy end-use efficiency to the regulated energy companies during the last 30 years are California (USA) (www.bigee.net/s/53m²ny; e.g., www.bigee.net/s/w3pphw), Italy (www.bigee.net/s/jtg7ky), and the United Kingdom (www.bigee.net/s/v15q41). Brazil also has an explicit funding and cost recovery mechanism for energy efficiency programmes, but no decoupling of energy company revenues from energy sales.

Governance level
As regulation of the prices or revenues of energy companies is usually exerted at the national or regional level, this type of policy will also be implemented at these levels of governance.

Sectoral focus

As this policy aims at a general change in incentives to energy companies, in principle all energy end-use sectors can benefit from it.

Related sectors

services
residential
industrial

Related options

All energy efficiency options can benefit from this policy in principle, since it aims at a general change in incentives to energy companies to stimulate these options.
Buildings concepts:

Low Energy Building
Ultra Low Energy Building
Zero/Plus Energy Building
Buildings options: particularly
Building envelope
Shading
Mechanical ventilation
Cooling
Heating
Domestic hot water
Lighting
Vertical transportation
User behaviour
Building energy management

Target group

Related target groups

Energy company
Energy regulator

Beneficiaries

Direct beneficiaries

Energy company
The regulated energy companies directly benefit from the policy or measure as their disincentive to assist their customers with improving energy efficiency is removed or turned into a positive incentive for such assistance.

Indirect beneficiaries

Investor-occupier
If energy companies offer more energy efficiency programmes to their customers after a change in regulation, all investors and users of energy-efficient buildings, equipment and appliances will benefit, and so will all their providers. Investor-occupiers, investors (landlords/landladies, developers, leasing companies, housing co-operations), and users (tenants, buyers of completed/ existing buildings, household members) will receive information, advice, and financial incentives and investor-occupiers and users will benefit from energy cost savings.
Manufacturer
On the supply side of energy-efficient building concepts, technologies, and solutions, property development companies, system suppliers, engineering consultants, installation contractors, facility management companies, manufacturers and retailers will see an increase in their business.

Barriers addressed

For the direct beneficiaries, i.e. the energy companies, the policy addresses the barrier, created by conventional price regulation, that they earn more by increased energy consumption.
Since energy companies usually assist their customers with energy efficiency programmes combining information and financial incentives, these programmes mainly address the following barriers:

Relevant barriers

Knowledge and information barriers: Particularly unavailability of information, and, Information and Search Costs The information component of the programmes will reduce or overcome these important barriers for potential investors but also some suppliers.
Economic and financial barriers: Especially access to financing / lack of capital and risk exposure, irreversibility, discount rate required Financial incentives or financing are direct means used to overcome such economic or financial barriers for potential investors in energy efficiency. The signal to the market will also reduce risk and uncertainty for (potential) providers of energy-efficient technologies and solutions, that a market can be found.
Lack of interest and motivation in energy efficiency-improvement: In particular: transaction costs or hassle/inconvenience (in combination with) time constraints, focus on core activities, small size and low priority The financial incentives, but also the information will motivate investors and suppliers to consider the energy-efficient technologies and solutions supported by the programmes. The programmes should make it easy to actually implement energy efficiency.

Incentives addressed

Relevant incentives

Directly increasing earnings or profits for actors on the supply side: Particularly if all three regulatory actions (recovery of programme costs; bonus for energy savings; and decoupling of revenues from energy volume) are implemented, energy companies will have a good incentive to run energy efficiency programmes, as they will increase their profits. The programmes will then also increase profits of suppliers of energy-efficient technologies and solutions to final consumers.
Improved reputation: Assisting their customers to save energy and costs will increase the reputation of energy companies and may induce them to such programmes, even if the regulator does not offer a bonus payment. However, this is usually a much weaker incentive than the bonus.
Saved energy costs: These are a major incentive for energy company customers to participate in the programmes and invest in energy efficiency.

Policy package

Adapting the regulation of energy companies to remove disincentives for energy efficiency and to enable them to increase, or at least, not reduce their profits when operating energy efficiency programmes is most important in combination with energy saving obligations for energy companies.
However, particularly the decoupling of revenues from energy volumes will also benefit all other policies and measures for energy efficiency as it will remove a reason for the energy companies to lobby against them.
In general, governments need to assess and decide which energy efficiency potentials and end-use actions they want to address through energy companies’ programmes, or alternatively, through an energy efficiency fund or through programmes directly offered and funded by the government. This will also depend on the general performance of energy companies and the regulator.

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Preconditions for implementation

An important structural pre-condition necessary to implement the policy is (1) to have a price or revenue regulation of energy companies in place, and (2) a rule or legislation that the regulatory practice shall, (a) allow cost recovery of expenses, or mandate a maximum energy price adder for energy efficiency programmes that reduce customers’ total energy service bills for energy plus energy efficiency; (b) base energy company revenues on multiple drivers and thus decouple profits from the volume of energy sales or transport; and if possible (c) offer a bonus for energy savings that reduce customers’ total energy service bills.

Agencies or other actors responsible for implementation
Design of such regulatory changes will normally be the task of government and legislation, while the regulatory authorities will be responsible for implementation.

Funding
Funding can either be provided via the energy prices and tariffs, since it will also be the energy consumers benefitting from the energy savings.
An alternative source of programme cost recovery for developing countries and emerging economies could be climate finance, such as Programmes of Activities (PoA) under the Clean Development Mechanism (CDM) or Nationally Appropriate Mitigation Actions (NAMAs).

Others
In order to prove that the energy companies’ programmes are effective in saving energy and cost-effective in reducing customers’ total energy service bills, agreed, reliable, and standardised methods for calculating savings, economic benefits, and costs need to be developed and used. An example is California’s standard practice methods. See also the part on monitoring and evaluation in the bigEE document “How to design and implement energy efficiency policies”.

Steps of design and implementation

The first step should be to analyse the current practice of revenue or price regulation as well as investment regulation in place in the country. It should determine what the incentives or disincentives are for energy companies to invest in energy efficiency as compared with investment in, and operation of, power plants and energy grids, and selling more energy to their customers.
If the results show that energy companies earn more by selling more energy and / or earn less by implementing energy efficiency programmes, the government should assess possible changes in regulation such as those discussed here to reverse this situation – make energy efficiency more profitable than expansion of energy supply.
If the assessment proves potential benefits, then the above-mentioned preconditions for implementation should be created. Implementation could start with pilot projects to collect experience on (cost-) effectiveness and increase trust in the overall benefits of the regulatory changes.

Quantitative target
Governments and legislators can set the quantitative target they want to achieve through energy company programmes. This requires knowledge of the overall and sectoral energy efficiency potentials and of the impact that is likely to be achieved with energy efficiency programmes. The target can also be mandated through an energy efficiency obligation to energy companies. It should be made consistent with the country’s overall energy efficiency targets and roadmap.

Co-operation of countries
Countries can co-operate by exchanging information and experience on principles as well as practical details, problems, and solutions to the problems of implementing such regulatory changes. The IEA’s DSM Implementing Agreement (www.bigee.net/s/k43h4p) is an example of such a co-operation.

Monitoring and evaluation

Monitoring
For the energy efficiency programmes offered by the energy companies, the regulator should request documentation from the energy companies in order to evaluate cost-effectiveness and allow cost recovery. Random checks of the accuracy of the documentation may be useful.
For evaluation of energy savings, the documentation should cover the number of participants or beneficiaries, the energy efficiency actions they have taken (e.g., purchase of energy-efficient buildings), and the unitary gross energy savings achieved by each action (either via agreed deemed savings or ex ante agreed calculations, or via ex-post evaluations). For evaluating economic benefits and costs, energy companies need to provide evidence of their costs incurred separately for the programme design, administration, communication and evaluation costs and for any financial incentives. They must also provide the incremental part of the energy or power (kW) prices that the participants/beneficiaries would have paid for the energy or power they saved. Furthermore, incremental costs by the customers to invest in energy efficiency or operate their premises and equipment in an energy-efficient way need to be estimated via market monitoring or ex-post evaluation.
For the decoupling of revenues from energy volumes, documentation needs to include the actual values of revenues and all drivers included in the formula the regulator uses to determine allowed revenues.

Evaluation
In order to be credible, evaluation should be done by independent institutes or consultants and not by the energy companies themselves, but the costs can be included in the energy prices.
The possibilities and formulas for evaluating energy savings will depend on the type of energy efficiency action supported as well as the type of energy efficiency programme (e.g., programmes focussing only on provision of information are more difficult to evaluate than financial incentive programmes. See our detailed files on these types of policies and measures). The same holds for economic benefits and costs, from the perspective of either the customer/participant or that of the national economy/society. The USA particularly has a long-standing experience in evaluation methods.
In addition to the data directly monitored for the energy efficiency programmes, evaluation of net energy savings compared to baseline trends should address side-effects such as rebound, multiplier, and free-rider effects; and the ‘lifetime’ and potential deterioration of energy savings.
For the economic benefits from the perspective of the national economy/society, standard values for the incremental energy supply costs that will be avoided in the long run for a kWh of energy or a kW of load should be developed by the regulatory authority.

Policy dynamics and handling side-effects

Relevant individual dynamics and side-effects

Dynamic market transformation and/or innovation: Regulators should motivate the energy companies to aim at dynamic market transformation and or innovation in technologies, behavioural or organisational approaches, through the programmes they implement.
Avoiding lost opportunities: The energy companies’ programmes should also aim to avoid lost opportunities by trying to maximise both participation rates and energy savings per participant or for the energy-efficient technologies and solutions promoted.
Minimising rebound effects: Regulators should also survey the energy companies’ programmes so that they are designed to minimise rebound effects. This can include absolute limits on the energy consumption of buildings promoted, as well as educating consumers on energy-efficient use of buildings and equipment.
Minimising snap-back effects: Snap-back effects can also be minimised through continuation of programmes to mainstream energy-efficient technologies and solutions for as long as they are needed, maybe for a full renovation cycle, to upgrade the whole stock of buildings and equipment to high energy efficiency levels. Securing these levels through legal minimum energy performance standards may reduce the need to continue information and incentive programmes.
Minimising free-rider effects: The programmes should also be designed to minimise free-rider effects, e.g., by promoting only technologies and solutions with high energy efficiency levels while maximising uptake of these at the expense of low-efficiency solutions.
Creating Spill-over effects: In order to maximise spill-over effects, the programmes can be discontinued if the energy-efficient technologies and solutions have become the mainstream. However, care needs to be taken that the markets don’t “snap back” to inefficient practices and technologies.

Sustainability aspects and co-benefits

Sustainability aspects
Regulators should also encourage the energy companies to promote sustainability aspects (like resource efficiency, health aspects, …), depending on the type of technology, solution, or action promoted.

Co-benefits
All kinds of co-benefits (i.e. “non-energy benefits” such as health improvement, labour market effects etc.) may thus arise from implementing the regulatory changes discussed here.

Implementation barriers

The following barriers are possible during the implementation of the policy:
Often, the economic situation and especially the profits of even monopoly energy companies are not very transparent to the public. The changes in regulation discussed here may thus be seen as a threat by the companies due to increased transparency, or to reduced freedom of investment action. This is likely to lead to resistance to the changes from their side.
There may be a lack of data on energy efficiency potentials as well as incremental costs of energy efficiency vs. expansion of energy supply. In addition, there may be a lack of experience with energy efficiency programmes. This may delay implementation.
The regulating body may be understaffed or have little experience of the kind of regulatory action required.

The following measures can be undertaken to overcome the barriers:
It is, therefore, important to highlight the benefits to the country, the consumers, and also the regulated energy companies. The latter will be more easily convinced if the changes include a bonus to the energy companies for energy savings in addition to programme cost recovery.
Resources need to be provided for data collection and pilot testing. Co-operation with comparable countries that have more experience with regulation for energy efficiency and energy efficiency programmes may speed up the learning process.
The regulator should receive the necessary resources and should try to learn from other countries’ experiences.

Find out the potential impacts of this policy type alongside energy savings and cost effectiveness.

Achievable energy savings

Some of the most advanced countries or states that combine regulation of energy companies, for energy efficiency, with an energy efficiency obligation to save a certain amount of energy each year are California (USA), Massachusetts (USA), Denmark, New South Wales (Australia) and the United Kingdom. These have achieved additional energy savings compared to baseline trends equivalent to 1 to 1.5 % of total energy consumption, of the sectors addressed, with each year of running the schemes and programmes. Some are now setting even higher targets for the years ahead (RAP 2012).

Expected costs

The costs for the regulator are likely to be small. Staffing requirements for a number of EU countries range from a few to around 30 persons (Thomas 2007). This includes management of an energy efficiency obligation scheme.
The costs for the energy companies’ energy efficiency programmes depend on the type and target of programme, of course.

Expected cost savings

Experience in many countries shows that there is usually a very high net benefit from energy efficiency programmes run by energy companies: the total costs to society (programme expenses of the energy company plus incremental investments by its customers) are then much lower than the cost for expanding supply, avoided through saving energy. For example, in several EU countries, it often costs only 2 to 3 Eurocents to save a kWh of electricity (Thomas 2007; Lees 2012). This compares to a wholesale price for electricity alone between 5 and 7 Eurocents per kWh.
Clearly, the cost savings and the resulting net benefits to consumers and the society from the energy companies’ energy efficiency programmes will depend on the type and target of programme and the incremental costs of energy efficiency and energy supply in a country.
However, there will be a net benefit in any case if the regulator demands this as a condition for allowing cost recovery and a bonus.

Authors

Thomas, Stefan (Lead author)

References and further reading

Lees, Eoin (2012): Energy efficiency obligations – The EU experience. The European Council for an Energy-Efficient Economy.www.bigee.net/s/nd9fp4 Moskovitz, David (1989): Profits and Progress Through Least-Cost Planning. Study of the NARUC Conservation Committee, November 1989
Politecnico di Milano; Wuppertal Institute for Climate, Environment and Energy; Ministerium für Wirtschaft und Mittelstand, Technologie und Verkehr NRW; Energieverwertungsagentur (2000): DSM pilot actions, DSM bidding, and removal of DSM disincentives from price regulation. A joint project in Italy, Germany and Austria. Part 3: Price regulation and removal of DSM disincentives in monopoly segments of restructured electricity markets. Milano
RAP (the Regulatory Assistance Project) (2012): Best Practices in Designing and Implementing Energy Efficiency Obligation Schemes. Research Report, Task XXII of the International Energy Agency Demand Side Management Programme. Stockholm www.bigee.net/s/dnzi3t
Thomas, Stefan (2007): Aktivitäten der Energiewirtschaft zur Förderung der Energieeffizienz auf der Nachfrageseite in liberalisierten Strom- und Gasmärkten europäischer Staaten: Kriteriengestützter Vergleich der politischen Rahmenbedingungen. Kommunalwirtschaftliche Forschung und Praxis 13. Frankfurt a. Main