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Regulation by Formula

Tools to facilitate changing utility economics.

Fortnightly Magazine - March 2010

in the event the company incurs new environmental costs resulting from the imposition of regulations that previously haven’t been imposed;

• New major construction projects: recover the retail revenue requirement with major construction projects not fully recovered through current base rates (commission pre-approval for the project is necessary);

• Storm reserve: in the event the company’s approved storm reserve reaches a balance below a pre-specified level, the company should be allowed to make an adjustment necessary to increase the storm reserve to the commission-approved level ( i.e., the increase must be grossed up for applicable taxes);

• Exceptional changes: it’s recognized that from time to time a utility might experience increases or decreases in costs, or decreases in revenues, that occur as a result of actions, events, or circumstances beyond the control of the company; and

• Loss of customers or customer load: a utility might also, from time to time, experience significant reductions in its base revenue due to loss of customer load targeted to some level of ROE reduction ( i.e., 0.5 percent).

Avoiding Pitfalls

Ratemaking by formula can present certain challenges for utilities and regulators.

Most notably, it might mitigate utility efficiency. The stimulus of regulatory lag is lost and the utility might be lulled into a cost-plus situation. The regulator must carefully review the annual cost-of-service study required as part of the utility’s annual filing to try to identify imprudent expenditures—especially an increase in expenditures as the higher sharing bands are reached. Performance incentives ( e.g., for reliability and customer satisfaction) tied to financial rewards and penalties also would be helpful. In addition, the regulator periodically should hold hearings that deal only with cost allocation and rate design, since over time with ratemaking by formula there is likely to be a mismatch between costs and allocation or rate structure. The cost of equity capital also could get out of whack with capital market conditions and should be the subject of separate hearings.

Tasks for the regulator, among others, include: establishing and monitoring operating parameters; conducting the annual review process; monitoring rate-base level; monitoring rate of return; evaluating any incentive results; pre-approving major capital expenditures; reviewing cost of service each year; pre-approving purchased power and natural gas contracts; establishing and monitoring commodity purchase incentives; and pre-approving major sales adjustments. Thus the regulators’ focus is proactive, devoted to pre-approvals and incentives.

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