Recent rate requests have been substantial - Law Seminars m Parmesano... · Hethie Parmesano of...

Hethie Parmesano of NERA Economic Consulting Speaker 15: 1

Law Seminars International | Utility Rate Cases | 02/08/08 in Las Vegas, NV

Inter-Class Clashes Over Rising Revenue Requirements: Revenue Requirements: Economic Issues

Presented at:Utility Rate Cases: Current Issues and StrategiesA Law Seminars International Conference

Dr. Hethie S. ParmesanoSenior Vice President

Las Vegas

February 8, 2008

Recent rate requests have been substantial

Utility Percent Amount Reason for the IncreaseFiling Date

Southern California Edison 6.2% $726m To to replace aging distribution infrastructure and business systems, meet regulatory requirements for generation and procurement, increased O&M expenses and employee

Nov-07

Requested Increase

Otter Tail Power Co. 11.0% $14.5m Fuel cost increase, new network investment and rate base growth.

Oct-07

Central Illinois Light 14.49% $30.9m To keep up with $900 million of planned system investments through 2010

Nov-07

Idaho Power 10.35% $63.9m Increased generation and network investment and O&M expenses

Jun-07

Pacificorp (WY) 9.50% $36.1m Increased fuel and purchased power costs and recent infrastructure investments

Jun-07

Northern States Power (MN) 13.95% $20.5m Recent infrastructure investments and increased operating costs.

Dec-07

1

Tucson Electric Power (AZ) 23.0% $158.2m End of 10-year rate freeze Jul-07

Oklahoma Gas & Elec 8.8% $5.4m Increased O&M expenses and investment in the McClain power plant and the Centennial wind farm facility.

Jul-06

Kansas City Power & Light 6.4% $28m To support a 5-year resource expansion plan including pollution control equipment; 100 MW of new wind generation; $42 million intransmission and distribution infrastructure; and demand response programs.

Mar-07

Public Service Co. (CO) 12.7% $107m To support investment in a coal-based power plant. Apr-06



Utility Revenue Requirements are Growing

Ramped up construction programs are a major causecause

New generation requirements, including renewables

Preparation for carbon trading program

New transmission (some with rate of return adders)

2

Long-overdue distribution system upgrades

Investment in advanced metering infrastructure (AMI)


Construction cost inflation is mind-boggling:

Handy-Whitman Price Indices for Selected Electric Utility Components (North Atlantic Region)

250

100

150

200

ndex

(199

8=10

0)

Total Transmission Plant

Total Distribution Plant

Overhead Conductors &Devices

Pad Mounted Transformers

3

0

50

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

In Pad Mounted Transformers




Other factors contribute to rising revenue requirements:requirements:

Catch-up after rate freezes

Incentive payments for DSM activities

Higher energy costs (and market prices)– Rising fuel prices

4

Rising fuel prices

– Increased use of expensive fuel and reduced use of cheap (dirty) fuel

Rising fuel prices

U.S. Natural Gas Price to Electricity Generators

$3$4$5$6$7$8$9

Dol

lars

per

MC

F

5

$0$1$2

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: EIA



Rising electricity market prices

Day-Ahead Wholesale Energy Prices by Hub[annual weighted averages]

9

2345678

ice

in C

ents

per

kW

h

NepoolCinergyEntergy

6

01

2001 2002 2003 2004 2005 2006 2007

Source: Based on EIA Averages of Trades on Intercontinental Exchange

Pri


Big increases in total revenue requirements mean louder arguments about revenue gallocation among customers:

Should small residential customers be protected (and does “small” mean “needy”?

Should residential customers in general (continue to) be protected because they are voters?

7

Should small businesses be protected because they have few options?

Should major employers be protected to increase or save jobs?



Settling these arguments requires defining and prioritizing ratemaking objectives

Typical objectives include:

Revenue adequacy

Cost-based rates (avoidance of cross-subsidies)

Equity

Gradualism (avoidance of unacceptable bill changes)

8

Economic efficiency

Promotion of other societal goals (e.g., reducing carbon emissions)

Existing Cross-Subsidies in Many Jurisdictions Complicate the Task

Generically: a cross-subsidy exists when a portion of the cost associated with one group’s service is recovered from another group.g p

The revenue allocations inherent in current rates may not reflect current costs:

– when specific policies (that may no longer make sense) called for cross-subsidies,

– in cases where rates have not been changed for years, or

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– when a series of across-the-board rate adjustments have been made.

But what is the proper measure of “cost”?



Alternative notions of “cost” for use in quantifying cross subsidies

1. Embedded costs allocated to the class

Equal rates of return on allocated investment imply no b idi d thi hcross-subsidies under this approach.

HOWEVER,

Embedded cost studies yield widely varying results, depending on the classification and allocation methods used.

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The use of embedded costs to define class revenue requirements may be inconsistent with other ratemaking objectives such as economic efficiency.


2. Marginal cost revenues of the class

Under this approach, no class is receiving a cross b id if it t l t th i l t f i itsubsidy if it pays at least the marginal cost of serving it

(marginal cost per unit times number of units).

HOWEVER,

Charging rates set equal to marginal costs for each class may not cover the total revenue requirement.

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Charging rates set equal to marginal cost for each class may produce too much revenue.

There may be a (positive or negative) marginal cost revenue gap.




3. Marginal cost revenues of the class, adjusted efficiently to close the revenue gap

Under this approach, no class is receiving a cross subsidy if it pays at least the marginal cost of serving it plus an efficient share of the revenue gap.

An efficient allocation of the revenue gap requires making adjustments to marginal cost prices that create minimal di t ti i ti d t h i

12

distortions in consumption compared to charging marginal costs as rates. (Ramsey pricing or a similar approach.)

This is the cost test I prefer to use to evaluate cross subsidies.

Example of cross subsidies

A mid-western utility with no rate case for two decades would require wildly different rate increases to bring all classes to full embedded cost.

Percent Rate Increase Required to Match Embedded COS

Irrigation

Large General Service

General Service

Farms

Residential

All Classes

13

-10% 0% 10% 20% 30% 40% 50% 60% 70%

Off-Peak Service

Interruptible Service

Controlled Water Heating

Other Public Authorities

Lighting



Heavy weight on “gradualism” objective may mean permanent cross-subsidies

In 2006, the Pennsylvania Commonwealth Court rejected transmission and distribution rates approved by the PA pp yPUC for PPL Electric Utilities Corporation because of excessive emphasis on gradualism (keeping total bill increases under 10%):

“[W]hile permitted, gradualism is but one of many factors to be considered and weighed by the Commission in determining rate designs, and principles of gradualism cannot be allowed to trump all other valid ratemaking

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cannot be allowed to trump all other valid ratemaking concerns and do not justify allowing one class of customers to subsidize the cost of service for another class of customers over an extended period of time.”

Lloyd v. Pa PUC, 904 A2d 1010, 1020

Increasingly, customers providing subsidies have options

Move the facility (or shift production) to a jurisdiction with y ( p ) jlower rates.

Invest in self-generation (which may be economically efficient, but is more likely to constitute uneconomic bypass if rates include subsidies).

Agitate for retail competition (or buy from a competitive

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retailer, if this is already permitted).

Cross-subsidies cannot be maintained if the subsidizing customers have an escape route.



What can be done?

Three approaches for managing the coming battles:

Reduce the total revenue requirement.

Help customers adjust to new higher rates.

Reconsider what constitutes “too large” a bill increase

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increase.

Strategies for reducing the revenue requirement

Securitize new debt.

Reduce volatility of costs and revenue requirement by reducing risk.

17



Securitization[This example shows use in stranded cost recovery.]

Use of Proceeds- retire debt- buy back equity- fund new investment

True-up

Utility InvestorsSPECTC

Proceeds

Rights to CTC

Principal + Interest

Proceeds

Rights to CTC

CTC in

18

True upas needed

Customers Government

AuthorizesCTC in

electricity bill

CTC = Competition Transition Charge

SPE = Special Purpose Entity

Examples of Securitization

Transmission line between Northern Ireland and Scotland

Pa P&L’s 2002 “synthetic sale” of the local distribution utility

Renewable energy purchase power agreements in many countries, including Italy

19

Storm damage costs in Florida

Environmental upgrades (e.g., scrubbers on coal plants) in Wisconsin and West Virginia



Other Mechanisms to Reduce Volatility of Costs (and Revenue Requirement)

Obtain pre-approval from regulatory commission for major investment. [The Western Governors Assoc. in 2006 recommended this approach for certain generation

j t id d tiliti t d i k ]projects, provided utilities manage costs and risks.]

Begin cost recovery as facilities are constructed. [This also spreads out cost recovery.]

Negotiate turn-key arrangements. [This shifts risk to the builder, which may or may not reduce revenue

i t ]

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requirements.]

Build with partners. For example, PPL is looking for a partner for its proposed 1,600-MW nuclear project.

Use insurance products.

Insurance Examples[from MMC Securities Corp.]

Power Price Protection – an outage contingent call option on power Used to either protect revenue or replacementon power. Used to either protect revenue or replacement cost of power.

Power Demand Protection – a weather and/or demand contingent call option on power. Used when demand is greater than forecast.

21



Strategies for helping customers adjust to higher rates

Give warning of coming increases.

Offer optional rates that allow customers to control their billbills:

– Time-of-use rates

– Critical-peak pricing

– Real-time pricing

– Interruptible programs

Push energy efficiency measures to cut consumption

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Push energy efficiency measures to cut consumption.

Promote budget billing.

Emphasize the benefits of reduced consumption on the environment.

Reconsider what is too high an increase

Acceptable increases vary depending on the customer.

– Rethink best way to provide help to needy familiesUse a needs test, so the help is targeted.Give a fixed credit on the monthly bill, rather than percentage discount or low-cost first block that distorts the price signal.Subsidize weatherization and more efficient appliances to reduce consumption by low-income customers.

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– Business customers complain about utility rate increases, but they deal with even higher increases in other costs; e.g., transportation, environmental, health care. (In the case of utility costs, they have someone to whom to address their complaints.)



Rate design within classes is an issue when there are big increases for the class

If rate increases are driven by rising peak loads, lack of time-of-use rates may be penalizing customers whose y p gpercentage of use on peak is below the class average.

The relationship between demand and energy charges in current rates may need to be altered to reflect a new cost structure.

Current block structures may make the problem worse.

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y p

Effect of Across-the-Board Increase (20%) on Steeply Inverted Rate Structure

Rates and Costs Before and After 20% Across-the-Board Increase

18

20

8

10

12

14

16

18

ce p

er k

Wh

in b

lock

Old Cost

New Cost

Old rate

New rate

25

0

2

4

6

kWh per month

Pric

50 kWh 300 kWh



Effect of Across-the-Board Increase (20%) on Steeply Inverted Rate Structure

Change in Monthly Cross-Subsidy Received (Provided) by Customer

-$4

-$2

$0

$2

$4

$6

$8Subsidy per month

Under Old RateUnder New Rate

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-$12

-$10

-$8

-$6

A (50 kWh) B (250 kWh) C (600 kWh)

Monthly kWh Use by Customer A, B, C

Conclusions

Establish explicit ratemaking objectives and be specific about definition and acceptable levels of cross-subsidies.

Higher prices will have elasticity effects – reducing the rate of growth in demand (and the timing of new capacity

Look for ways to control the size of overall rate increases.

Look for ways to help customers control their own bill increases.

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g ( g p yadditions) as well as customers bills (compared to a bill based on old use times new rates).

The silver lining – given growing concern about global climate change and energy use’s contribution to the problem, higher electricity prices may help make a dent in the growth of carbon emissions.



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Hethie S. Parmesano

Senior Vice PresidentLos Angeles, CAg ,+1 213 346 [email protected]

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