Energy Regs Flashcards
key attributes of a public utility
Service to public; “essential service”
Monopoly power
Exclusive franchise territory (avoid duplication of services)
Obligation to serve
Reasonable prices
Technological limits (scope and nature of monopoly may change as technology changes)
Technology can overtake you and you lose the monopoly power (EX: landline telecommunications)
Charles River Bridge case
Bridge provided critical service to connect land, argues another bridge cannot be built.
n 1785, the Massachusetts legislature incorporated the Charles River Bridge Company to construct a bridge and collect tolls. In 1828, the legislature established the Warren Bridge Company to build a free bridge nearby. Unsurprisingly, the new bridge deprived the old one of traffic and tolls. The Charles River Bridge Company filed suit, claiming the legislature had defaulted on its initial contract.
Court: tech. limits come into play here, • Railroads (and canals) at the time were providing quicker methods of transportation than turnpike roads with horse and buggy.
• The proprietors had almost immediately realized their anticipated profits because this was a for-profit bridge, not just a toll meant to recoup the investment and maintain the structure. This does not appear to have any impact on the court’s decision, which focuses on the government’s role of encouraging or implementing innovations and technological developments for the advantage of the community.
Court held that the legislature neither gave exclusive control over the waters of the river nor invaded corporate privilege by interfering with the company’s profit-making ability. In balancing the rights of private property against the need for economic development, the Court found that the community interest in creating new channels of travel and trade had priority.
Taney (Majority): if you grant exclusive monopolies then you stifle technological developments, technology can overtake and restrict these natural monopolies; Dissent: you’re going to deter investment if the promised monopoly is not guaranteed.
Munn v. Illinois
charged a toll for every bushel of grain that passed through the warehouse.
Illinois regulated grain warehouse and elevator rates by establishing maximum rates for their use. Was this constitutional rate regulation?
states may regulate the use of private property “when such regulation becomes necessary for the public good.”
“[I]t is apparent that all the elevating facilities through which these vast productions of ‘seven or eight great States of the West’ must pass on the way to ‘four or five States on the seashore’ may be a ‘virtual’ monopoly.”
“[T]he owner of property is entitled to a reasonable compensation for its use, even though it be clothed with a public interest . . . .”
- Effects the flow of commerce (grain passing through from states in West to all the states in the East;
- An essential service (to feed the masses)
- High capital costs
- Virtual monopoly
Munn refers to “private property being devoted to a public purpose.”
• Munn v. IL: clothed with public interest; public interest demands we regulate your rates for grain.
!Regulated rates is not a taking b/c they will be entitled to reasonable compensation, a rate of return built in, subject to regulatory approval.
- Reasonable rate of return helps the utility owner ATTRACT CAPITAL and that depends on if regulators give them a fair rate of return.
What about a service station on a remote island? Cars have very limited ability to get off the island, and thus there is a captive market for the service station operator. Is the operator “clothed the public with an interest in [its] concerns”? What about a ferry boat operator providing service to this island?
the service station: If cars can easily get on and off the island then not really monopoly, but if cars totally reliant on the service station then monopoly power with captive customers.
It’s an essential service (probably)
Duty to serve (maybe)
Barrier to entry? Another gas station may come in…
the ferry boat: yes, if the ferry boat is the only way on and off the island that charges a toll, becomes a thing of public interest and use then it should be subject to regulation to ensure the boat is maintained to prevent accidents to the public and that the tolls are reasonable so the public can use the ferry.
Natural monopoly? Monopoly power? Barrier to entry?
What about an individual in a small, rural town who buys a garbage truck and begins to provide service to pick up customers’ garbage at their houses?
it depends, what did the townspeople do with their trash before the garbage truck service? If the service isn’t promoting the general welfare then it is not subject to regulation, but if the townspeople rely on the service to handle their sanitation needs then yes, the service is subject to regulation.
Cellco Partnership v. FCC
FCC regulating mobile data providers, requiring them to provide roaming services to other providers
difference between a common carrier and a private carrier
- A common carrier must offer service indiscriminately and on general terms to all people.
- A private carrier makes individualized decisions in particular cases whether and on what terms to serve.
• Rate hearing, what is the Representation you make:
o if are you holding yourself out as serving all comers then you serve the public indiscriminately and everybody gets the same deal;
o if you are private you are not serving everybody.
Here • The services provided by Verizon appear as the Company holding out itself to serve the public, like a public utility. • Clothed with the public interest, can’t grant preferential treatment you like and discriminate to those you don’t like.
Tripp v. Frank:
- Does a ferry leaving from same point but taking passengers to another point several miles up entrench on the original ferry?
- NO. plaintiff loses, it’s not the same track.
- Public policy: reward entrepreneurs by allowing them to recover their investment, give them reasonable opportunity to recover their investment.
o High capital cost: high initial investment ties to the monopoly power. Becomes a barrier to entry if high capital costs.
THE REGULATORY COMPACT
- Mon power has to serve all in this exclusive territory and PSC grants a reasonable rate of return .
Go to PSC to get the exclusive territory and obligation to serve.
- Stranded costs: dealt with when states opened up to competition; OR Mon Power buying Harrison Coal Plant based on promise by PSC for exclusive territory but then WV allows competition so Duke Power comes in and offers service.
o Mon Power would argue stranded cost of coal plant, which was purchased based on regulatory compact. Utilities that make investment based on regulatory compact for guaranteed rate of return.
Key Q’s to ask to determine if entity requires regulation (from Munn v. IL)
Is it an essential service?
Duty to serve?
Barrier to Entry (High capital costs to get into business)?
Natural monopoly or monopoly power?
• Nebbia v. NY: state’s exercising their police powers, states get a lot of deference. States can regulate you if the public interest requires it; the assets you devote to public service are entitled to a reasonable rate of return.
common law principles come into play: if you look like a public utility under common law cases, you will be regulated. Any such business can be called a public utility.
Five Basic Powers of PUC
- Assign Service Territory. To assign territories through “certificates of public convenience and necessity (CCN).”
- Set service standards. To enforce the duty to serve by establishing standards of service; ensure quality of service.
- Regulate Rates. To review the utility’s rates and reject those that are not just and reasonable. WV Section 24-2-3
- Approve Spending. To review the utility’s major capital expenditures, including borrowings, against a standard of “prudent investment.” WV Section 24-2-3
- Control Abandonment. To prevent the utility from abandoning service without its approval. WV Section 24-3-7.
• No Discrimination or Preference: (WV 24-3-2) Everybody gets the same deal. Utility can’t grant any preferences for you or discriminate against you.
characteristics of a natural monopoly?
single firm that is able to provide a good or service to a market at a lower average cost than two or more firms because of economies of scale or other network economies
• A single firm is more efficient than 2 or more firms. If 2 or more firms operated in this market, prices would be higher and output would be lower, since the quantity demanded would decrease with higher prices, such a market is a natural monopoly.
public interest to grant a single firm an exclusive franchise to provide utility service within a defined territory b/c • A single utility is better able to coordinate interdependent aspects of an industry’s operations or because it is able to process information more efficiently.
- Government regulates monopoly pricing to protect consumers against price abuse and to ensure monopoly rents are spent on socially valuable items.
- An economic loss produced by monopoly pricing is reduced access to products and higher prices.
• Regulators are trying to mimic what rates would be if this were a competitive market. But Regulators must set rates high enough to attract investment/capital on reasonable terms but low enough rates that ratepayers aren’t getting gouged with unreasonable prices.
Missouri Regulators Deny Aluminum Maker’s Plea for Rate Relief
- Rate reduction of aluminum company, Noranda, would be placed on the backs of other ratepayers within its service territory ($500M).
- Noranda’s annual power bill is $160M, Noranda is demanding to pay 3 cents/kWh from their current 4.14 cents/kWh.
o Noranda wants its own rate class (not I, C, or R), making the case that we are not getting like and contemporaneous service b/c we have a different load profile and utility making $ off us so we deserve our own rate class.
PSC must decide if they can be treated as their own rate class, but other classes have to make up for that $50M that Noranda isn’t paying
• WV 24-3-2: No Discrimination or Preference: what is a PSC to do with this law?
o New classification of service.
PSC must do a cost of service study to prove that the one entity is paying too much and deserves their own rate. MO regs deny aluminum makers plea here.
• Distribution and transmission = monopoly:
o Must allow others to use your transmission line; if you own a transmission line, you must allow others to use it subject to regulation so you get a return on your investment.
o Distribution poles and lines are a natural monopoly subject to regulation.
• Generation function is not a natural monopoly.
o Wholesale level of electricity generation allows competitors.
o Utilities hoard the market on being able to build power generation, open to competition: Merchant plants.
o FERC opened up generation market to competitors in early 90s
Ratemaking Formula:
Revenue Requirement = (Rate Base * Rate of Return) + Operating Expenses
• Ex: Duke’s rate base will go up due to purchase of NG fired plant from private entity, Calpine, in Florida. This is lower investment for Duke than building its own plant.
Rates Base: original cost – cost of depreciation (FERC). Its easy there is no dispute.
Operating Expenses consist of
cost of fuel, employees, line trucks, rent,
Depreciation, Taxes.
Tree Trimming.
To set the price. Price = Rev Req / Customer Service Needed
- if one set of customers (residential) with 28 million kWh of service
- Rev Req / customer service needed
- $35M / 28M kWh
- $1.25 per kWh
Constitutional Standards: Hope and Bluefield
• This constitutional requirement is typically incorporated in interpretation of “just and reasonable” rates in state rate-making statutes
Bluefield: public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties.
Hope: From the investor or company point of view, it is important that there be enough revenue not only for operating expenses, but also for the capital costs of the business. These include service on the debt and dividends on the stock. By that standard the return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.
•
• Discounted Cash Flow (DCF) model is most common method for calculating cost of equity
–
DCF formula is simply stated as
Required ROE = Dividend/Price + growth • Dividend/Price is the dividend yield and g is the long-term expected dividend growth rate.
Discounted Cash Flow (DCF) Analysis:
- If the utility is publicly traded, the dividend yield can be calculated by looking at the utility’s current dividend and its stock price over a representative period.
- If the utility stock is not publicly traded, a proxy group of “comparable” companies is used for purposes of the DCF analysis. a comparable group of companies with similar risks and uncertainties to compensate investors accordingly.
*Screens are used to determine comparable companies (distribution only service, companies with significant merchant generation, similar S&P bond rating, revenue screen (similar rev), no recent mergers).
The contentious issue is growth component, intended to capture the growth rate investors expect. To determine growth component look to:
- Growth estimates developed by professional analysts
- Historical growth in earnings, dividends and book value over a recent period, such as five years
- Estimates of expected growth rates in the overall economy, such as GDP
Risk Premium Analysis
• Method begins with currently observable market returns, such as yields on government or corporate bonds, and adds an increment to account for the additional risk associated with equity
• A commonly used risk premium analysis compares authorized electric utility ROEs to contemporaneous long-term interest rates on utility bonds
– Equity risk premium is then measured by the difference between the average authorized ROE and the average debt cost for each year
- Sample calculation:
- Data from years 1980-2005 suggests a risk premium of 4.25% (spread between yields on government or corporate bonds and common stocks)
- This is added to projected single-A utility debt cost of 6.7%
- ROE suggested by risk premium analysis is 11.0% (4.25% + 6.7% = 10.95%)
Bluefield
• “Just compensation” depends upon many circumstances and must be determined by the exercise of a fair and enlightened judgment.
o This 1923 case still cited for what utilities should be allowed to earn on rates.
(it needs to be able to attract investors, must give them a return that corresponds to that level of risks versus the other entities out there competing for capital).
(must be able to compete with similarly risky entities)
o Should assure confidence in the financial soundness of the business.
o Should be adequate to maintain and supports its credit and enable it to raise money necessary for discharge of its public duties.
Hope
Hope Natural Gas (1944) is the 2nd leading case cited in rate hearing testimony.
• MUST balance the investor and the consumer interests
• A reasonable return:
o Maintains financial integrity
o Must be enough revenue not only for the operating expenses but also frht ecaptical costs of the business
o Return should be commensurate with returns on investments in other enterprises having corresponding risks
o Return should be sufficient to assure confidence in financial integrity of the enterpricse to as to maintain its credit and attract capital.
it is the result reached not the method employed which is controlling.”
o Great discretion to ratemaking method.
it is the result reached not the method employed which is controlling.
Hope: End Result Test
End Result Test: is the total effect of the rate order unjust and unreasonable? That’s all we care about, not how you got there.
• Does it meet financial integriety test to allow utility to attract capital.
- It’s the total effect of the rater order - cannot be unjust and unreasonable.
- The fact that the method employed to reach that result may contain infirmities is notthen important.
- Court isn’t going to look behind it but will see if you are recovering operating expenses and earning enough profit to attract enough capital on reasonable returns, earning returns of companies with corresponding risks, - court will not pick at particular method used to determine the rate base.
If the total effect of the rate order cannot be said to be unjust and unreasonable, judicial inquiry under the Act is at an end.”
• Company says original cost $100M; PSC says with depreciation its $60M:
o $100M * RR (6%) = $6M + op expenses
o $60M * RR (10%) = $6M + op expenses
^must give investors higher return (10%) b/c they bearing risk of inflation
• Rate or Return reflects risk; Court: you can higher rate base and lower rate of return and number on the end could be the same.
o If you use current cost = lower rate of return
o If original cost with depreciation = higher rate of return
But it all washes out, and you get same result with either scenario
Three conditions of a fair return on the invested capital of a public utility:
- sufficient to maintain the financial integrity of the utility;
- sufficient to compensate the utility’s investors for the risks assumed;
- sufficient to enable the utility to attract needed new capital.
Re Duquesne Light Co. v. Barasch
*utility argue violating hope and bluefield standard b/c they aren’t getting a reasonable return b/c abandoned plant is not included in the rate base;
- For Duquesne denial of plant reduced annual return by 0.4%
- For PennPower: denial of plant reduced annual return by 0.5%.
- End result: the overall impact of the orders is not constitutionally objectionable.
• the utilities did not make the showing that the total effect of the rate order was unreasonable. Slight reduction in the rate of return is not enough to be constitutionaly objectionable.
o Supreme court: “overall impact of the rater orders is not constitutionally objectionable. no argument has been made that these slightly reduced rates jeopardize the financial integrity of the company
The reductions here are so slight (.4 and .5), still in range of reasonableness;
• Rate case range looked at by PSC was probably 10% to 18%, wide range.
• Reasonable rate could probably be anywhere from 14% to 17%.
• Courts give great deference to regulators.
“The economic judgments required in rate proceedings are often hopelessly complex and do not admit of a single correc result.”
“The constitution is not designed to arbitrate these economic niceties. “
“The constitution protects the utility from the net effect of the rate order on its property. “
o Rate of Return: stock and debt (2 pieces)
o Debt: what is the total outstanding interest rate on all the debt we have outstanding.
o Most utilities 50% debt and 50% equity (common stock).
o The higher the equity the less risk, the higher rate of return; equity is more expensive than debt
o Higher debt ratio = higiher risk = more leveraged.
o Higher debt ration is CHEAPER but less safe, more risk.
o Higher equity ratio is More expensive but less risky.
*PUC will generally not allow a high equity ratio because of the higher costs for customers. Balancing of economy v. safety.
To calculate ROE
Look at comparable group of companies with comparable risks (Bluefield, Hope)
how are debt costs determined
look at actual interest rates from outstanding debt issuances
If you’re making profit more than your rate of return you will get hauled in to the Service Commission.
• Alternative: is to propose a rate decrease for customers as Green Mountain Power did
How can a utility decrease rates twice in past few years?
- 1) *When you merge with other Company your operating costs are lower. “Synergy Savings” but downside is it can result in layoffs because positions are duplicated.
- 2) The utility got out of and got rid of a its ties to a generation facility (Vermont Yankee).
Smyth v. Ames
“Rate Base” at issue
the corporation may not be required to use its prop for the benefit of the public w/o receiving just compensation for the services rendered by it.”
determining “fair value” of asset.
criteria identified by the court for determining “fair value” of the rate base
- 1) original cost of construction
- amount expended in permanent improvements
- 2) the amount and market values of the utility’s bonds and stocks
- 3) the present as compared with the original cost of construction
- 4) the probable earning capacity of the property under particular rates prescribed by statute;
o For a regulator to apply these Fair Value standards:
1) original cost construction is easy
amount expended in permanent improvement is easy to track in asset accounts
2) market value of bonds/stocks: difficult for regulator, stock prices always going up and down. The stock will be attractive if the regulators set high rates and if regs set low rates then investors wont like stock: very circular.
3) present v. original cost const. (replacement cost) is more difficult b/c you would have to look at all materials and equipment used, labor, etc.
4) Probable earning capacity: same as #2, difficult for regulator.
For fair value, investors bear risk of inflation b/c rates of reg utilities may be lower than rates of non-reg utilities
For historical values, investors do not bear risk of inflation, it’s accounted for.
Re Jersey Central Power & Light v. FERC:
• Utility entitled to earn a rate of return on assets that are used and useful. If not being used then can’t put in rate base and earn a return on it;
• By not putting into rate base, JCPL loses the time value of $ (shares the pain b/c the utility is not made and it gets no return on investment while amortized); popular for regulators to do;
• FERC didn’t have a hearing or analysis, they said no use and useful in the rate base, not entitled to earn a return on assets not used and useful.
o Court: Hope Case, FERC didn’t do its job by looking at what affect the disallowance would have on the utility’s ability to raise capital. It’s the end result that counts, but FERC didn’t do any analysis when making their JCPL decision.
o Court: do your job, make analysis as to whether disallowing the cost will cripple the utility.
DC Circuit vacates FERC decision. • FERC reached its determination by flatly refusing to consider a factor to which it is undeniably required to give some weight. Since no fact finding and hearing was held by FERC, the court remands for FERC to hold a hearing to determine whether the rate order it issued constituted a reasonable balancing of the interests; FERC didn’t do HOPE End Result Analysis (so remanded).
• FERC held hearing on remand but made same decision. It doesn’t adversely effect utilities ability to raise capital. FERC just had to do end result analysis.
Jersey Central: Starr Concurring Opinion:
Look at Regulatory compact: “a monopoly on service in a particular geographical area is granted to the utility in exchange for a regime of intensive regulation, including price regulation”
Prudent investment rule “too weighted in favor of utility”; “used and useful” rule “heavily skewed in favor of ratepayers”
• Prof likes majority and concurrence opinions more than dissent here.
Mikva Dissenting Opinion:
Majority decision “would virtually insulate investors in public utilities from the risks involved in free market business.”
“This would drastically diminish protection of the public interest by thrusting the entire risk of a failed investment onto the ratepayers.”
o If this utility were in free market, would it recover on its investment that was never completed? No, why treat them differently.
Why should utility customers have to compensate the utility for its investment in a nuclear plant that never operated?
• The utility behaved reasonably when it undertook construction b/c it had obligation to serve, it was fulfilling that obligation, and circumstances changed so the plant was no longer needed.
o Prudent Investment Test.
Commission has to do a” prudence review”
see if actions/decisions were reasonable at time they were made. Trying to avoid hindsight regulation;
o PSC looks at standard utility practice, what do other utilities do at the time.
o What info did utility have when the investment was made?
o If bad decision then utility will pay;
Confiscatory rate
exists when an unreasonable balance has been struck in the regulation process so as unreasonably to favor the ratepayer interest at the substantial expense of investor interests.”
Allowance for Funds Used During Construction (AFUDC)
provides compensation to build plant during the period the plant is under construction.
Once the plant comes on line, the regulator allows the utility to capitalize the interest the account has earned, so the interest is added to rate base along with the dollars the utility invested.
• Utility can’t raise rates for the 5 years of construction and when plant is completed it goes online at $130M instead of $100M amortized over useful life of plant; so the $130M is depreciated over useful of the plant.
o AFUDC presrves Matching principle: customers in years 1-5 are not paying for anything they aren’t getting. In year 6, those customers are paying for that plant, including financing cost to build the plant.
Construction Work in Progress (CWIP)
provides compensation to build plant in rate base before the plant is completed.
put in rate base some or all of the utility’s investment in a yet-to-be-completed plant.
• Utility can actually raise its rates as it is incurring costs to build the plant.
• Over course of 5 years of construction rates go up $30M, but when plant goes online in year 6 it goes online (into rate base) at $100M (The recorded cost of plant b/c no captilized interst of AFUDC approach. The other $30M is in rates).
o CWIP violates matching principle: customers in years 1-5 are paying price of financing plant and getting no benefit)
hypo: if builing new nuc plant and you are CEO, do you prefer CWIP or AFUDC
- CWIP would attract more investors which can be an issue for something as costly as a nuclear plant.
- AFUDC would be preferred for consumers to protect them from the risk that the plant never comes online, which is possible due recent changes in nuclear energy policy in Germany and France, for example.
Utility hates AFUDC; CWIP is preferred. AFUDC provides no cash flow, ratio of $ to pay debt service is really low and can result in a downgrade of credit rating b/c they don’t have the cash.
Depreciation annually is higher under AFUDC than CWIP
CWIP and AFUDC from perspective of consumers and shareholders
Better deal for utility customers (arg for both):
• CWIP (phasing in of rates, less depreciation)
• AFUDC (matching principle, you pay when it’s online, not when it’s being built)
Better deal for utility shareholders:
• CWIP (clearly better off, rates raised each year is safer investment)
Advantages of AFUDC
matches benefits and burdens. Customers who benefit from the plant’s operation (i.e., who receive the electricity generated by it) have the burden of paying for it.
the regulator sends appropriate price signals to customers
• AFUDC appropriately matches risks to the utility and its customers. It protects customers from the risk of paying a return on a plant that never comes on line.
• Disadvantages of using AFUDC:
AFUDC can give investors a skewed picture of how a utility is doing. (utility can recognize on its financial statements what it earns in its AFUDC accounts as earnings. But those earnings do not actually produce cash flow until the plant goes on line )
• AFUDC keeps the risks associated with construction of a new plant on utilities until the plant is on line. (No sharing of risk can cause concern for bond rating agencies).
• Advantages of including CWIP in rate base:
- Investors are risk averse. Allowing CWIP reduces the risk to a utility of a failed investment. Bond rating agencies, likely to give a better bond rating.
- A better bond rating for a utility allows it to acquire capital on more advantageous terms, so a better bond rating can reduce a utility’s cost of capital.
• Disadvantages of including CWIP in rate base
utility is receiving a return on its investment before the plant is on line, thus, customers are paying for something that is not yet providing service to them.
• CWIP violates the principle of intergenerational equity. Intergenerational equity is a cost causation principle: those who cause a utility to incur a cost should bear the cost. With CWIP, customers who receive no service from a plant will bear some of the cost.
violation of matching principle also means regulator is sending inappropriate price signals to customers.
• CWIP v. AFUDC for utility:
o CWIP attractive to utility if spending $10B over 10 years. B/C n AFUDC model, utility can’t raise rates, just paying Billinos per year in debt service during construction period – can really stretch a utilities finances.
• With CWIP, utility can raise rates every year so cash flow matches expenditures during construction.
• AFUDC could shock customers with higher rate in year 6. Whereas CWIP sneaks in higher rates each year over life of construction.
What is a Test Year
The starting point for setting utility rates
Usually the most recent historical period
Some states use a “future” test period
(most states use historical period and adjust from there; but some states use a “future” test period).
o EX: Assume rate case filing of July 1 ’14, 10 month statutory suspension period; most likely test period will be the 12 months ended Dec 31, 2013 with “rate effective period” beginning on May 1, 2015 (the 10 months inbetween for PSC doing discovery, research, etc.)
provides a best estimate
• Test year is adjusted for extraordinary events.
o Adjust test period results for non-recurring events (“normalizing” adjustments)
Ex: Superstorm Sandy = non-recurring; normalize that out.
o Adjust test period results for known and measurable future events (“pro forma” adjustments).
Not extraordinary in the test period but you know it will be different once rates take effect in 2015.
EX: 5 year union agreement where employees get 5% raise. Health insurance premiums going up.
*Needs to be known and measurable.
Test Year: “Allowed” vs. “earned” returns
What if economic downturn causes major industries to close and revenues are lower than forecasted?
What if winter is colder than forecasted, and utility generates more revenue?
o 9% return on equity is your allowed return; in order to attract capital and maintain financial integrity.
o What if economic downturn so revenue is lower (7%)?
That’s part of risk of operating utility, you can’t retroactively recover that
Retroactive ratemaking is prohibited
o What is winter is colder than forecasted, and utility generates more revenue?
Utility can over earn, utility gets to keep that.
Now, if you consistently overearn, the PSC will require a rate reduction;
But a short-term bump in revenue is kept.
What is the standard used to determine whether or not an operating expense is recoverable in rates (building rates, CEO salary, pay for employees)? What is the origin of that standard?
Ordinary and necessary
• Origin: dictum in Smyth v. Ames:
o “under the evidence there is no ground for saying the the operating expenses of any companies were greater than necessary.”
Non-recurring
Reasonable
Prudent (investment or expenditure)
Provides benefits to ratepayers
General presumption of management competence
Missouri ex rel. Southwestern Bell Tel. Co. v. Public Serv. Comm’n, 262 U.S. 276 (1923), utility doesn’t need to prove prudence of every single expenditure or investment.
Legit Op Exp? • Contribution to an industry-wide gas research institute
o oppose: more cost effective for all gas utilities to get together and do R&D than for one to do it on its own
o
o defend: as long as some benefit is shown from R&D then should fine.
Legit Op Exp?: • Research programs in solar energy and nuclear reactor technology standards
depends on part of the country.
Legit op Exp?: discount on electric charges for company employees
o defend: offered as part of total compensation package.
o some statutes specifically provide that this is allowed;
Legit op Exp?: • A commercial scale plant demonstrating a new coal gasification technique
o oppose: why don’t you build the same old stuff instead of spend money on this new technology, ratepayers shouldn’t bear that risk.
o defend:
o its an incremental cost b/c of new technology so its riskier
Legit op Exp?: • Expenses incurred when a plant under construction is abandoned
o Jersey Central Case. prudently decision making at the time?
Prudence Standards (Jersey Central Case):
• Prudence of utility investment or expenditures
• Prudence is based on what the utility knew or should have known at the time of its decision
o No hindsight evaluation
o were actions reasonable in light of the circumstances at the time?
• Role of regulatory compact. (utility built plant on role of obligation to serve so commission has obligation to treat the utility fairly).
Legit op Exp?: • Advertising expenses encouraging the conservation of electricity, making the construction of new power plants unnecessary:
o defend: less of a drain on utility
o these are always recoverable in rates.
Legit op Exp?: • Flyers included with utility bills responding to allegations that a utility’s nuclear facilities are unsafe:
o defend: substantial investment in facility; utility could say it will lessen lawsuits.
o 1st amendment right to inform ratepayers at their expenses? Utility can’t have ratepayers pay for it.
o Litigation is allowed to recover in operating expenses.
o Prof: this is generally not recoverable
Legit op Exp?: • A utility-sponsored research lab to investigate the effects of electro-magnetic fields from power lines:
o Yes, might reduce litigation expenses of landowners suing.
Legit op Exp?: • The medical costs for future retired employees:
o defend: part of our total compensation package.
Legit op Exp?: • Demo project for commercialization of carbon capture and sequestration CCS tech:
o WV PSC said yes
o VA said no: we don’t want our utilities doing demo projects
o Without having both states AEP canceled the project.
Legit op Exp?: • Promotional advertising:
not allowed
• Institutional advertising (love your utility): not recovered in rates
Central Maine Power Co., 26 P.U.R.4th 388 (Maine PSC 1978)
Disallowing advertisements designed to influence pending rate proceedings as “political.”
Legit op Exp?: • Conservation advertising:
to save energy: always allowed
Legit Op Exp? • Lobbying expenses to shift opinion on an issue:
typically Not allowed.
Zone of Interess (P. 97)
• What can be taken into account in determining “just and reasonable” rates?
o Balancing of investor and consumer intersts
o What about enviro impact of utility’s actions?
• That’s not what setting just and reasonable rates is about; Look at agency’s stat auth, it’s not to engage in enviro protection is to make just and reasonable rates (even tho its clear the PSC action does have envrio impac).
*must look at agency’s stat. authority.
o Role of the energy regulator on environmental issues
Recovery of envrio related costs in rates different than using rate proceedings to evaluate environmental impacts
Recovery of envro costs in rates is an issue and EPA clean power plan is good ex of utility incurring costs that must be recovered in rates.
Transfer of Mitchell Coal Plant
Facts:
AEP proposing transfer of 50% interest in Mitchell to Wheeling Power
Currently owned by AEP Generation (unregulated subsidiary)
780 MW of new generating capacity
• Is this a good deal for Wheeling Power:
o Not fair for ratepayer, great for shareholders
o Violates matching principle, in that Wheeling and its ratepayers have never received any benefits from the Conner Run impoundment and have not been responsible for any of the material placed in the impoundment.
• EPA will issue rules on Dec 19 on regulation of coal ash under RICRA (hazardous substance) which would close Connor Run.
• Ratepayers are getting no benefit from Connor Run
o Will not be used and useful.
o Ratepayers shouldn’t have to pay anything with this facility.
What is a cost of service study?
see if industrial paying too much, residential paying too little so utility can recommend different rate increases for each customer classes;
• AEP wants to raise residential rates more than industrial rates in WV
o Due to rising day to day OPERATING COSTS/EXPENSES; also tree trimming costs; and also costs due to Superstorm Sandy and derecho (extraordinary event that can be recovered b/c it was so big and costly)
Create a deferred account and recover costs over a # of years; typically cant do retroactive costs, but exception: if it’s big enough you can.
• Recession, hot summer, warm winter, etc. = not big enough for retroactive; something like Hurricane Sandy damage is.
power plant purchase goes into rate base.
- EX $96M for…
* the cost of a Harrison County power plant purchase
• Suspension of Initial Filing (tariff sheets filed for rate increase are suspended; Bottom line: 10 month statutory suspension period when filing tariff sheets for rate increase.
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• Parties to rate proceeding: o Commission staff o Consumer advocates o Large Inudstiral Customer Gorup o Enviro Groups o Other individual large customer o Criteria for standing to intervene (broad)
• Next Steps: o Discovery on initial testimony o Filing of opposing testimony by staff, other parties o Discover on opposing test o Filing of rebuttal test by company o Discovery on rebuttal test o Hearings Before full commission or Admin Law Judge.
• Next Steps:
o Briefs to commish
o Decision b commish
o Compliance filing of tariff sheets to implement decision
o Petitions for rehearing/reconsideration
Standard of review
• Very hard to overturn PSC decisions.
Johson act: can’t appeal rate case orders to federal court if adequate state remedy;
Just compensation for assets devoted to public service. If PSC haven’t given you what you need, you can’t make a federal case out of every rate decision (Johson act ).
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• Note: Hope, bluefield, duquesene and Rash (cite by company for why company is justified for reasonable expenses)
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How to assign costs according to cost causation
Functionalization: Production, transmission, distribution, general
Classification
Demand-related: Provide capacity to serve peak load
Energy-related: Vary with energy consumption
Customer-related: Vary by number of customers
Allocation
Allocate costs to customer classes, based on cost causation
Demand costs are typically allocated based on peak usage, on the theory that the utility constructs capacity to meet its peak
Example: Allocation of generation demand costs depending upon how “peak” is defined
Would you classify the following costs as (a) demand-related, (b) energy-related, or (c) customer-related?
Meters: Customer Related Costs
A nuclear base load generating unit: Energy Related Costs
Fuel costs: Energy Related Costs
A natural gas-fired peaking generation unit: Demand Related Costs
Postage meter for the billing department: Customer Related Costs
Principle: cost causers bear the cost.
Must also look at bill impact; even if economist says we should raise rates 50%, that isn’t an increase that the PSC is going to approve.
Break up costs into bundle of costs to allocate the pie
Allocation: how do you drop the costs down into customer classes.
Allocate by cost causation
Peak generation demand cost: demand costs allocated based on peak usage, on theory that the utility consructs capacity to meet peak. Which customer class is driving the need for us to acquire or build plant? That class gets the cost of the plant.
Allocation: Franklin Electric Company’s annual peak demand currently occurs in January, due primarily to electric space heating load. The Resource Planning Division of Franklin Electric just completed its integrated resource plan, and observed that as temperatures get warmer in the summer, air conditioning load is increasing. As a result, Franklin Electric is expected to become a summer peaking utility within 5 years. What approach would you recommend using to allocate demand costs to customer classes?
• 2 CP
o if a “needle” peak occurs once per year, a 1 CP method may be appropriate, while a 2 CP approach would be more appropriate if the peaks each season are fairly equal.
• Objectives of rate design:
From the customer’s perspective, easy to understand
From the utility’s perspective, easy to administer
Consistent pricing philosophy
Cost-based (equitable and non-discriminating)
Effective in yielding total revenue requirements
o provide revenue stability and predictability
o Promote efficient allocation of resources
o Tarrifs are clear enough so people aren’t fighting about what the words mean.
Rate Designs to KNow
- Declining Block (cheaper as you use more)
- Uniform Rate structure (flat line but not “flate rate”)
- Inverted Block (price goes up as you use more)
- Time of Use (seasonal or time of day)
what’s a rachet
concept: what’s max amount of elec. You are taking at any one time during a month; utility ties it to the capacity related costs; component of the rate is tied to peak usage. See notes slides from 9-11.
EX for Industrial entity: • Max consumption measured at the customer’s meter during any 24-hour period beginning at 9:00 AM Central, and ending at 9:00 AM Central the following day during the most recent peak months of Dec., Jan., and Feb. {Same concept as the ratchet} Cost causers bear the cost; trying to allocate among the basic charge, demand charge, energy charge so slice of pie covers revenue requirement; Sends economic signals.
Richard Pierc: three examples where price level regulation was adopted instead of traditional cost-of-service regulation, and the experience was “not encouraging.”
- The Natural Gas Policy Act (NGPA)
o NGPA failed to capture all that was going on with NG prices; the interplay with NG and Oil; - Crude Oil Windfall Profits Tax Act (COWPT)
o Crude Oil Tax: failure b/c demand factors weren’t reflected accurately - Public Utility Regulatory Policies Act (PURPA)
o PURPA: notion that encouraged non-utility generation; utilities forced to estimate costs for next 10-20 years, estimates were wrong so contracts were very expensive and required buyouts. Utlity had to sign contracts for next 10-20 years, required by law, and costs ended up being much lower.
Avoided cost: in the past, if you had to acquire an incremental MWh; figure out costs to build a new coal plant (Ex: 7.3 kwh/h) compared to a qualifying facility that would come online;
• Avoided costs were way higher than actual costs 5-7 years out.
now we will just go onto wholesale market (PJM website) to look at what avoided cost will be.
You are the Vice President of Rates for Commonwealth Energy, which is experiencing rapid load growth and will be adding several new generating units over the next decade. Would you recommend to the CEO that Commonwealth Energy implement the typical form of performance-based ratemaking (Change in Revenue Requirement = P minus X plus Z)? Why or why not?
No. performance based ratemaking “may not work for utility with significant capital additions . . . unless a rate base adjustment component is included.” Here, the utility will be adding new generating units over the next decade: i.e., significant capital additions.
Alternative Forms of Regulation (AFORs) include
a. Performance-based ratemaking (PBR)
b. Price caps or rate freezes
c. Earnings sharing mechanisms
d. Non-traditional rate mechanisms
AFOR may include any ratemaking process that does not involve traditional rate base/rate of return regulation
Objective of AFORs to streamline the process and provide incentives for utility efficiency
- Reduce regulatory compliance costs
- Provide utility with greater operating flexibility
(May not work for utility with significant capital additions
a. Unless a rate base adjustment component is included)
AFOR: PERFORMANCE-BASED RATEMAKING (PBR) formula (Change in Revenue Requirement = P minus X plus Z)
P is growth in external inflation measure (GDP or Industry Specific)
X is some measure of productivity, to ensure that prices decline in real terms (inc. in costs offset by gains in productivity)
Z adjusts for exogenous factors that are outside the control of the utility (reg changes, tax changes, etc)
(PBR also typically includes Service Quality Measures)
(PBR also commonly include sharing mechanisms to promote sharing benefits with customers)
(benchmarking, yardstick regulation)
AFOR: Decoupling or partial decoupling
Intended to remove the disincentives for utilities to encourage DSM (conservation)
Decoupling partially severs the relationship between sales volumes and revenues
AFOR: Weather Adjustment MEchanism
Variations in weather may cause utility to over or under recover fixed costs. Utility reduces risk associated with weather.
Some utilities have a Weather-Adjusted Rate Mechanism (WARM) which allows real-time adjustments to customers’ bills to reflect the effect of weather on gas use.
- if weather colder than normal, rate per therm is reduced.
- if warmer than normal, rate per them increased.
AFOR: Fuel Cost Adjustment MEchanism
In WV, the Expanded Net Energy Cost (ENEC) mechanism is a fuel cost adjustment mechanism (See Allegheny Energy ENEC Fact Sheet.
*These are very common because Fuel costs are large expenses, volatile at times, and difficult to predict; thus this category of op expenses is moved outside the ratemaking into a Fuel Adjustment Mechanism to receive special treatment.
True up piece to this (if over recovered or under recovered, rate is adjusted) look at what was projected a year ago versus what actually happened.
