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Regulation by Formula

Tools to facilitate changing utility economics.

Fortnightly Magazine - March 2010

for Change

Ratemaking by formula addresses two types of issues: those relative to earnings, and those relative to revenues. In summary, a rate-of-return band is established around the allowed return on equity (ROE) from the utility’s last general rate case. Earnings outside the band are shared with customers through rate decreases for excess earnings and rate increases for deficient earnings. The revenue aspect of the model incorporates new assets and other significant cost items into rates without a full blown general rate case. Significant sales reductions can be incorporated into rates, as well as revenue losses from conservation activities.

Under ratemaking by formula, earnings up to a pre-defined level are retained by the utility. Earnings in excess of that level are shared with customers by reducing rates—referred to as asymmetrical ratemaking. Earnings below a pre-defined level result in an increase in rates to bring earnings up to the pre-defined level—referred to as symmetrical ratemaking.

Ratemaking tied to earnings isn’t new. For example:

Sheffield Gas Act approved by the British Parliament in 1855 limited dividends when price of gas higher than a preset level, but allowed a higher dividend when prices were below a preset level;

• Consumers’ Gas of Toronto in 1877 refined the process to identify a specific return target allowing for price decreases above the target and price increases below the target (included a $1 million dead band); and

• Recent earnings-based ratemaking by formula applications include New Mexico 1975; MidAmerican (Iowa) 2001; Entergy LA 2005; Entergy Gulf States 2006; Entergy Mississippi 2006; and Southwestern Electric Power Co. 2007.

The mechanics of the earnings side of ratemaking by formula is tied to the allowed rate of ROE. The calculation is a three-step process: First, establish earnings targets; second, calculate jurisdictional regulated income; and third, determine whether jurisdictional regulated income exceeds either or both earnings targets.

The earnings targets are applicable to earnings between the allowed ROE (Target ROE) as established by the state regulatory commission up to a preset number of basis points above that target ( i.e., 80 basis points). The first target for an asymmetrical application is calculated as follows: Equity Portion of Jurisdictional Rate Base x Allowed ROE = Equity Earnings Target 1 . The second target is calculated as follows: Equity Portion of Jurisdictional Rate Base x (Target ROE + 0.8 percent) = Equity Earnings Target 2 . The first target for a symmetrical application (Target 3) is the same as for asymmetrical applications. Target 3 is calculated as follows: Equity Portion of Jurisdictional Rate Base x Allowed ROE - 0.8 percent = Equity Earnings Target 3.

The next step in the process is the determination of earnings sharing with customers through pre-established sharing bands. For example: earnings between Target 2 plus 0.5 percent are shared 50:50 between shareholders and customers; earnings between Target 2 plus 0.5 percent up to 1 percent are shared 60 percent with customers, 40 percent with shareholders; and earnings above Target 2 plus 1.5 percent go to customers.

For example, with an ROE of 10 percent, Target 2 is