Transcript Slide 1

Tariff Development I:
Overview of Rate Regulation
and Basic Ratemaking Process
Energy Regulatory Partnership Program
Abuja, 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 Company
Case No. U-###
Calculation of Revenue Requirement
Line
Description
Amount
Total
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
4
Company Use and Lost Gas Expense
5
Operation and Maintenance (O&M) Expense
6
Uncollectibles Expense
$24,274
7
Depreciation and Depletion Expense
$90,546
8
Federal and Other Income Tax Expense
9
Other Taxes
10
Other Items (Amortization of Debt Discount)
11
Allowance for Funds Used During Construction (AFUDC)
12
Other Revenue (Column D, From Non-Ratepayer Sources)
13
Additional Income Taxes from Page 1 (the Revenue Multiplier)
14
Other (not reconciled)
15
Total Revenue Requirement
16
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)
19
Total Revenue Requirement
$136,954
Expenses (from Page 3 of 6)
$32,313
$298,316
$8,041
$53,216
$1,500
-$1,400
-$103,014
$18,400
-$1
$559,145
Revenue Requirement Calculation - Commission
$91,197
$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's
INTERIM Case U-15500 - Overall Cost of Capital
2006 Historical Test Year
(a)
Line
No
Description
(b)
(c)
Amount
(d)
(e)
(f)
(g)
Weighted
Cost of
Ratemaking
Capital
Permanent
Capital
Ratemaking
Capital
Cost
Rate
Weighted
Cost of
Permanent
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%
5
Short-Term Debt
6
8.76%
$166,719,072
4.03%
5.93%
0.24%
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
11
12
JDITC - LT Debt
JDITC - Preferred Stock
JDITC - Common Equity
$21,153,908
$474,880
$34,247,613
0.51%
0.01%
0.83%
5.24%
4.01%
11.00%
0.03%
0.00%
0.09%
13
JDITC - Total
$55,876,400
14
Other Capital Structure Adj'mts
0.00%
0.00%
0.00%
15
TOTAL
$0
$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:
– Preferred Stock:
– Common Equity:
50%
0-5%
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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Overall Rate of Return
Staff Calculation of W EPCo's
INTERIM Case U-15500 - Overall Cost of Capital
2006 Historical Test Year
(a)
Line
No
Description
(b)
(c)
Amount
$1,356,411,998
(e)
(f)
(g)
W eighted
Cost of
Ratemaking
Capital
Permanent
Capital
Ratemaking
Capital
Cost
Rate
W eighted
Cost of
Permanent
Capital
37.86%
32.80%
5.24%
1.98%
1.72%
0.85%
0.74%
4.01%
0.03%
0.03%
53.11%
11.00%
6.74%
5.84%
1
Long-Term Debt
2
Preferred Stock
3
Common Equity
$2,195,994,892
61.29%
4
Total Permanent Capital
$3,582,856,690
100.00%
5
Short-Term Debt
6
$30,449,800
(d)
8.76%
$166,719,072
4.03%
5.93%
0.24%
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%
0.51%
0.01%
0.83%
5.24%
4.01%
11.00%
0.03%
0.00%
0.09%
0.00%
0.00%
0.00%
10
11
12
JDITC - LT Debt
JDITC - Preferred Stock
JDITC - Common Equity
$21,153,908
$474,880
$34,247,613
13
JDITC - Total
$55,876,400
14
Other Capital Structure Adj'mts
15
TOTAL
$0
$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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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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Common Equity Cost Rate
• 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
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Legal Guidelines
• 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.”
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Legal Guidelines (Continued)
• 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 and
dividends on the stock. By that standard the return to the equity
owner should be commensurate with returns on investment 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.”
• 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.
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Cost of Equity Approaches
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
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Cost of Equity Approaches
(Continued)
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
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Bond Rating Agencies
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
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Ratings of Michigan’s
Two Largest Utility Company’s
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-
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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?
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