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Labor Costs and the Rate Case

Incentives, staffing, and benchmarking in a tight economy.

Fortnightly Magazine - March 2012

require lower skill levels and draw from local markets—for example, non-critical security services—they wouldn’t factor into employee compensation costs.

Some U.S. regulatory commissions have explicitly acknowledged that utilities’ employee compensation strategies are developed to attract, retain, and motivate employees, and that the proper concern of regulators is whether a utility can demonstrate that the overall level of employee compensation expenses is reasonable. These regulators have established criteria, including market labor rates, for evaluating reasonable compensation levels, but they recognize that the allocation of the package over its various components, including incentive compensation, is a matter best left to management. The Massachusetts Department of Public Utilities (MDPU) offers an example of this approach.

The MDPU sets forth evaluation criteria that explicitly recognize “that the different components of compensation are to some extent substitutes for each other and that different combinations of these components may be used to attract and retain employees.” Utilities are required to demonstrate that their costs conform to those criteria and that their total unit-labor cost “is minimized in a manner supported by their overall business strategies.” Utilities are also required to compare their costs against a market-based standard. 10

Regulators in Indiana and Nevada also have considered overall compensation against established evaluation criteria. In Indiana, regulators evaluated Vectren South’s compensation package, including incentive compensation up to a board-approved level, and found that it was at the low end of the competitive range in the market, relative to comparable companies. As a result, Indiana regulators approved the utility’s compensation request. 11 Similarly, in Nevada, the Nevada Public Utilities Commission (NPUC) has evaluated a combined compensation package of payroll and benefit costs. The commission found that Sierra Pacific had actually reduced its payroll and benefit costs by about $16 million, “reflecting the reduction in growth that has occurred during the recession,” 12 and approved Sierra Pacific’s compensation request.

What Utilities Should Do

Given the complex compensation issues involved, and the competing claims of stakeholders in rate proceedings, utilities need to anticipate the issues that intervenors and regulators are likely to focus on and develop a record that establishes the reasonableness of employee compensation expenses. Utilities’ compensation presentations should offer regulators clear and concise information regarding levels of total employee compensation over time and compared with other utilities. As much as possible, these presentations should conform to prior commission decisions and should reflect concerns about current economic conditions. To the extent changing circumstances justify departures from prior regulatory precedent, these departures should be identified, and the justification for the change should be clearly articulated. Among other things, the utility should be able to identify changes in employee compensation and explain to regulators why these changes have occurred and why the observed expenses are reasonable.

Also, to the extent that a utility has been able to reduce employee compensation costs through discrete initiatives, such as severance programs or initiatives that improve labor productivity, regulators might be tempted to appropriate some or all of the expense savings prior to the rate effective period, on behalf of ratepayers. However, this treatment is short-sighted because regulatory