1. 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

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

3. Regulation and Ratemaking Regulation and Ratemaking

4. October 3, 2012 4 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

5. October 3, 2012 5 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

6. October 3, 2012 6 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

7. Cost of Service Cost of Service

8. October 3, 2012 8 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

9. October 3, 2012 9 Cost-of-Service Steps 1. Compile 2. Functionalize 3. Levelize 4. Classify 5. Assign 6. Allocate 7. Determine Return

10. October 3, 2012 10 Cost-of-Service Steps 1. Compile 2. Functionalize 3. Levelize 4. Classify 5. Assign 6. Allocate 7. Determine Return Step 1 Compile appropriate rate base, expenses, and revenues (often by FERC account); decide upon categories of customers to be analyzed

11. October 3, 2012 11 Step 1: Total Company Summary Total System Rate base$16,826,786 Revenues$8,049,850 Expenses O&M – fuel$2,236,885 O&M – other2,245,054 Depreciation &779,145 amort. expense Taxes other than431,509 income taxes Total adjusted$5,692,593 expenses Income taxes$927,414 Net operating$1,429,843 income Rate of return8.50% ResidentialCommercialIndustrialLighting Total Retail Service Total Other Service

12. October 3, 2012 12 Cost-of-Service Steps 1. Compile 2. Functionalize 3. Levelize 4. Classify 5. Assign 6. Allocate 7. Determine Return Step 2 Functionalize rate base and expense items by four major functions: a. generation/supply b. transmission c. distribution d. general plant and administration

13. October 3, 2012 13 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

14. October 3, 2012 14 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.

15. October 3, 2012 15 Develop Levelized Demand and Energy Allocators Service Level Designation and Power Flow Diagram 1 2 3 4 5 Transmission Line 46kW to 500 KW lines Generation and Territorial Input Transmission to Distribution Transformation Primary Distribution Lines 25kV and lower Line Transformers Indicates power flow Service Level

16. October 3, 2012 16 Cost-of-Service Steps 1. Compile 2. Functionalize 3. Levelize 4. Classify 5. Assign 6. Allocate 7. Determine Return Step 4 Classify rate base and expense items by cost causative (and observable) characteristics: a. Energy-related b. Demand-related c. Customer-related d. Revenue-related

17. October 3, 2012 17 Step 4: Classifying Costs  Gross plant assets (and depreciation): demand, energy, and customer components Service LevelGenerationTransmissionDistribution DemandEnergyDemand Customer Level 1 Level 2 Level 3 Level 4 Level 5

18. October 3, 2012 18 Cost-of-Service Steps 1. Compile 2. Functionalize 3. Levelize 4. Classify 5. Assign 6. Allocate 7. 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

19. October 3, 2012 19 Step 5: Directly Assign  Revenue from sales  Customer substations  Radial customer-specific lines  Meters  Sales support and billing costs

20. October 3, 2012 20 Cost-of-Service Steps 1. Compile 2. Functionalize 3. Levelize 4. Classify 5. Assign 6. Allocate 7. Determine Return Step 6 Allocate those common rate base, expense, and revenue items to the customer categories * appropriate allocators must be developed

21. October 3, 2012 21 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)

22. October 3, 2012 22 Developing Demand Allocators Load Shape Determinants Rate Class Information Allocation Factors: Allocating Costs by Rate Class and Function Demand Allocation Methods: 1) Average & Excess 2) 12 NCP 3) 12 CP 4) Marginal Cost 5) Equivalent Peaker 6) Proportional Responsibility 7) Other

23. October 3, 2012 23 Cost-of-Service Steps 1. Compile 2. Functionalize 3. Levelize 4. Classify 5. Assign 6. Allocate 7. Determine Return Step 7 Determine rate of return for evaluation

24. October 3, 2012 24 Illustrative Cost-of-Service Study: Rate Base ($million)

25. October 3, 2012 25 Illustrative Cost-of-Service Study Revenues, Expenses, Rate of Return ($million)

26. October 3, 2012 26 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

27. October 3, 2012 27 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

28. Rate Design Rate Design

29. October 3, 2012 29 Bonbright Principles Criteria of a Sound Rate Structure  Simple and acceptable  Freedom from controversy  Yield total revenue requirements  Revenue stability  Rate stability  Fair  Avoid undue discrimination  Encourage efficient use From James C. Bonbright, Principles of Public Utility Rates, 1968. Although dated, many still look to these for guidance in setting public utility rates.

30. October 3, 2012 30 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

31. October 3, 2012 31 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?

32. October 3, 2012 32 Rate Design Flow Chart

33. October 3, 2012 33 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

34. October 3, 2012 34 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

35. October 3, 2012 35 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

36. October 3, 2012 36 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

37. October 3, 2012 37 Blocked Tariff Pricing Hour of the Day Monthly Consumption (kWh) Price Hourly Consumption (kWh) I II III III High Cost 7001400 124

38. October 3, 2012 38 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

39. October 3, 2012 39 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.

40. October 3, 2012 40 Hours-of-Use Tariff Pricing Hours of Use Price Hourly Consumption (kWh) I II I High Cost 400 Hours of Use = kWh/(kW) (max = 720 (100% load factor)) Hour of the Day 124

41. October 3, 2012 41Summary  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

42. Appendix 1. Illustrative COS Tables Appendix 1. Illustrative COS Tables

43. October 3, 2012 43 Typical Power Company Cost-of-Service Study Present Rate Summary ($000’s)

44. October 3, 2012 44 Typical Power Company Cost-of-Service Study Present Rate Summary ($000’s)

45. Appendix 2. Time-Dependent Rates Appendix 2. Time-Dependent Rates

46. October 3, 2012 46 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

47. October 3, 2012 47 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

48. October 3, 2012 48 Time-of-Use Pricing P OPP MC P MC OP Prices can be moved closer to marginal cost. D OP PFPF PFPF DPDP $/kWh kWh Off-Peak Peak kWh $/kWh

49. October 3, 2012 49 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

50. Appendix 3. Alternatives to Traditional Rate Cases Appendix 3. Alternatives to Traditional Rate Cases

51. October 3, 2012 51 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?

52. October 3, 2012 52 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

53. October 3, 2012 53  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) Strategic Planning and Alternatives to Rate Cases

54. October 3, 2012 54 Formulary-Based Ratemaking 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