Carl Peterson, Ph. D. Center for Business and Regulation University of Illinois Springfield

Cost Allocation and Rate Design for Gas LDCs

August 8, 2019

0

Outline• Introduction• Factors affecting Rate Design • Introduction to Cost of Service• Embedded Cost of Service• Interclass Revenue Allocation • Rate Design• Current Issues

1

Cost of Service and Rate Design• Cost of service is an analytical approach to

determining who should pay for the total revenue requirement

• Judgment is a major part of cost of service and reasonable people do disagree

• Cost of service supports rate design, but rate design is often related to the objectives of designing rates

2

What is the Role of the Public Utility Price?• Capital Attraction: Prices need to be set such that utilities

are willing to provide the level of service necessary to serve all comers. This applies to both the rate structure and the rate levels.

• Efficiency-Incentive: Prices in a competitive market provide incentives for firms to produce more efficiently to maximize profits. As regulation is a substitute for competition, regulated prices should provide incentives for effective production.

• Demand Rationing: Consumers also need price signals to make decisions about consumption.

• Income Distribution: Prices also serve as both a method of transferring cash from consumers to producers and as a method of transferring cash between consumers. 3

Objectives for Rates* • Low-income and medical baseline customers should have access to

enough electricity to ensure basic needs (such as health and comfort) are met at an affordable cost;

• Rates should be based on marginal cost;• Rates should be based on cost-causation principles;• Rates should encourage conservation and energy efficiency;• Rates should encourage reduction of both coincident and non-

coincident peak demand;• Rates should be stable and understandable and provide customer

choice;• Rates should generally avoid cross-subsidies, unless the cross-subsidies

appropriately support explicit state policy goals;• Incentives should be explicit and transparent;• Rates should encourage economically efficient decision-making;• Transitions to new rate structures should emphasize customer

education and outreach that enhances customer understanding and acceptance of new rates, and minimizes and appropriately considers the bill impacts associated with such transitions.

*ALJ Ruling in CPUC R.12-06-013 “Order Instituting Rulemaking on the Commission’s Own Motion to Conduct a Comprehensive Examination of Investor Owned Electric Utilities’ Residential Rate Structures, the Transition to Time Varying and Dynamic Rates, and

Other Statutory Obligations.”

4

Objectives often loaded with jargon that needs definition • What is marginal cost?• What is cost causation?• What does “encourage” mean and how is that

different from “incentive?”• What is a cross-subsidy?• What are stable rates? What are understandable

rates?• What is economically efficient decision-making? • What is a bill impact and how do we minimize bill

impacts?

Cost of service can answer some of these questions 5

Cost of Service and RatesRevenue Requirement

Cost of Service

Rate Design Objectives

Operational DataEconomic Analysis

Judgment

Other Factors Rate Shock

Social Concerns

Policy Concerns

Final Prices

Revenue Recovery

Price Signals

Equity

6

Overview of Ratemaking

Non-utility revenue

Operating Costs

Costs

Capital Costs

Total Appropriate Costs to Recover

Utility Revenue

Revenues

Total Revenues=

Non-utilityrevenue

THIS IS CALLED THE REVENUE REQUIREMENTS APPROACH

Overview of Ratemaking Gas Supply Chain

Upstream Downstream

Commodity

ProductionCommodity Price

Marketer

Commodity Price

Transmission

StorageCompetitive or Tariff

Rate

Pipeline Contract Demand +

Variable Charge

Marketer

Contract

Distribution

Storage

CommodityLocal Production

Contracts

= WACG

Delivery Costs

Customer

Competitive Supply Charge

or

Purchase Gas Adjustment

Base Rates

Overview of RatemakingGas Supply Chain Costs

Gas Commodity Transmission/Storage Distribution Consumer

Producer A ($2.95)

Producer B ($3.15)

Producer C ($3.35)

Storage A ($0.75)

ESS

FTS/STSPipeline A ($0.70)FTS/FTNNMarketer A ($2.50)

Marketer B ($3.10) Pipeline B ($0.40)

Producer D

Producer E

Marketer C ($4.00)

LNG($5.00)

LocalProduction

($3.00)

Weighted Average Cost of Gas (WACOG)

($3.40)

• O&M Expenses

• Depreciation

• Taxes

• Return on Rate Base

Purchased Gas Adjustment

(PGA) Clause

Base Rates

Upstream Downstream

Overview of Ratemaking Retail Prices• Base rates: rates that recover the costs of investment and

operations of the network• Generally set in a rate case using the cost of service principles

and applications discussed in this presentation • Some costs may be taken out and addressed on a single-issue

basis (e.g., pensions, bad debt, lost revenues, etc.)• Utility earns a margin (i.e., profit) from these rates

• Purchased Gas Adjustment: rates that recover the cost of purchasing gas for customers that buy from the utility • Generally set on a annual or semi-annual basis based on the

cost of procuring the commodity (and transport to deliver commodity)

• Revenues from these prices are reconciled to actual costs generally on an annual basis.

10

OUTSIDE FACTORS AFFECTING COSTING AND RATES

Part I

11

Electric Generation Increase

12

Climate Cycles

13

Energy Intensity

14

Electricity Generation • The Facts

• Natural gas use in electric generation has increased and is expected to outpace all other sources until 2040

• Natural gas electric generation now accounts for about 30% of total mWh produced up from 13% in 1996 and may exceed coal generation soon. (Perhaps as soon as next year in PJM measured by capacity.)

• Natural gas electric generation growth competes for gas with traditional summer storage injection

• Working natural gas storage inventories posted a rare summer net withdrawal of 6 billion cubic feet (Bcf) for the week ending July 29, 2016, according to EIA's Weekly Natural Gas Storage Report. Record-high consumption of natural gas for electric power generation drove this withdrawal.

• Natural gas electric generation is important because it tends to set electric prices in the wholesale markets for many of the peak hours (even in areas that have relatively low levels of natural gas generation)

• Do we have a problem?• Perhaps, let’s see. 15

Economics of Building a Peaker

16

C’Baseload

Peak load increases

F’Baseload

Number of Efficient Peaking Plants IncreasesmWPeaking

Hours

Hours

Cost

Load

CPeaker

CBaseload

FPeaker

FBaseload

Peak load is expected to increase in US 9% by 2024

Summer winter differentials getting bigger

System is getting more “peaky”

Fixed cost of base load plants increasing

Pricing is connected between energy industries• Is market building too many gas plants?

• Maybe not;• Market is responding to the supply (e.g., higher fixed

cost of baseload units) and demand factors (e.g., greater peak demand)

• Then what is the problem?• The incremental costs of peaking generation are not

born directly by those customers that “cause” them• Poor peak pricing in the electric market is helping

drive peak demand which is driving new peaking plants--leading to what has been described as the “toxic peak”

• Solution:• Get electricity pricing correct! 17

Other Factors • Energy efficiency standards as well as

continued utility spending on demand-side management programs will likely promote further conservations gains.

• The reduction in the cost of self-generation and a policy bias toward self sufficient supply is likely to reduce utility-delivered electricity volumes.

• Real electricity prices are likely to rise over time. 18

THE BASIC COST OF SERVICE STUDYPart II

19

Introduction to Cost of Service

• Cost of service studies (COSS) are used to:• Attribute costs to different customer classes• Determine how costs will be recovered from

customers within classes• Calculate costs of different services• Separate costs between jurisdictions• Determine revenue requirement between

competitive and monopoly services• General types of cost studies

• Embedded (Test year accounting costs)• Marginal (Change in costs related to change in

output)• What are the basic differences?

20

Philosophy of Cost Studies • Cost causation is the attempt to apportion the cost to those who caused

the cost to be incurred• We generally will look for a link between the customer

activity/characteristics and the cost incurred• An understanding of the operational and economic attributes of the system

are used in determining this link • Cost causation is not necessarily an economic concept

• Joint and common costs • Costs that are not directly attributable to a customer or customer class• Distribution mains(gas) or lines/substations (electric) • Requires some “allocation”• Sometimes the question of “who benefits” from the cost is mixed into the

equation

21

Steps in COSS• Obtain test year utility revenue requirement

• Other revenues (e.g., off-system sales, Hub sales, etc.)

• Jurisdictional revenues/costs• Obtain load and market characteristics of

customers base• Determine customer classes• Billing determinants

• Weather normalization may be a big issue here • Allocation of costs to cost-causers• Market characteristics (e.g., bypass

opportunities) 22

Customer Class Determination

• End use• Space heat, non-space heat, etc.• Type of customer and meter (residential,

commercial, industrial, electricity generation)• Size and usage

• volume and capacity• Load factor (average usage relative to peak usage)

• Type of load • Firm, interruptible• Competitive alternatives (related to opportunity

cost) 23

Typical Base RatesResidential Commercial Industrial

Customer Charge $25/ month

$ 20.80 (<1,000 cfh)$72.80 (1-10k cfh)$132.60 (> 10k cfh) $2678/ month

Demand Charge$ 1.53 (<10,000 peak)12.36 ¢ (>10,000 peak)

Volumetric

4.85 ¢/thermor0 -50 therms: 28.5 ¢>50 therms: 15.5 ¢

0 -100 therms: 14.72 ¢100-4900 therms: 12.36 ¢> 4900 therms 7.62 ¢

0.52 ¢/therm

Definition

Single Meter 1 or 2 dwelling (residential) units

Any general use less than 40,000 therms

Any general use over than 40,000 therms

Other Rates and Charges• Transportation rates: unbundled for use in

transporting 3rd party gas • Storage service: provided to customers who

wish to purchase storage but are not required to purchase it from the utility (typically transport customers)

• CNG Vehicle rate • Contract rates

• Bypass• Electric Generation

• Riders (Gas Charge, pooling services, IT, EE, decoupling, etc) 25

Embedded Cost Studies• Step 1: Functionalize (production,

distribution, transmission etc.)• Functionalization is generally an accounting

exercise (i.e., use USOA)

• Step 2: Classification (demand-related, volume-related, customer-related, etc.)

• Step 3: Allocation• Direct assignment• Allocator (demand, energy, customers, etc.) 26

COSS for Gas Utility

(1) Cost Functionalization

(2) Cost Classification

(3) Cost Allocation

Total Cost of Service

DistributionTransmissionOther Gas Supply

Production & Gathering Storage

Commodity

Variable

CommodityDemand

(Capacity)Customer

Fixed

Source: R. Feingold “Traditional and Unbundled

LDC Rate Design” AGA Rates School, June 2009, Center for

Business and Regulation, Chicago, IL

27

Quick Quiz: Exhibit 13, answer questions 1, 2, and 3

Step 1: Functionalization• What is the purpose of the cost?

• Gas production• Distribution (low pressure mains)• Transmission (high pressure mains)• Customer Service (costs associated with hooking up

customers, meters, service drops, etc.)• General plant and administrative and general expenses

(management costs, costs of buildings and offices, etc.)• Determines what part of the operations of the utility

will be allocated the costs • Best approach is direct assignment (e.g., generation

rate base and return assigned based on plant)• Other examples, fuel, O&M, depreciation 28

Functionalization- General Plant• General plant and overhead (A&G) is more

difficult • General plant often allocated based on the

net plant (e.g., if 50% of net plant is generation, then 50% of general plant is allocated to generation)

• A&G often allocated based on direct labor e.g., if 30% O&M is distribution then 30% A&G is allocated to distribution 29

Functionalized Revenue Requirement Exhibit 6.0 (COSS)

30

Step 2: Classification of Costs• Costs are assumed to be related to demand,

volume, customer, or revenues. • Capacity (demand) costs (e.g., gas mains) do not change as output changes,

but do change as the capacity of the system changes. These are fixed costs that are generally classified as demand-related (i.e., related to kW or thermcapacity).

• Energy-related costs change with output (e.g., fuel). These are classified as energy-related or volumetric (i.e., related to therm throughput).

• Customer-related costs (e.g., meters, services) change with the number of customers added to the system.

• Revenue-related costs (e.g., revenue taxes) are related to the revenue received by the company.

• Used to set the different pricing elements (e.g., customer charge, energy charge, demand charge)

31

Classification of Costs-Examples-GasFunction Demand Commodity Customer Revenue

Production & Gas SupplyGas Supply Capacity VolumeStorage Capacity VolumeLNG Capacity VolumePropane Capacity Volume

TransmissionCompressor Stations Capacity VolumeMains Capacity VolumeRegulatory Stations Capacity Volume Specific Assignment

DistributionCompressor Stations CapacityMains Capacity No. CustomersM&R Stations Capacity No. CustomersServices Capacity No. CustomersMeters No. CustomersHouse Reg No. CustomersImd M&R Stations Specific AssignmentCustomer Installations Specific Assignment

OtherCustomer Accounts No. CustomersSales Expense No. Customers

RevenueRevenue from Sales RevenueRevenue Taxes Revenue

Source: Adapted from American Gas Association, Gas Rate Fundamentals, (Arlington, VA, 1987)

Classification with Allocation Methods

32

Classification-Examples• Gas mains: Are these costs solely demand-

related or is there also a customer cost component (or are they solely customer-related)?

• If some costs are customer-related, how much? • Minimum system study• Zero-intercept

33

Application: The Logic of Classification--Gas Distribution Mains

• What are gas distribution mains used for?• Meeting peak demand?

• Historic and future planning parameters• Mains are sized to meet the highest peak demand on the peak day

• Meeting average demand?• What evidence exists concerning the reason for investment (e.g.,

maintenance and replacement of existing mains)

• Hooking up customers?• How does investment cost change with number of customers?

34

Classification Example

35

Step 3: Allocation to Customer Classes • Process of assigning revenue requirement to

customer classes • Customer classes attempt to group customers with

similar cost characteristics • Allocation requires an understanding of the cost

drivers similar to classification and requires analysis of system and class demand characteristics • Demand-related • Volume-related • Customer-related 36

Load Data • Pattern of demand over a cycle (day, month,

year)• Average load total usage divided by hours in

cycle • Peak load is maximum demand on system

• Coincident peak is a customer or customer’s classes’ maximum load at the time of the system peak demand

• Non-coincident peak is the maximum load of the customer or customer class at any time

37

Load Factor• LF = average load / peak load

• If a customer uses an average of 245 therms/day during the peak month with the maximum daily usage of 612 the LF = 245/612 = 0.40 or 40%

• LF is between 0 and 1: Higher (lower) load factor the less (more) variable the load is relative to the average load• Higher load factors translate into lower average costs • Load factors vary between customer classes

(industrial tend to have high load factors, residential tend to have low load factors)

38

Demand Allocators • 1-CP: measures the peak of a customer class at

the system peak (e.g., an hour out of the year)• 4-CP: Averages four highest hours of the year

(typically during the peak season)• 12-CP

• Averages four highest hours of the year (typically during the peak season)

• NCP - Allocates demand-related costs based on maximum demands of individual classes of service regardless of when those demands occur.

• Average and Excess (A&E): = LF*AVG DEM + (1-LF)* (Class NCP – AVG DEM)

• Average and Peak: Same as A&E using Class CP instead of NCP

39

Demand Allocation

40

Average and Excess

41

What is the difference?

Source: R. Feingold “Traditional and Unbundled LDC Rate Design” AGA Rates School, August 2010, Center for Business and Regulation, Chicago, IL

42

Energy and Customer Related Allocators • Total energy usage by class• Customer-related

• Number of customers • Weighted number of customers

• Meter costs• Billing costs• Services • Meter-reading

43

Special Studies • Customer specific usage: large distribution

mains or substations ; services; meters, records and accounts

• Uncollectible expenses • Unbundled administrative costs• Special charges

• Service activation • Reconnection• Miscellaneous fees 44

What information is needed for ECOSS?• Uniform system of accounts

• Plant investment• O&M expenses • Overhead

• Billing Determinants • Projected and actual revenues by customer class• Sales (weather adjusted) by customer class• Number of customers • Demand (for large customers)

• Load research • Peak demand by customer class• Special studies (transport customers, storage, etc.)

• Other revenues (off-system sales, hub revenues, etc)45

Points to remember• ECOSS are not particularly accurate –should be

used as a guide• Problems do arise when prices diverge too far

from cost of service • How much effort should you put into a cost

study?• Utilities have a tremendous amount of unique

information – ask for it.• Some will argue you should use sensitivity

analysis on cost studies ---let’s see what that does 46

Allocator for mains -CP

47

ABC NG CompanyExhibit 1.0 (COSS)Summary of Embedded Cost of Service Study Using CP for MAINS

(A) (B) (C) (D) (E) (F)

SC-1

Residential SC-2 Commercial SC-3 Large General Service

SC-4 Contract Service SYSTEM TOTAL

Current Operating Revenues 102,870,000$ 111,210,708$ 143,553,515$ 1,761,526$ 359,395,748$ Current Other Revenue 572,461$ 618,876$ 798,860$ 9,803$ 2,000,000$ CURRENT TOTAL REVENUE 103,442,461$ 111,829,584$ 144,352,375$ 1,771,328$ 361,395,748$

OPERATING EXPENSESOperation and Maintenance 66,871,750$ 49,448,243$ 85,967,246$ 1,346,448$ 203,633,687$ Depreciation Expense 19,650,377$ 11,228,161$ 14,075,582$ 687,468$ 45,641,588$ Administrative and General and Cust Exp 18,262,016$ 6,244,934$ 4,593,886$ 208,054$ 29,308,890$ Taxes Other Than Income 5,075,413$ 4,297,287$ 8,483,968$ 113,120$ 17,969,787$ Income Taxes-State 270,202$ 292,109$ 377,062$ 4,627$ 944,000$ Income Taxes-Federal 3,587,326$ 3,878,187$ 5,006,059$ 61,429$ 12,533,000$

TOTAL OPERATING EXPENSES 113,717,084$ 75,388,922$ 118,503,802$ 2,421,145$ 310,030,953$

CURRENT NET OPERATING INCOME (10,274,623)$ 36,440,662$ 25,848,573$ (649,817)$ 51,364,795$

RATE BASENet Plant in Service 354,847,992 201,958,094 248,689,391 11,035,753 816,531,230 Rate Base AdditionsWorking Capital 28,244,145 23,913,954 47,212,402 629,499 100,000,000 Materials and Supplies 1,618,672 1,370,509 2,705,743 36,077 5,731,000 Rate Base SubtractionsAccum. Deferred Income Taxes 19,488,460 16,500,628 32,576,557 434,354 69,000,000 Customer Service Deposits 28,244 23,914 47,212 629 100,000

NET RATE BASE 365,194,104$ 210,718,015$ 265,983,766$ 11,266,345$ 853,162,230$

CURRENT RETURN -2.81% 17.29% 9.72% -5.77% 6.02%Unitized Return (0.47) 2.87 1.61 (0.96) 1.00 PROPOSED REVENUES @ Equal Returns 148,410,524$ 95,407,133$ 143,772,260$ 3,491,448$ 391,081,365$

PROPOSED NET OPERATING INCOME 34,693,440 20,018,211 25,268,458 1,070,303 81,050,412

PROPOSED ALLOWED RETURN 9.50% 9.50% 9.50% 9.50% 9.50%

REVENUE INCREASE PER CUSTOMER CLASS 44,968,063 (16,422,451) (580,115) 1,720,120 29,685,617

PERCENT INCREASE 43.47% -14.69% -0.40% 97.11% 8.21%

Change only allocator for mains from AP to CP

48

Change only allocator for mains from CP to Seaboard

49

What about marginal cost?• What is true at the consumption level associated with marginal cost?

The value consumers place on the good when price = marginal cost price is equal to the cost society must bear to produce that level of output. Said another way, consumers are willing and able to pay only the opportunity cost of production.

• What does this say about production? Producers are producing only that amount of product to which the opportunity cost is just paid for by the price. This implies that those producers are producing at minimum cost (i.e., without waste).

• What does this say about consumers? Consumers are consuming at a price that maximizes their satisfaction. That is, resources could not be used in another application that would produce higher value to consumers. If consumers are charged above (below) marginal cost they will consume less (more) than the optimal amount

50

What about Marginal Cost?• Economists argue that short-run marginal

cost is the optimal price• Short-run marginal cost would not include

(sunk) capital• Utilities are capital intensive • How to solve dilemma?

• Use of long-run marginal costs for rate making• Long-run means that all inputs are variable and the fixed costs of

capital are variable

• Translate capital investment into annual cost using the carrying charge calculation. 51

Connection between Marginal and Embedded • If marginal costs are below average cost then average cost

must be falling. What does this say about embedded cost? Maybe nothing! Why?

– Average costs are a theoretical construct based on very specific technical cost minimization conditions. The average cost curves are drawn assuming the best available technology.

– Embedded costs are a regulatory construct based on the actual technology that is in place at the time and are a function of historical decisions (and the cost of those decisions).

– For example imagine an economy with high inflation, the technology behind an average cost curve might still allow marginal cost to be below average cost, yet embedded cost could be growing (think about 1970s/80s in the electric industry)

– What causes the divergence? Degree of optimal historical investment Philosophy of regulator Size and type of recent additions

52

Practical Issus in Marginal Cost Analysis

• Sunk Costs: Economists agree that short-run marginal cost is the optimal pricing metric. The problem is that utilities are mostly capital costs and have large sunk costs.

• MC are Hypothetical: As MC must represent the opportunity cost as such the calculations are by nature forward-looking and require estimation

• MC will not normally equal revenue requirement: MC is a forward-looking economic cost and revenue requirement is a regulatory construct based on historical costs. An adjustment is required to reconcile MC and RR.

• Embedded costs are perceived to be easier to understand. Many PUCs place a high weight on the ability of consumers and the general public to understand the process of ratemaking. Embedded costs are taken directly from the books of the utility and are therefore viewed as understandable.

53

How is MC used in Gas Rate Design?

54

Interclass Revenue Allocation

55

ABC NG CompanyExhibit 1.0 (COSS)Summary of Embedded Cost of Service Study

(A) (B) (C) (D) (E) (F)

Line No.

SC-1 Residential SC-2 Commercial SC-3 Large

General Service SC-4 Contract

Service SYSTEM TOTAL

1 Current Operating Revenues 102,870,000$ 111,210,708$ 143,553,515$ 1,761,526$ 359,395,748$ 2 Current Other Revenue 572,461$ 618,876$ 798,860$ 9,803$ 2,000,000$ 3 CURRENT TOTAL REVENUE 103,442,461$ 111,829,584$ 144,352,375$ 1,771,328$ 361,395,748$

4 OPERATING EXPENSES5 Operation and Maintenance 66,242,326$ 49,658,567$ 86,368,289$ 1,364,505$ 203,633,687$ 6 Depreciation Expense 18,874,207$ 11,605,506$ 14,457,417$ 704,459$ 45,641,588$ 7 Administrative and General and Cust Exp 18,262,016$ 6,244,934$ 4,593,886$ 208,054$ 29,308,890$ 8 Taxes Other Than Income 5,075,413$ 4,297,287$ 8,483,968$ 113,120$ 17,969,787$ 9 Income Taxes-State 270,202$ 292,109$ 377,062$ 4,627$ 944,000$

10 Income Taxes-Federal 3,587,326$ 3,878,187$ 5,006,059$ 61,429$ 12,533,000$ 11 TOTAL OPERATING EXPENSES 112,311,490$ 75,976,590$ 119,286,681$ 2,456,192$ 310,030,953$

12 CURRENT NET OPERATING INCOME (8,869,029)$ 35,852,994$ 25,065,694$ (684,864)$ 51,364,795$

13 RATE BASE14 Net Plant in Service 340,020,392 209,166,713 255,983,801 11,360,324 816,531,230

Rate Base Additions15 Working Capital 28,244,145 23,913,954 47,212,402 629,499 100,000,000 16 Materials and Supplies 1,618,672 1,370,509 2,705,743 36,077 5,731,000 17 Rate Base Subtractions18 Accum. Deferred Income Taxes 19,488,460 16,500,628 32,576,557 434,354 69,000,000 19 Customer Service Deposits 28,244 23,914 47,212 629 100,000 20 NET RATE BASE 350,366,505$ 217,926,634$ 273,278,176$ 11,590,916$ 853,162,230$

21 CURRENT RETURN -2.53% 16.45% 9.17% -5.91% 6.02%22 Unitized Return (0.42) 2.73 1.52 (0.98) 1.00

Interclass Revenue Allocation

56

ABC NG CompanyExhibit 1.1Interclass Revenue Allocation

(A) (B) (C) (D) (E) (F)

Line No.

SC-1 Residential

SC-2 Commercial

SC-3 Large General Service

SC-4 Contract Service

SYSTEM TOTAL

1 REVENUES @ CURRENT RATES 103,442,461 111,829,584 144,352,375 1,771,328 361,395,748 2 RETURN @ CURRENT RATES -2.53% 16.45% 9.17% -5.91% 6.02%3 RETURN INDEX (0.42) 2.73 1.52 (0.98) 1.00 4 PROPOSAL AT EQUALIZED RETURNS5 PROPOSED REVENUES 145,596,308 96,679,620 145,248,108 3,557,329 391,081,365 6 PROPOSED INCREASE (DECREASE) 42,153,847 (15,149,963) 895,733 1,786,001 29,685,617 7 PERCENT INCREASE (DECREASE) 40.75% -13.55% 0.62% 100.83% 8.21% 8 PROPOSED NET OPERATING INCOME 33,284,818 20,703,030 25,961,427 1,101,137 81,050,412 9 RETURN 9.50% 9.50% 9.50% 9.50% 9.50%

10 RETURN INDEX 1.00 1.00 1.00 1.00 1.00

Interclass Revenue Allocation

57

CONSTRAINED PROPOSAL (BASED ON ECOSS) CONSTRAINED REVENUES 111,939,388 96,679,620 145,248,108 1,771,328 355,638,444

PROPOSED INCREASE (CONSTRAINED CLASSES) 8,496,927 - - -

PERCENT INCREASE (CONSTRAINTS) 8.21% NONE NONE 0.00%

REVENUE SHORTFALL FROM CONSTRAINTS 35,442,920

REALLOCATION OF SHORTFALL - 14,163,767 21,279,153 -

PROPOSED REVENUES (CONSTRAINED) 111,939,388 110,843,388 166,527,261 1,771,328 391,081,365

PERCENT INCREASE (ALL CLASSES) 8.21% -0.88% 15.36% 0.00% 8.21%

PROPOSED NET OPERATING INCOME (372,102) 34,866,798 47,240,580 (684,864) 81,050,412

RETURN -0.11% 16.00% 17.29% -5.91% 9.50%

RETURN INDEX (0.01) 1.68 1.82 (0.62) 1.00

SC-1 Residential

SC-2 Commercial

SC-3 Large General Service

SC-4 Contract Service

SYSTEM TOTAL

REVENUES @ CURRENT RATES 103,442,461 111,829,584 144,352,375 1,771,328 361,395,748 RETURN @ CURRENT RATES -2.53% 16.45% 9.17% -5.91% 6.02%RETURN INDEX (0.42) 2.73 1.52 (0.98) 1.00 PROPOSAL AT EQUALIZED RETURNSPROPOSED REVENUES 145,596,308 96,679,620 145,248,108 3,557,329 391,081,365

PROPOSED INCREASE (DECREASE) 42,153,847 (15,149,963) 895,733 1,786,001 29,685,617

PERCENT INCREASE (DECREASE) 40.75% -13.55% 0.62% 100.83% 8.21%RETURN 9.50% 9.50% 9.50% 9.50% 9.50%

Interclass revenue issues• Can customer class withstand increase to

cost of service?• What do we do with revenues for special

contract customers?• What types of subsidies exist?

58

RATE DESIGNPart III

59

Introduction to Rate Design• Rate design covers both the structure of

rates (which rate elements show up on the tariff) and the level of rates (which may be thought of as the “pricing” function)

• Traditionally rates were used (almost) solely to recover revenue, but today rates are also used to send signals, but what signals?• What does it cost to serve the customer?• How do we encourage “good” behavior?• Should we take into account externalities? 60

Economists Approach to Pricing • Define the value of a transaction

• Economists refer to this value as consumer surplus which represents the excess value consumers derive from paying the market price below the consumers willingness-to-pay (i.e., demand curve) plus producer surplus (i.e., profit).

• In a competitive market profit = 0 so the total surplus equals consumer surplus • The argument goes that competitive markets will maximize consumer surplus and a

monopoly market will reduce consumer surplus below the maximum amount by raising the price and lowering the quantity sold

• That is, there are customers who would have been willing to buy the product at the market price but were shut out of the market due to the higher monopoly price.

• Optimal pricing asks the question: how does the regulator set the price such that, subject to the break-even constraint, surplus is as high as it possibility can be.

• Two things to remember:• Total surplus = consumer surplus plus producer surplus. The

economics does not differentiate between the two.• Surplus (always) increases if the quantity sold increases 61

Is that how regulators look at it?• Economists will argue that does not matter

who gets the surplus as long as it is as large as possible

• Most regulators are charged with balancing the interests of consumers and utilities

• Therefore, pricing in practice does not seem to fit pricing in theory

62

The Bonbright Criteria for Sound Rate Structure • Revenue-related attributes

• Effective at yielding total revenue requirement without increase rate base beyond what is necessary or creating incentive for undesirable product quality

• Revenue stability and predictably • Stable rate structures

• Cost-related attributes • Static efficiency (efficient control of demand and supply)• Reflection of total costs and benefits (including externalities) • Fairness as to the allocation of costs to address these equity

concerns (1) horizontal (treating equals as equals); (2) vertical (unequals treated unequally) and (3) anonymous (avoid uneconomic bypass)

• Practical attributes • Simplicity, convenience of payment, feasibility, understandability,

public acceptance• Rates should be free from interpretation controversy

63

Terms used in Rate Design • Billing determinants: Factors used to

compute a customer’s bill (e.g., number of customers, usages, demand, power factor, etc.)

• Base Rates: rates that are set in the tariff until allowed to increase by a decision of the regulatory body.

• Riders: mechanisms used to track certain costs (e.g., fuel or purchased power) 64

Types of Utility Tariffs• Flat rates.• Declining Tariffs.• Inverted Black Tariffs.• Hopkinson (Two-part) Tariffs. • Demand Ratchets• Modern pricing (more unbundling, more

granular costing)

65

Pricing Illustration

66

Modern Pricing • Electric and gas markets have been evolving

over the last 20 years • New pricing issues have lead to new types of

pricing:• Competitive Rates • Consolidation of rates • Unbundling • Peaking rates • Line extension

67

Questions to Consider • Suppose a gas company is selling delivery

service at an average cost, but its competitor (e.g., an interstate pipeline) is selling at marginal cost. • How does this affect the decision to price delivery

service? (Hint: suppose a customer can switch service between the two competitors.)

• How would you evaluate a proposal from a company with multiple subdivisions to consolidate its rates into one system-wide rate?

• Why would a utility unbundle rates? 68

Questions to Consider • What is a line extension rate?

• Regulator will typically include a set number of feet of line extension in rates (e.g., 100 feet)

• What is the problem? • Suppose a customer is 125 feet from the nearest

main at $15 a foot that would entail a loss of margin to extend beyond the 100 feet

• Run a simple financial calculation (is it worth extending the line)

• Might have to include future gas sales growth • What about competition (electric, oil, etc.)? 69

Summary of pricing discussion• Pricing is not always about the economics:

social, political, and other factors influence decisions

• History matters: the best tax is an old tax (is this still true?)

• Economic conditions in service territory –• Rate impact studies important • Declining usage

70