Cost of Service, Rate Design,Cost of Service, Rate Design, and Price Efficiency and Price Efficiency

Bruce ChapmanChristensen Associates Energy

ConsultingOctober 3, 2012

Wisconsin Public Utility InstituteWisconsin Public Utility InstituteFundamental Course: Energy Utility BasicsFundamental Course: Energy Utility Basics

October 3, 2012 2

AgendaAgenda

Regulation and Ratemaking Cost of Service Rate Design

Regulation and RatemakingRegulation and Ratemaking

October 3, 2012 4

Rationale for RegulationRationale for Regulation

Not all markets for electricity services are “workably competitive,” capable of producing competitive outcomes

Rate regulation tries to approximate competition: Price ≈ Marginal Cost

In practice, regulation strives to satisfy many goals

October 3, 2012 5

Goals of Public Utility Ratemaking: Goals of Public Utility Ratemaking: A Balancing ActA Balancing Act

Reasonable rates for consumers Fair return for investors, comparable

to return earned by other businesses with corresponding risk

Rates that reflect cost Minimization of subsidies Protect customers from large bill

impacts Social concerns

October 3, 2012 6

Rate Application ChallengesRate Application Challenges

Energy and demand forecast Revenue requirements Rate of return and return on equity Cost of service:

Allocate costs to jurisdiction, customer class and rates within each customer class

Rate design: Design rate structures and set prices

Cost of ServiceCost of Service

October 3, 2012 8

Why Compute Cost of Service? Why Compute Cost of Service?

Per the National Association of Regulatory Utility Commissioners (NARUC), the cost-of-service standard remains the primary criterion for reasonableness of rates

What is an embedded Cost-of-Service Study? An analysis in which a utility's embedded cost

of providing service (i.e., revenue requirements) is determined by jurisdiction and customer classes or other groupings within jurisdiction

Embedded costs are the accounting costs on the company’s balance sheet and income statement, adjusted for regulatory conventions

October 3, 2012 9

Cost-of-Service StepsCost-of-Service Steps

1. Compile 2. Functionalize3. Levelize4. Classify5. Assign6. Allocate7. Determine Return

October 3, 2012 10

Cost-of-Service StepsCost-of-Service Steps

1. Compile

2. Functionalize

3. Levelize

4. Classify

5. Assign

6. Allocate

7. Determine Return

Step 1Compile appropriate rate base, expenses, and revenues (often by FERC account); decide upon categories of customers to be analyzed

October 3, 2012 11

Step 1: Total Company SummaryStep 1: Total Company Summary

TotalSystem

Rate base $16,826,786

Revenues $8,049,850

Expenses

O&M – fuel $2,236,885

O&M – other 2,245,054

Depreciation & 779,145 amort. expense

Taxes other than 431,509income taxes

Total adjusted $5,692,593expenses

Income taxes $927,414

Net operating $1,429,843income

Rate of return 8.50%

Residential Commercial Industrial Lighting

TotalRetail

Service

TotalOther

Service

October 3, 2012 12

Cost-of-Service StepsCost-of-Service Steps

1. Compile2. Functionaliz

e3. Levelize4. Classify5. Assign6. Allocate7. Determine

Return

Step 2Functionalize rate base and expense items by four major functions:

a. generation/supplyb. transmissionc. distributiond. general plant and

administration

October 3, 2012 13

Step 2: FunctionalizationStep 2: Functionalization

Production (Generation) Process of converting other forms of energy

into electricity Transmission

Process of sending the electricity generated at the centralized power station through wire at high voltage to the substation where it is transformed to low voltage

Distribution Process of delivering electricity to customer

meters through low voltage lines General plant support and other

October 3, 2012 14

Cost-of-Service StepsCost-of-Service Steps

Compile Functionaliz

e Levelize Classify Assign Allocate Determine

Return

Step 3

Identify rate base, expenses, and customers (and their usage) with voltage service levels:

Customers are responsible for costs at their level and higher.

October 3, 2012 15

Develop Levelized Demand Develop Levelized Demand and Energy Allocatorsand Energy Allocators

Service Level Designation and Power Flow Diagram

1

2

3

4

5

Transmission Line46kW to 500 KW lines

Generation and Territorial Input

Transmission to Distribution Transformation

Primary Distribution Lines25kV and lower

Line Transformers

Indicates power flow

Service Level

October 3, 2012 16

Cost-of-Service StepsCost-of-Service Steps

1. Compile

2. Functionalize

3. Levelize

4. Classify

5. Assign

6. Allocate

7. Determine Return

Step 4

Classify rate base and expense items by cost causative (and observable) characteristics:

a. Energy-relatedb. Demand-relatedc. Customer-relatedd. Revenue-related

October 3, 2012 17

Step 4: Classifying CostsStep 4: Classifying Costs

Gross plant assets (and depreciation): demand, energy, and customer components

Service Level Generation

Transmission Distribution

Demand Energy Demand

Demand

Customer

Level 1 Level 2 Level 3 Level 4 Level 5

October 3, 2012 18

Cost-of-Service StepsCost-of-Service Steps

1. Compile

2. Functionalize

3. Levelize

4. Classify

5. Assign

6. Allocate

7. Determine Return

Step 5

Assign those rate base expense and revenue items that can be directly associated with serving the previously decided upon customer categories

October 3, 2012 19

Step 5: Directly AssignStep 5: Directly Assign

Revenue from sales Customer substations Radial customer-specific lines Meters Sales support and billing costs

October 3, 2012 20

Cost-of-Service StepsCost-of-Service Steps

1. Compile

2. Functionalize

3. Levelize

4. Classify

5. Assign

6. Allocate

7. Determine Return

Step 6

Allocate those common rate base, expense, and revenue items to the customer categories* appropriate allocators must be developed

October 3, 2012 21

Step 6: Develop AllocatorsStep 6: Develop Allocators

Determine customers for each class by voltage level of service

Determine energy consumption (kWh) by voltage level and customer class

Determine demand (kW) by voltage level and customer class

Coincident peak (CP) Noncoincident peak (NCP)

October 3, 2012 22

Developing Demand AllocatorsDeveloping Demand Allocators

Load Shape Determinants

Rate Class Information

Allocation Factors: Allocating Costs by

Rate Class and Function

Demand Allocation Methods:

1) Average & Excess

2) 12 NCP3) 12 CP4) Marginal Cost5) Equivalent

Peaker6) Proportional

Responsibility7) Other

October 3, 2012 23

Cost-of-Service StepsCost-of-Service Steps

1. Compile

2. Functionalize

3. Levelize

4. Classify

5. Assign

6. Allocate

7. DetermineReturn

Step 7

Determine rate of return for evaluation

October 3, 2012 24

Illustrative Cost-of-Service Study:Illustrative Cost-of-Service Study:Rate Base ($million)Rate Base ($million)

Description System ResidentialSmall

BusinessLarge

Business Lighting Other Wholesale

InvestmentGross Plant 1,500 700 300 250 25 75 150Accumulated Depreciation 600 280 120 100 10 30 60Net Plant 900 420 180 150 15 45 90

Current Assets & LiabilitiesMaterials & Supplies 55 26 12 10 0 2 5Cash Working Capital 35 15 8 6 0 3 3Other 10 5 3 2 0 0 0Net Current Assets 100 46 22 18 0 5 8

Rate Base 1,000 466 202 168 15 50 98

October 3, 2012 25

Illustrative Illustrative Cost-of-Service StudyCost-of-Service StudyRevenues, Expenses, Rate of Return ($million)Revenues, Expenses, Rate of Return ($million)

Description System ResidentialSmall

BusinessLarge

Business Lighting Other Wholesale

RevenuesElectricity Sales 450 200 125 100 8 17 0Other Operating Revenues 5 3 1 1 0 0 0Revenue-Nonassociated 45 2 1 1 0 1 40Adjusted Revenues 500 205 127 102 8 18 40

ExpensesOperation & Maintenance 325 150 75 65 5 10 20Depreciation 50 25 10 9 1 1 4Taxes excl. Income Tax 25 12 6 5 1 1 2Adjusted Expenses 400 187 91 79 7 12 26

Operating Income 100 18 37 24 2 6 15Income Taxes 25 5 9 6 0 2 4Net Operating Income 75 14 27 18 1 5 11

Rate of Return (NOI/RB) 7.50% 2.90% 13.55% 10.49% 7.40% 8.93% 11.05%

October 3, 2012 26

Cost-of-Service SummaryCost-of-Service Summary

COS analysis distributes rate base, revenues, and costs across tariff groups according to a well-defined set of rules: Create rows for each function and voltage

level Classify each row by cost causation factor Spread across columns of rates according to

assignment and allocation COS Results: essentials for rate design

Revenue requirement (target: 12%, actual 8.94%)

Unit costs and current rate of return by tariff

October 3, 2012 27

Common Criticisms of Common Criticisms of Cost-of-Service RatemakingCost-of-Service Ratemaking

Incentives to utilities: Cost-plus: cost coverage except for

expenditures deemed imprudent by regulator

Potential to distort utility capital decisions

Pricing outcomes: Use of accounting/embedded costs means

that prices will not necessarily be close to marginal cost

Inefficiency of price signals can encourage excessive/needlessly low consumption

Rate DesignRate Design

October 3, 2012 29

Bonbright PrinciplesBonbright PrinciplesCriteria of a Sound Rate StructureCriteria of a Sound Rate Structure

Simple and acceptable Freedom from controversy Yield total revenue requirements Revenue stability Rate stability Fair Avoid undue discrimination Encourage efficient use

From James C. Bonbright, Principles of Public Utility Rates, 1968. Although dated, many still look to these for guidance in setting public utility rates.

October 3, 2012 30

Goal CompatibilityGoal Compatibility

How do we resolve competing goals? Examples:

Rate simplicity vs. price pattern matching cost pattern.

Cost responsibility vs. customer incomes.– Customer charges are typically below fixed

costs

Revenue recovery of embedded cost vs. price efficiency of marginal cost

Desire to promote conservation and renewables vs. pursuing least cost

October 3, 2012 31

ConsiderationsConsiderations

Does the approach recognize all costs?

Can revenue recovery be separated from pricing to some degree?

Can we achieve with pricing what we first try to achieve with rules and regulations? Prices are self-policing. Can prices be used to support

regulations and rules?

October 3, 2012 32

Rate Design Flow ChartRate Design Flow Chart

Rate Design Process

ChooseAlternative

Designs

VerifyRevenues

BillImpact

Analysis

Resulting Rate Design

Metering & Billing Data

AccountingInformation

EmbeddedCOSS

MarginalCOSS

Load Research

& Analysis

MarketResearch

Competitive Forces

Strategic Goals

TacticalGoals

Post RolloutEvaluation

Rate Design Process

ChooseAlternative

Designs

VerifyRevenues

BillImpact

Analysis

Resulting Rate Design

Metering & Billing Data

AccountingInformation

EmbeddedCOSS

MarginalCOSS

Load Research

& Analysis

MarketResearch

Competitive Forces

Competitive Forces

Strategic Goals

Strategic Goals

TacticalGoals

TacticalGoals

Post-RolloutEvaluation

October 3, 2012 33

Types of Charges Types of Charges

Three major ways to bill a customer Customer or base charge:

$/customer/month Demand (highest level of measured

consumption): $/kW/month Energy: $/kWh usage/month

October 3, 2012 34

Traditional Rate DesignsTraditional Rate Designs

Energy-only Rates Flat Rates Blocked Rates

Demand and Energy Rates Customer, Demand, and Energy rates

(Hopkinson) Hours-of-Use rates (Wright)

Time-Differentiated Rates Seasonal Rates Time-of-Use Rates

October 3, 2012 35

Flat RatesFlat Rates

Customer billed via customer and energy charges. Energy price is a single number applying to all consumption in period.

The flat rate is a guaranteed price for a product which depends on: Load-weighted average of embedded cost Hourly cost volatility Customer load volatility Hourly cost volatility/ customer load correlation

Provider offers risk management of electricity service costs to customers

October 3, 2012 36

Blocked RatesBlocked Rates

Energy price varies with amount consumed Surpassing a block threshold causes the marginal

price for energy to change Beyond the first block, the average price paid

differs from the marginal price There can be multiple thresholds; n thresholds

results in n+1 blocks

Block prices can be set to be decreasing, increasing, u-shaped, or n-shaped with load

Moving block prices in the direction of marginal cost can improve price efficiency e.g., high summer tail block price for air

conditioning

October 3, 2012 37

Blocked Tariff PricingBlocked Tariff Pricing

Hour of the Day

Monthly Consumption (kWh)

Price

HourlyConsumption

(kWh)

I

II

III

III

III

HighCost

700 1400

1 24

October 3, 2012 38

Demand and Energy RatesDemand and Energy Rates

Hopkinson demand rate: Bills customers for maximum measured

demand and for energy usage, plus customer charge

Example:– $10.00 per kW of maximum demand per month– $0.08 per kWh usage in a given billing month– $200 per month customer charge

Rates can have declining or inverted block demand and/or usage charges

October 3, 2012 39

Wright Hours-of-Use RateWright Hours-of-Use Rate

Requires measurement of monthly demand (kW) and usage (kWh), but

Charges customers according to usage per demand unit: (HOU = kWh/kW)

Acts as a customer-specific blocked rate Provides blocked pricing efficiency under

traditional metering Example:

e.g., 5 ¢/kWh for first 300 “hours of use,” 4¢/kWh thereafter

Watch out! Increase your peak demand and you push kWh back across the block boundary.

October 3, 2012 40

Hours-of-Use Tariff PricingHours-of-Use Tariff Pricing

Hours of Use

Price

HourlyConsumption

(kWh)

I

II

III

HighCost

400

Hours of Use = kWh/(kW)(max = 720 (100% load factor))

Hour of the Day1 24

October 3, 2012 41

SummarySummary

Regulation and Ratemaking Leads to embedded cost-based COS

Cost of Service Seven steps yield costs and rate of return by

rate; provide basis for revenue request and rate setting

Rate Design Rates serve multiple objectives, leading to

trade-offs– Revenue recovery and pricing efficiency are central

Innovative rates add pricing efficiency and complexity

Appendix 1. Illustrative COS TablesAppendix 1. Illustrative COS Tables

October 3, 2012 43

Typical Power CompanyTypical Power CompanyCost-of-Service StudyCost-of-Service Study

Total Small Large High Total Total UnitLine Electric General General Load Outdoor Retail All Other PowerNo. Description System Residential Services Service Factor Lighting Service Service Sales1 2 3 4 5 6 7 8 9 10 11

Investment

1 Electric Gross Plant 1,591,960 825,803 295,638 154,890 61,577 30,527 1,368,435 36,340 187,1852 Accumulated Depreciation 630,023 339,107 124,597 68,486 26,438 8,127 566,755 16,147 47,1213 Net Plant 961,937 486,696 171,041 86,404 35,139 22,400 801,680 20,193 140,0644 Materials and Supplies 62,495 28,685 13,877 9,392 3,649 576 56,179 1,866 4,4505 Cash Working Capital 44,079 20,200 9,443 6,402 2,646 487 39,177 1,226 3,6766 Other Rate Base Items 20,856 8,288 2,893 1,464 589 352 13,586 343 6,9277 Total Electric Investment 1,089,367 543,869 197,254 103,662 42,023 23,815 910,622 23,628 155,117

Revenues

8 Revenue from Sales 494,911 248,383 120,912 75,423 29,018 7,507 481,243 13,668 09 Other Operating Revenues 5,847 4,262 782 275 105 36 5,460 387 010 Revenue-Nonassociated Sales 58,078 1,345 734 568 241 27 2,915 106 55,05711 Total Adjusted Revenue 558,836 253,990 122,428 76,266 29,364 7,570 489,618 14,161 55,057

Present Rate SummaryPresent Rate Summary($000’s)($000’s)

October 3, 2012 44

Typical Power CompanyTypical Power CompanyCost-of-Service StudyCost-of-Service Study

Total Small Large High Total Total UnitLine Electric General General Load Outdoor Retail All Other PowerNo. Description System Residential Services Service Factor Lighting Service Service Sales1 2 3 4 5 6 7 8 9 10 11

Expense

12 Operation & Maintenance 352,635 161,599 75,542 51,215 21,165 3,897 313,418 9,809 29,40813 Depreciation 57,998 31,449 11,030 5,575 2,153 2,001 52,208 1,288 4,50214 Amort. of Inv. Tax Credit -2,238 -1,116 -392 -198 -76 -71 -1,853 -46 -33915 Real & Personal Prop. Tax 16,560 8,992 3,338 1,851 732 279 15,192 440 92816 Payroll Tax 4,055 2,426 828 385 143 63 3,845 87 12317 Other Taxes 1,002 613 216 99 36 16 980 22 018 Expenses Exc. Inc. Tas 430,012 203,963 90,562 58,927 24,153 6,185 383,790 11,600 34,622

19 Operating Income 128,824 50,027 31,866 17,339 5,211 1,385 105,828 2,561 20,435

20 State & Federal Income Tax 31,487 10,575 9,128 5,026 1,336 152 26,217 609 4,661

21 Net Operating Inocme 97,337 39,452 22,738 12,313 3,875 1,233 79,611 1,952 15,774

22 Rate of Return 8.94% 7.25% 11.53% 11.88% 9.22% 5.18% 8.74% 8.26% 10.17%

Present Rate SummaryPresent Rate Summary($000’s)($000’s)

Appendix 2. Time-Dependent RatesAppendix 2. Time-Dependent Rates

October 3, 2012 46

Time-Differentiated RatesTime-Differentiated Rates Price differs by season and/or hour of the day Pricing can be tariff-based or “dynamic,”

based on recent wholesale prices or marginal cost

Why? Costs differ by time; prices better reflect cost

causality Can induce load shifting, lowering overall costs Customer’s time pattern of usage determines cost

Why not? Large price differences are needed to induce

significant shifting (e.g., peak/off-peak ratio of 3:1) Wide range of bill impacts: instant winners, losers,

and adverse selection produce revenue attrition Many customers do not like them

October 3, 2012 47

Seasonal Rates Seasonal Rates

Rates that differ by the season of the year

Seasonal rates are still fixed for the season and are not dynamic

May have two or more seasons

October 3, 2012 48

Time-of-Use PricingTime-of-Use Pricing

POP

PP

MCP

MCOP

Prices can be moved closer to marginal cost.

1OPQ1

PQ 0PQ

DOP0

OPQ

PF

PF

DP

$/kWh

kWh

Off-PeakPeak

kWh

$/kWh

October 3, 2012 49

Time-of-Use PricingTime-of-Use Pricing

Prices differ by the period of the day Two or more pricing periods in a day

– Peak/off-peak– Peak/shoulder/off-peak

Traditional TOU rates are set well in advance and fixed by period, rather than being dynamic, i.e., reflecting current marginal cost

Summary: time differentiating traditional rates can improve costing accuracy but prices still have limited marginal costing

Appendix 3.Appendix 3.Alternatives to Traditional Rate CasesAlternatives to Traditional Rate Cases

October 3, 2012 51

Strategic Planning and Strategic Planning and Alternatives to Rate CasesAlternatives to Rate Cases

Rate Cases are expensive. Must we have Rate Cases? Are there ways to avoid Rate Cases?

Are there ways to dampen Cost-of-Service impacts and Rate Case shock?

October 3, 2012 52

Adjustment ClausesAdjustment Clauses

Some clauses are automatic; some require a hearing and audit

Apply to major expense categories such as fuel, purchased power, and purchased gas

Allow adjustment to rates based on fluctuation in specific costs from a base level

Key criterion: costs are largely beyond the control of the utility

October 3, 2012 53

Move from historical test period basis: Future test period

Historical test period with pro forma adjustments

Accounting orders Decoupling Automatic Revenue Adjustment

Mechanisms Formulary-Based Ratemaking (FBR)

Strategic Planning and Strategic Planning and Alternatives to Rate CasesAlternatives to Rate Cases

October 3, 2012 54

Formulary-Based RatemakingFormulary-Based Ratemaking

Automatic, pre-scheduled review of a company’s earnings Defined formula for evaluations Provides rates of return or margin coverage Usually specific about allowed cost and

revenue inputs– Typical disallowances include: lobbying, charitable

donations, advertising, civic, and club dues

– Cash working capital and construction work in progress are usually allowed, with limitations