Cost of Service, Rate Design, and Price Efficiency

Bruce Chapman Christensen Associates Energy Consulting

October 3, 2012

Wisconsin Public Utility Institute Fundamental Course: Energy Utility Basics

Agenda

 Regulation and Ratemaking  Cost of Service  Rate Design October 3, 2012 2



Regulation and Ratemaking

Rationale 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 4

Goals of Public Utility Ratemaking: A 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 5

Rate 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 October 3, 2012 6



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 8

October 3, 2012

Cost-of-Service Steps

1.

Compile 2.

Functionalize 3.

Levelize 4.

Classify 5.

Assign 6.

Allocate 7.

Determine Return 9

Cost-of-Service Steps

1.

2.

3.

4.

5.

6.

7.

Compile Functionalize Levelize Classify Assign Allocate Determine Return

Step 1

Compile appropriate rate base, expenses, and revenues (often by FERC account); decide upon categories of customers to be analyzed October 3, 2012 10

Step 1: Total Company Summary

Total System Rate base Revenues Expenses $16,826,786 $8,049,850 O&M – fuel O&M – other Depreciation & amort. expense $2,236,885 2,245,054 779,145 Taxes other than income taxes Total adjusted expenses 431,509 $5,692,593 Income taxes Net operating income Rate of return $927,414 $1,429,843 8.50% Residential Commercial Industrial Lighting Total Retail Service Total Other Service

October 3, 2012 11

Cost-of-Service Steps

1.

2.

3.

4.

5.

6.

7.

Compile Functionalize Levelize Classify Assign Allocate Determine Return

Step 2

Functionalize rate base and expense items by four major functions: a.

generation/supply b.

c.

d.

transmission distribution general plant and administration October 3, 2012 12

Step 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 13

Cost-of-Service Steps

       Compile Functionalize 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 14

October 3, 2012

Develop Levelized Demand and Energy Allocators

Service Level Designation and Power Flow Diagram

Service Level 1 Generation and Territorial Input Transmission Line 46kW to 500 KW lines 2 Transmission to Distribution Transformation 3 Primary Distribution Lines 25kV and lower 4 Line Transformers 5

Indicates power flow

15

Cost-of-Service Steps

1.

2.

3.

4.

5.

6.

7.

Compile Functionalize Levelize Classify Assign Allocate Determine Return

Step 4

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

b.

c.

Energy-related Demand-related Customer-related d.

Revenue-related October 3, 2012 16

Step 4: Classifying Costs

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

Service Level

Level 1 Level 2 Level 3 Level 4 Level 5

Generation

Demand  Energy 

Transmission

Demand

Distribution

Demand Customer        October 3, 2012 17

Cost-of-Service Steps

1.

2.

3.

4.

5.

6.

7.

Compile Functionalize Levelize Classify Assign Allocate 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 18

Step 5: Directly Assign

 Revenue from sales  Customer substations  Radial customer-specific lines  Meters  Sales support and billing costs October 3, 2012 19

Cost-of-Service Steps

1.

2.

3.

4.

5.

6.

7.

Compile Functionalize Levelize Classify Assign Allocate 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 20

Step 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 21

Developing Demand Allocators

Load Shape Determinants Rate Class Information Demand Allocation Methods: 1) Average & Excess 2) 12 NCP 3) 12 CP 4) Marginal Cost 5) Equivalent Peaker 6) Proportional Responsibility 7) Other Allocation Factors: Allocating Costs by Rate Class and Function

October 3, 2012 22

Cost-of-Service Steps

1.

2.

3.

4.

5.

6.

7.

Compile Functionalize Levelize Classify Assign Allocate Determine Return

Step 7

Determine rate of return for evaluation October 3, 2012 23

Illustrative Cost-of-Service Study:

Rate Base ($million) Description Investment

Gross Plant Accumulated Depreciation Net Plant

Current Assets & Liabilities

Materials & Supplies Cash Working Capital Other Net Current Assets

Rate Base System Residential Small Business Large Business Lighting

1,500 600 900 55 35 10 100 1,000 700 280 420 26 15 5 46 466 300 120 180 12 8 3 22 202 250 100 150 10 6 2 18 168 25 10 15 0 0 0 0 15

Other

75 30 45 2 3 0 5 50

Wholesale

150 60 90 5 3 0 8 98 October 3, 2012 24

Illustrative Cost-of-Service Study

Revenues, Expenses, Rate of Return ($million) Description Revenues

Electricity Sales Other Operating Revenues Revenue-Nonassociated Adjusted Revenues

Expenses

Operation & Maintenance Depreciation Taxes excl. Income Tax Adjusted Expenses

Operating Income

Income Taxes

Net Operating Income Rate of Return (NOI/RB) System Residential Small Business Large Business Lighting

450 5 45 500 325 50 25 400 100 25 75 7.50% 200 3 2 205 150 25 12 187 18 5 14 2.90% 125 1 1 127 75 10 6 91 37 9 27 13.55% 100 1 1 102 65 9 5 79 24 6 18 10.49% 5 1 1 7 2 0 1 7.40% 8 0 0 8

Other

17 0 1 18 10 1 1 12 6 2 5 8.93%

Wholesale

0 0 40 40 20 4 2 26 15 4 11 11.05% October 3, 2012 25

Cost-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 26

Common Criticisms of Cost-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 October 3, 2012 27



Rate Design

Bonbright Principles

Criteria of a Sound Rate Structure

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

        Simple and acceptable Freedom from controversy Yield total revenue requirements Revenue stability Rate stability Fair Avoid undue discrimination Encourage efficient use October 3, 2012 29

Goal 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 30

Considerations

 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 31

October 3, 2012

Rate Design Flow Chart

32 Competitive Forces Strategic Goals Tactical Goals Post Rollout Evaluation

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 33

Traditional 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 34

Flat 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 35

Blocked 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 36

Hourly Consumption (kWh) Price 1 October 3, 2012

Blocked Tariff Pricing

III II High Cost Hour of the Day I 24 I 700 37 II III 1400

Monthly Consumption (kWh)

Demand 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 38

Wright 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 39

Hourly Consumption (kWh)

Hours-of-Use Tariff Pricing

Price 1 October 3, 2012 I 400 40 II High Cost Hour of the Day I 24 Hours of Use = kWh/(kW) (max = 720 (100% load factor)) II

Hours of Use

Summary

 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 October 3, 2012 41



Appendix 1. Illustrative COS Tables

Typical Power Company Cost-of-Service Study

Present Rate Summary ($000’s) Total Electric System

3

Residential

4

Small General Services

5

Large General Service

6

High Load Outdoor Factor Lighting

7 8

Total Retail Service

9

Total All Other Service

10

Unit Power Sales

11

Line No.

1

Description

2 1 2 3 4 5 6 7 Investment Electric Gross Plant Accumulated Depreciation Net Plant Materials and Supplies Cash Working Capital Other Rate Base Items Total Electric Investment Revenues 8 9 10 11 Revenue from Sales Other Operating Revenues Revenue-Nonassociated Sales Total Adjusted Revenue 1,591,960 630,023 961,937 62,495 44,079 20,856 1,089,367 494,911 5,847 58,078 558,836 825,803 339,107 486,696 28,685 20,200 8,288 543,869 295,638 124,597 171,041 13,877 9,443 2,893 197,254 154,890 68,486 86,404 9,392 6,402 1,464 103,662 61,577 26,438 35,139 3,649 2,646 589 42,023 30,527 1,368,435 8,127 22,400 566,755 801,680 576 487 352 23,815 56,179 39,177 13,586 910,622 248,383 4,262 1,345 253,990 120,912 782 734 122,428 75,423 275 568 76,266 29,018 105 241 29,364 7,507 36 27 7,570 481,243 5,460 2,915 489,618 36,340 16,147 20,193 1,866 1,226 343 23,628 187,185 47,121 140,064 4,450 3,676 6,927 155,117 13,668 387 106 14,161 0 0 55,057 55,057 October 3, 2012 43

Line No.

1

Description

2 Expense 12 13 14 15 16 17 18 Operation & Maintenance Depreciation Amort. of Inv. Tax Credit Real & Personal Prop. Tax Payroll Tax Other Taxes Expenses Exc. Inc. Tas 19 Operating Income 20 State & Federal Income Tax 21 Net Operating Inocme 22 Rate of Return

Typical Power Company Cost-of-Service Study

Present Rate Summary ($000’s) Total Electric System

3

Residential

4

Small General Services

5

Large General Service

6

High Load Outdoor Factor Lighting

7 8

Total Retail Service

9

Total All Other Service

10

Unit Power Sales

11 352,635 57,998 -2,238 16,560 4,055 1,002 430,012 128,824 31,487 97,337 8.94% 161,599 31,449 -1,116 8,992 2,426 613 203,963 50,027 75,542 11,030 -392 3,338 828 216 90,562 31,866 51,215 5,575 -198 1,851 385 99 58,927 21,165 2,153 -76 732 143 36 24,153 17,339 5,211 10,575 39,452 7.25% 9,128 22,738 11.53% 5,026 12,313 11.88% 1,336 3,875 9.22% 3,897 2,001 -71 279 63 16 6,185 1,385 152 1,233 5.18% 313,418 52,208 -1,853 15,192 3,845 980 383,790 105,828 26,217 79,611 8.74% 9,809 1,288 -46 440 87 22 11,600 2,561 29,408 4,502 -339 928 123 0 34,622 20,435 609 1,952 8.26% 4,661 15,774 10.17% October 3, 2012 44



Appendix 2. Time-Dependent Rates

Time-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 46

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 47

$/kWh P P MC P P F

Peak

Time-of-Use Pricing

Off-Peak

$/kWh Q 1 P Q 0 P D P kWh P F P OP MC OP Q 0 OP Prices can be moved closer to marginal cost.

Q 1 OP D OP kWh October 3, 2012 48

Time-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 October 3, 2012 49



Appendix 3.

Alternatives to Traditional Rate Cases

Strategic Planning and Alternatives 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 51

Adjustment 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 52

Strategic Planning and Alternatives to Rate Cases

 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) October 3, 2012 53

Formulary-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 October 3, 2012 54