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Tariff Development I:Overview of Rate Regulation

and Basic Ratemaking Process

Energy Regulatory Partnership ProgramAbuja, Nigeria

July 14-18, 2008

Ikechukwu N. Nwabueze, Ph.D.Director, Regulated Energy Division

Michigan Public Service Commission

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Rate Making Principles

Principles of Rate Regulation

• Fairness to both the regulated utility and the ratepayers

• Avoidance of unjust or undue discrimination between rate classes or customers

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Rate Making Principles (Continued)

Objectives in Setting Rates

• Protect the ratepayer’s interest by assuring safe, reliable and reasonably priced services

• Fairly apportioning cost among customers• Protect the shareholder’s interest by

allowing the utility a reasonable opportunity to earn a fair rate of return on its investment

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Determining Revenue Requirements

• Revenue Requirement = r(RB) + Expense + Depreciation & Depletion Expense + Taxes

• R(RB) = Income Requirement = Rate of Return multiply by Rate Base– Rate Base represents the investor-supplied plant facilities and other

investments required in supplying utility service to consumers– Rate of Return can be defined as a judgmentally determined percentage

that, when multiplied by an established rate base amount, provides a return that is intended to allow a utility (1) to meet its obligations to present capital investors (interest and dividends) and (2) to compete on reasonable terms in the financial markets for future capital requirements

– REVENUE REQUIREMENT must be sufficient to cover the COSTS OF SERVICE, which are comprised of TOTAL OPERATING EXPENSES (including all taxes and depreciation charges), and a FAIR RETURN on the net plant rate base authorized for the utility

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Utility CompanyCase No. U-###

Calculation of Revenue Requirement

TotalLine Description Amount Amount

Revenue Requirement = r(RB) + E + D + T

r(RB) = Income Requirement = Rate of Return times Rate Base

1 Rate Base $1,904,152

2 Rate of Return 7.1924%

3 Income Requirement (Line 1 x Line 2) $136,954 $136,954

Expenses (from Page 3 of 6)4 Company Use and Lost Gas Expense $32,313

5 Operation and Maintenance (O&M) Expense $298,316

6 Uncollectibles Expense $24,274

7 Depreciation and Depletion Expense $90,546

8 Federal and Other Income Tax Expense $8,041

9 Other Taxes $53,216

10 Other Items (Amortization of Debt Discount) $1,500

11 Allowance for Funds Used During Construction (AFUDC) -$1,400

12 Other Revenue (Column D, From Non-Ratepayer Sources) -$103,014

13 Additional Income Taxes from Page 1 (the Revenue Multiplier) $18,400

14 Other (not reconciled) -$1

15 Total Revenue Requirement $559,145

Revenue Requirement Calculation - Commission16 Revenue Deficiency (from Page 1 of 6) $50,160

17 Gas Sales Revenue (from Page 3 of 6) $417,788

18 Transportation Revenues (from Page 3 of 6) $91,197

19 Total Revenue Requirement $559,145

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Expenses

• Operations and Maintenance Expenses – Booked O&M Expense– Remove Disallowances– Remove Items Adjusted Elsewhere– Apply Inflation Factor

• Employee Benefits• Depreciation and Amortization• Federal and City Income Tax• Property Tax

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Utility Plant Used and Useful

• For property to be classified as PLANT, it must be in use and useful

• Property not in use or not useful is placed in Construction Work in Progress or Held for Future use

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Cost of Capital and Associated Issues

Staff Calculation of WEPCo'sINTERIM Case U-15500 - Overall Cost of Capital2006 Historical Test Year

(a) (b) (c) (d) (e) (f) (g)

Weighted WeightedCost of Cost of

Line Permanent Ratemaking Cost Permanent RatemakingNo Description Amount Capital Capital Rate Capital Capital

1 Long-Term Debt $1,356,411,998 37.86% 32.80% 5.24% 1.98% 1.72%

2 Preferred Stock $30,449,800 0.85% 0.74% 4.01% 0.03% 0.03%

3 Common Equity $2,195,994,892 61.29% 53.11% 11.00% 6.74% 5.84%

4 Total Permanent Capital $3,582,856,690 100.00% 8.76%

5 Short-Term Debt $166,719,072 4.03% 5.93% 0.24%

6 Other Interest Bearing Accts $0 0.00% 0.00% 0.00%

7 Customer Deposits $0 0.00% 0.00% 0.00%

8 Deferred Investm't Tax Credits $0 0.00% 0.00% 0.00%

9 Deferred Federal Income Tax $329,468,789 7.97% 0.00% 0.00%

10 JDITC - LT Debt $21,153,908 0.51% 5.24% 0.03%11 JDITC - Preferred Stock $474,880 0.01% 4.01% 0.00%12 JDITC - Common Equity $34,247,613 0.83% 11.00% 0.09%

13 JDITC - Total $55,876,400

14 Other Capital Structure Adj'mts $0 0.00% 0.00% 0.00%

15 TOTAL $4,134,920,951 100.00% 7.95%

Notes: Long-Term Debt is cost of outstanding issues.Short-Term Debt consists of commercial paper, s-t notes.Common Equity cost rate is last authorized rate by Commission.JDITC means Job Development Investment Tax Credits.

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Cost of Capital Concept• Defined as the minimum rate of return that is necessary to

attract capital to an investment.• Forward looking concept• Opportunity cost – it is the cost of alternative investments that

were forgone• Determined in the markets – it is demand for and supply of

capital that determines the price for capital• Depends on the risk of an investment• Goal is to allow the utility to earn a rate of return which is fair

and consistent with its investment in plant and equipment• Utility’s cost of capital is the return investors expect, or

require, in order to provide the utility with capital• Equity consists of shares that are issued to the public and any

applicable premiums and retained earnings

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Types of Return

• Authorized: The rate of return regulators have determined to be the company’s overall cost of capital, including the rate of return investors require on common equity in a rate proceeding.

• Required: What investors desire as a return for investing their money in the common stock of a company.

• Expected: What investors believe the investment will return.

• Actual: What the books of account reflect at the end of the accounting cycle.

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Capital Structure

• The overall rate of return of a utility company depends on the capital structure that is used to finance its investment.

• The permanent capital structure or capitalization of a firm is represented by long-term debt, preferred stock and common equity.

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Capital Structure (Continued)

• The correct mix of debt and equity in a utility’s capitalization is important because debt is cheaper than equity. The tax advantage of debt makes equity about twice as expensive as debt.

• Long-term Goal for Permanent Capital Structure– Debt: 50%– Preferred Stock: 0-5%– Common Equity: 45-50%

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Ratemaking Capital Structure

• Components– Long-term Debt– Preferred Stock– Common Equity– Short-term Debt– Customer Deposits– Other Interest Bearing Items– Deferred Income Taxes– Deferred Federal Income Taxes– Job Development Investment Tax Credits

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Staff Calculation of WEPCo'sINTERIM Case U-15500 - Overall Cost of Capital2006 Historical Test Year

(a) (b) (c) (d) (e) (f) (g)

Weighted WeightedCost of Cost of

Line Permanent Ratemaking Cost Permanent RatemakingNo Description Amount Capital Capital Rate Capital Capital

1 Long-Term Debt $1,356,411,998 37.86% 32.80% 5.24% 1.98% 1.72%

2 Preferred Stock $30,449,800 0.85% 0.74% 4.01% 0.03% 0.03%

3 Common Equity $2,195,994,892 61.29% 53.11% 11.00% 6.74% 5.84%

4 Total Permanent Capital $3,582,856,690 100.00% 8.76%

5 Short-Term Debt $166,719,072 4.03% 5.93% 0.24%

6 Other Interest Bearing Accts $0 0.00% 0.00% 0.00%

7 Customer Deposits $0 0.00% 0.00% 0.00%

8 Deferred Investm't Tax Credits $0 0.00% 0.00% 0.00%

9 Deferred Federal Income Tax $329,468,789 7.97% 0.00% 0.00%

10 JDITC - LT Debt $21,153,908 0.51% 5.24% 0.03%11 JDITC - Preferred Stock $474,880 0.01% 4.01% 0.00%12 JDITC - Common Equity $34,247,613 0.83% 11.00% 0.09%

13 JDITC - Total $55,876,400

14 Other Capital Structure Adj'mts $0 0.00% 0.00% 0.00%

15 TOTAL $4,134,920,951 100.00% 7.95%

Notes: Long-Term Debt is cost of outstanding issues.Short-Term Debt consists of commercial paper, s-t notes.Common Equity cost rate is last authorized rate by Commission.JDITC means Job Development Investment Tax Credits.

Overall Rate of Return

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Capital Costs

• To determine the cost of debt we look at the interest rate or coupon rate that the utility paid to finance that debt.

• Preferred stock carries a fixed commitment and its cost is calculated the same way as debt.

• Determining the cost of common equity is more complex than determining the cost of debt. Since a stockholder is not guaranteed a cash flow or a return, there is higher risk involved in holding the stock of a company.

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• Determining a company’s required rate of return on its common equity is defined by a general equation.

• Required Rate of Return = Risk-free Rate + Risk Premium

- Risk-free Rate: Real rate of return on riskless security + inflation.

- Risk Premium is composed of:

Interest Rate Risk Premium Market Risk Premium

Business Risk Premium Regulatory Risk Premium

Financial Risk Premium Liquidity Risk Premium

Common Equity Cost Rate

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• In the Bluefield Water Works and Improvement Co. vs. Public Service Commission, 262 U.S. 679, 692-693 (1923) case, the Court stated:

“A 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 part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but has no

constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures.”

Legal Guidelines

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• In the Federal Power Commission vs. Hope Natural Gas Company, 320 U.S. 591, 603 (1944) case, the Court stated:

“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 anddividends on the stock. By that standard the return to the equity owner should be commensurate with returns on investment in otherenterprises having corresponding risks. That return, moreover,

shouldbe sufficient to assure confidence in the financial integrity of theenterprise, so as to maintain its credit and to attract capital.”

• Supreme Court established an “end result” doctrine which surmised that how a capital structure and rate of return is determined is not important so long as end result is appropriate and reasonable for the case at hand.

Legal Guidelines (Continued)

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1. Comparable Earnings: Return commensurate with those investments in enterprises of comparable risk. Historical Approach.

2. Discounted Cash Flow Method (DCF): Return based on hypothesis that the market price of stock will equal the discounted value (present value) of all future earnings. DCF model equation is:

K = (D1 / P) + g

Cost of Equity Approaches

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3. Capital Asset Pricing Model (CAPM):

- KS = RF + B (Km-RF) where

- KS = Cost rate on equity capital of the firm

- RF = Risk free rate of return

- Km = Market rate of return

- B = Market risk of the stock

Risk of a portfolio of assets is less than the average of the risks of individual assets.

4. Risk-Premium Approach:

KS = RF + Risk Premium

Cost of Equity Approaches (Continued)

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Moody’s – Fitch – Standard and Poor’s

Non-Financial Criteria Financial Criteria

Market/Service Territory Leverage

Fuel Supply Cash Flow

Operating Efficiency Earnings Protection

Regulatory Treatment Financial Flexibility

Management Accounting Quality

Competition Construction Spending

Bond Rating Agencies

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S&P Moody’s Fitch

DTE Energy BBB- Baa2 BBB

Detroit Edison A- A3 A-

MichCon BBB+ A3 A-

CMS Energy BBB- Ba1 BB+

Consumers Energy BBB Baa1 BBB-

Ratings of Michigan’s Two Largest Utility Company’s

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Rate Base Determination

• Balance Sheet

– Plant

• Remove Depreciation Reserves

– Related Account Balances

• Working Capital

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Test Year and Adjustments

• O&M adjustment (remove known & measurable, and add in inflation)– Uncollectibles– Disallowances

• Plant adjustment– Recalculate depreciation– Construction Work in Progress– Held for Future Use

• Tax adjustment– To take in affect the above adjustments

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Data Collection and Processing, Monitoring

• Commission ordered periodic filings

• Audit requests

• Discovery questions

• Motion to Compel

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Developing Chart of Accounts and Instructions for Regulated Utilities

• We use the Uniform System of Accounts (USoA)(Generally accepted or applied by all the states)

– USoA is a set of rules that prescribe the types of accounting records that must be kept by utilities. There are USoAs for both electric and gas utilities.

– USoA prescribe a uniform set of account numbers for all balance sheet and income statement accounts

– USoA also provides detailed descriptions of the types of items that should be included in each account.

– USoA prescribes the accounting period. Income Statement detail must be segregated on a monthly basis, and balance sheet accounts must be measured at the end of each month. Utilities must close their books at the end of each year.

– Finally, USoA has instructions to aid utilities in properly recording transactions.

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Questions?