When it comes to utilities, some analysts make a fundamental mistake. They assume that a utility's profits are tied to sales of natural gas or electricity. In many states, any linkage between energy sales and utility margins no longer exists.
"Decoupling" is the term that state regulators use to describe the process that breaks that link. According to the National Association of Regulatory Utility Commissioners (NARUC), the rates that utilities charge are determined by the "cost of service" theory of regulation. Rates are set at a level sufficient to allow the utility to recover costs incurred in providing service to its customers on the basis of the operating experience of a typical 12-month period. The utility's revenue requirement is then determined by adding all the operating expenses plus an allowed return on investment.
In decoupling's simplest form, prices are adjusted to maintain a constant target revenue. The target revenue varies with the number of customers, but not on the basis of how much natural gas or electricity the utility sells. The result is that decoupled utilities should no longer have an incentive to maximize their sales of natural gas or electricity.
Decoupling has been going on for over a decade. According to the Natural Resources Defense Council (NRDC), 21 states, plus the District of Columbia, have adopted decoupling for the delivery of natural gas, three states are in the middle of implementing decoupling regulations, and 26 states prefer not to decouple. The NRDC reports that 14 states and the District of Columbia have decoupled their electric rates, three are pending and 33 prefer not to decouple at all.
Decoupling is not the same as restructuring. Texas, Pennsylvania, Delaware and New Jersey have restructured their electric utilities, but they have not decoupled electric rates from revenue.
The states that have already decoupled their electric utilities are Hawaii, Arizona, California, Oregon, Idaho, Wisconsin, Michigan, Ohio, Maryland, New York, Connecticut, Rhode Island, Massachusetts and Vermont. And as stated, the District of Columbia has also decoupled. Soon Washington, Minnesota and Arkansas will join.
Investors benefit if a utility has been decoupled. Decoupled utilities simply rent their distribution systems to consumers on a cost-plus basis. Since those fixed-price rentals are not linked to energy consumption, decoupled utilities are not threatened by wind power, solar power, demand response or any other new technology.
This means utilities such as Edison International (EIX), Sempra Energy (SRE), PG&E (PCG), Portland General Electric (POR), Consolidated Edison (ED), Northeast Utilities (NU), Pepco Holdings (POM) and even Exelon's (EXC) Maryland operations are indifferent if their native states require more renewable energy resources or energy efficiency.
The general idea is to promote energy efficiency and to stop promoting energy consumption. However, when it comes to state regulations, everyone has a better idea. As the Department of Energy reports, some states implemented full decoupling, whereby the utility "recovers the allowed revenue no matter the reason for the variation in the allowed revenue and actual revenue."
Other states allowed partial decoupling. This means the utility recovers only some of the difference between the allowed revenue and actual revenue.
Still other states have implemented limited decoupling. The DOE reports that limited decoupling occurs only when revenue deviates from allowed revenue for specific reasons defined by the policy, such as unusual weather, economic downturns or energy efficiency.
As you might expect, most southern states want no part of decoupling of their natural gas or electricity. It is not a surprise; they did not want to restructure any of their utilities, and they avoided deregulating their wholesale power markets. Utilities such as Duke Energy (DUK), SCANA (SCG), Southern (SO), NextEra Energy (NEE) and TECO Energy (TE) are managed like your grandfather's utility.
When a state announces an enhanced "smart metering" or an aggressive energy-efficiency program, look to see if that state has decoupled its electric utilities. If so, the utility will make a return on capital for the new metering systems, and it will not be harmed by reduced energy sales.
Looking forward, it appears more states will be motivated to decouple their utilities. Unlike restructuring, decoupling is not necessarily bad news for investors. In fact, during periods of slow energy consumption, it could be a safety net.