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Restoring Financial Balance

With looming mandates and aging infrastructure, utilities need regulatory support.

Fortnightly Magazine - November 2011

must be streamlined and delays in replacing infrastructure must be minimized.

The regulatory obligation is to provide utilities with adequate and timely cost recovery. The regulatory process should set rates that are as close as practical to the costs expected to be incurred in the period that the rates are effective, including the return of, and on, invested capital.

There are several implications for matching utility costs and rates.

First, for costs that are beyond the control of a utility but material in nature relative to earnings, there should be recognition by regulators of the need for cost-tracking mechanisms.

Second, for planned additions to rate base that are part of a multi-year capital expenditure program, such as infrastructure replacement, regulators should provide a method for cost recovery between rate cases for these additions. Of course, this shouldn’t serve as a blank check, but should be a carefully reviewed process to assure that new facilities are consistent with the approved plan and that the costs are prudent.

Third, the regulatory process should recognize that the utility must have a reasonable opportunity to actually earn the allowed rate of return on its assets. Failure to provide an opportunity to earn the allowed rate of return will result in further detriment to the financial metrics of the company—even if the allowed return is set at the required market-based level to support a favorable debt rating. By improving the financial metrics for the utility, regulators ensure that the costs for customers will be lower in the future as the result of lower capital costs over the life of the assets.

How can we rebalance the regulatory compact? It won’t be easy, even though tools are available to both utilities and regulators, including policies that will: increase utility cash flow to improve financial metrics; support the approval and implementation of innovative ratemaking mechanisms to match cost and revenue in near real-time; and promote the development and implementation of cost-effective utility programs for renewable resources, conservation and energy efficiency, for example.

Policies that increase cash flow include allowance of construction-work-in-progress (CWIP) in the rate base, recovering fixed costs in fixed charges, and improving equity returns on more equity in the capital structure.

Time to Innovate

The key element of improving a utility’s financial metrics is the ability to actually generate free cash flow. This requires innovative ratemaking mechanisms such as cost tracking, revenue decoupling, future test years, and infrastructure cost recovery arrangements. Each of these innovative ratemaking approaches may be used individually, or in combination, depending on the particular requirements of the utility. The process of assuring least-cost programs for utility services requires detailed review and analysis of program economics. It also means that today’s successful program might not be successful in the future, based on the law of diminishing returns. Thus, there’s a need for regular review and modification to utility programs.

Rebalancing the regulatory compact also requires transparency for customers. The process of regulation isn’t well understood or appreciated by the general public. Getting customers involved requires a significant effort on the part of both regulators