2010 NASUCA Mid-Year Meeting NASUCA 2010 Mid-Year Conference Presented by: Lee Smith Senior Economist and Managing Consultant Presented to: June , 2010 Panel: Gas Distribution Company Rate Design: What Is In the Customer's Best Interest: Straight-Fixed Variable, Inclining Blocks, Decoupling San Francisco, CA  Fisherman's Wharf

2 RATEMAKING PRINCIPLES  Generally accepted major 5 principles  Equity or Fairness  Efficiency in price signals  Utility Earnings Stability  Simplicity  Rate Continuity

3 WHY ACTUAL RATEMAKING REACHES DIFFERENT RESULTS IN DIFFERENT CASES  Tradeoffs between principles  Different fundamental conditions between states and utilities  Different interpretations of the principles  Political differences

4 Different fundamental conditions exist between states and utilities  There are significant differences in the gas utility framework between states and even within states, which will affect application of the same principles  Age of Gas Plant  Rate of growth of gas use  Cost of Gas Supply, and ratio of gas supply costs to total customer gas bill  Degree of weather sensitivity  Relationship between residential and C&I (particularly process) load  Energy substitutes for gas, esp. for heating use

5 Impact of different fundamental conditions on ratemaking  The faster the utility is growing the higher is marginal cost  Higher ratio of gas supply costs to total customer bill makes delivery rate less important; also affects decisions regarding hedging policy  Higher degree of weather sensitivity creates more concerns with rate impacts (continuity),also with earnings stability – again will affect hedging policy  Higher proportion of residential load makes average gas cost higher  Whether major substitute for gas is regulated fuel or unregulated (oil) should be considered (more later)  The older the gas system, the more replacement compared to new capacity being built

6 Today’s Major Topic – Inclining blocks rates or not  Depends on interpretation of “efficient price signal”  Depends on interpretation of fairness

7 What makes an Efficient Price Signal – Two Views View 1 - Customers can make efficient decisions when then are informed of the cost consequences of their decisions – leads to pricing incremental use at marginal cost View 2 – Gas rates should include inclining blocks whatever the marginal cost  Because marginal costs don’t reflect full societal costs; and/or  Because customers may use less because the inclining block tells them that using less is important

8 Some Qualifiers to Marginal Cost Pricing Customers can make efficient decisions when then are informed of the cost consequences of their decisions  This theory suggests that customer charge is not a very useful price signal for customers who are already on the system; what matters is the tailblock  Tailblock usage level should be set to capture most discretionary use  There is some thought that most customers do not actually make usage decisions on this basis (economic theory vs. reality  Marginal cost analysis often based on black box approach, not always well scrutinized or understood

9 How Have Some Regulators Moved from View 1 to View 2?  Marginal costs don’t reflect full societal costs; and/or  Customers may use less because the inclining block tells them that using less is important Massachusetts DPU “the design of distribution rates should be aligned with important state, regional and national goals…” “and…lower customers’ bills through increased end-use efficiency” Customers have incentive to be cost effective when rates based on marginal costs Some customers cannot increase end-use efficiency – the early adopters are stuck

10 Impacts of Ratemaking Based on View 2  Higher tailblock delivery charges result in less earning stability to utility  If rates are decoupled, the lower earnings stability means that decoupling adjustments will be more frequent and larger  If gas rates don’t signal the supply cost of gas, the actual impact of delivery charges on usage may be small  If tailblock rates are higher than marginal cost, customers will not be incented to make efficient decisions There will be incentive to switch to other energy sources – particularly a problem if the alternative is oil Customers may choose lower comfort levels even though the value they place on comfort is higher than the cost of gas

11 Question of the Day – Fixed Variable vs. Inclining Block Let’s consider three basic questions from the customer perspective: 1.Is the customer charged fairly 2.Can the customer control his/her bill 3.Does the rate let the customer make efficient choices

12 One Extreme – Distribution costs all collected through customer charge; variable collects gas costs 1.The distribution costs of serving all customers within a rate class are not identical – smaller older customers will be charged more than the cost of serving them 2.There is a large portion of the bill which the customer cannot control 3.The rate does not inform the customer of full marginal cost to make efficient choices

13 Other Extreme – Low customer charge; two energy blocks with tailblock above marginal costs 1.Smaller older customers will be not be overcharged; larger customers may pay more 2.The customer can control his/her annual bill (although if there is also decoupling there will be annual variability out of control 3.Rate incents customer to reduce use beyond economically efficient reduction 4.Rate incents some customers to switch to alternative energy source

Setting Rates – a Non Conclusion 14  The choice is not easy  Your choice will be affected by your regulatory environment  Your choice should be an informed one

15 Thanks! End of Presentation    End of Presentation    Lee Smith La Capra Associates One Washington Mall, 9 th Floor Boston, MA , ext. 117 Contact Information: