Ratemaking Special Report
In a joint survey conducted by Navigant Consulting and , utility executives identify the biggest challenge to their business.
No matter what position you subscribe to when characterizing the degree of competition in today's energy industry, it is clear that regulation continues to serve as a major influence on the business strategies and operations of the gas and electric distribution utilities in North America. While it is readily understood why such regulatory oversight is necessary in this segment of the business, it is less clear how regulators internalize this important role, and how they choose to interact with utilities in implementing energy policies, reviewing operational issues, and approving the revenues and rates upon which the financial health of this industry segment is premised.
The results of a previous Navigant Consulting/ survey, " The Outlook for the North America Power Industry," identified regulatory uncertainty as the most critical issue for utility executives to resolve over the next five years. The words of one electric utility leader cut to the chase, "We need to solve regulatory uncertainty so we can plan and execute." Indeed, respondents to that survey (72 percent) said regulatory uncertainty was the top issue to solve to ensure a strong future for the industry. Understanding the key issues and challenges inherent in the utility regulatory process is the first step to gaining valuable insights into this uncertainty, and being able to manage it effectively.
Moreover, the challenges associated with regulatory uncertainty have no doubt been heightened by the recent increased activity in rate case filings by electric and gas distribution utilities. Regulators and other interested parties are now, more than ever, primed to closely examine all aspects of a utility's financial performance, business strategies, and day-to-day operations. It no longer is simply a matter of the utility making its financial case for rate relief. Instead, utility rate cases are fast becoming the focal point for management's public disclosure and defense of many of the key business practices and policies that affect each of the business segments of the organization.
With this situation as a backdrop, Navigant Consulting and recently conducted a comprehensive survey, ,1 to solicit the insights of utility leaders into the key issues and challenges surrounding regulatory uncertainty, and their implications on the rate case and ratemaking activities of gas and electric distribution utilities. Specifically, survey respondents identified: (1) how utilities define regulatory uncertainty; (2) the most critical regulatory issues facing utility companies; (3) how and where these issues are raised in utility rate case proceedings; (4) the types of ratemaking and pricing proposals submitted by utilities to address these issues; and (5) the outcomes of these regulatory proceedings.
Besides identifying these broader issues, the survey results captured the particulars of recent rate case filings of the utility respondents to identify: (1) the specific business issues, related total cost of service claims, and ratemaking proposals most often raised; and (2) the outcomes of these cases compared to the proposed utility requests.
The Major Causes of Regulatory Uncertainty
Utility leaders clearly indicated that regulatory uncertainty most often is caused by lack of longer-term direction and progression of regulatory decisions, unanticipated actions by regulators and their impact upon a utility's current business strategies, and the potential for costs disallowances. In addition, nine other causes were cited most often (). Besides these stated causes, survey respondents noted other causes of regulatory uncertainty such as, inconsistent application of policies by state regulators among the utilities they regulate, lack of regulator understanding of key issues facing utilities, and current personal or political influences on current regulatory commissioners' voting patterns.
Interestingly, more than 90 percent of survey respondents either strongly agreed or agreed with the proposition that regulatory uncertainty is caused by the energy market changing at a faster pace than the related regulatory policies that establish the rules of the game in the marketplace. This perspective may be indicative of the inherent lag that often is observed between the time the market demands a new service or creates a new business opportunity, and when the utility receives final approval from the regulator to implement its proposal to address the market's needs.
To be fair in their assessment, some survey respondents also conceded that certain internal perspectives of the utilities themselves cause regulatory uncertainty. One survey respondent noted that "management has forgotten that utilities must invest in infrastructure and then file rate cases to earn on the investment." In another instance, a respondent concluded that regulatory uncertainty was caused by the "changing corporate structures and the provision of services by other affiliates." In both these situations, it appears that utility management may have been so distracted with its internal restructuring activities and related business initiatives that it simply lost sight of the regulatory process, and the value of having a well-conceived regulatory strategy that keeps the regulatory agenda in focus for management and links any required regulatory initiatives back to its overall corporate strategy.
Important Regulatory Objectives Sought by Utilities
With these types of regulatory uncertainties as givens, utilities seek to achieve a wide range of strategic and business objectives within the context of the regulatory process. Our survey identified those objectives most important to utilities. The results clearly indicate that the ability to earn a fair rate of return on assets and promoting profitable growth are the most important objectives for utilities to achieve (). At the same time, 100 percent of the survey respondents ranked the ability to effectively manage business risks as either the most important or an important objective for their utilities to achieve. And the majority of survey respondents (95 percent) believed that having the proper ratemaking tools to address their customers' energy needs was an important regulatory objective.
Although in recent years the concept of performance-based ratemaking (PBR) has taken a bit of a breather, upward of 87 percent of the survey respondents said it was important that regulators provide their utilities with an appropriate level of management discretion to achieve operational efficiencies. Yet, at the same time, more than one-third of survey respondents believed that achieving less regulation, not more, was not important.
Of all the regulatory objectives ranked by survey respondents, promoting the efficient use of energy by a utility's customers was ranked as the least important. This view underscores some of the recent commentary and related positions put forward in the energy industry dealing with the problem that regulated gas and electric utilities are penalized for aggressively promoting energy efficiency.2 For a gas utility, this occurs because traditional utility rate structures are designed to capture most of a gas utility's revenue requirements for fixed costs through volumetric retail sales of natural gas, so that a utility can recover these costs fully only if its customers consume a certain amount of natural gas.
Recent Utility Rate Case Activities
Approximately half of the utilities represented in the survey filed general rate cases within the last 24 months, and slightly more than half intend to file rate cases in the near future (over the next 12 months). Roughly two-thirds of the surveyed utilities that did not file rate cases in recent times intend to file rate cases over the next 12 months. For those utilities that did not file rate cases in recent times, they went without a rate case for 9 years on average, with a range of between 3 years and 14 years. At the same time, however, approximately one-third of the utilities surveyed indicated that they are precluded from filing rate cases because of either rate freezes or stay-out provisions (with most expiring between late 2005 and the end of 2006).
The overall profile of the rate cases filed by the surveyed utilities during the last 24 months is presented in Table 1. Of note is that the revenue increases approved by regulators represented approximately 40 percent of the revenue increases the surveyed utilities had originally requested in their rate-case filings. In addition, approximately 41 percent of the rate cases filed ended in a negotiated settlement rather than through a fully litigated proceeding.
Regulator and Stakeholder Controversy: What's Hot and What's Not
Not surprisingly, there was a great deal of controversy in these rate cases across a wide range of topics and issues related to the utility's total revenue requirement as well as to other parts of its rate-case filing. The survey respondents clearly indicated that certain aspects of their utilities' rate-case filings were very controversial, while others were not controversial at all. It is important to distinguish between the concept of a "controversial issue" and an "important issue." While certain rate case issues can be seen as controversial in nature, there can be other issues that are still important ones. However, they don't get the same attention in the utility's rate cases because: (1) the utility may have simply done a better job at making its case with the regulator and other stakeholders; (2) the parties to the rate case may have already been sensitized to the issue beforehand (by the utility previewing its upcoming rate case with parties or because the issue was already raised and contested in a prior rate case); or (3) there are other regulatory forums in which these issues can be addressed, including generic or rulemaking proceedings, technical workshops, and periodic informal meetings between utility management and regulators.
The basis upon which a utility determines the amount of revenue increase it will request in a rate case is its total revenue requirement (or total cost of service). Recognizing the natural adversarial roles that exist between the utility, regulator, and other stakeholders in the rate-case environment, it was expected that survey respondents would see a number of components in the utility's total revenue requirement as controversial (). The more controversial components of the utility's total revenue requirement include rate of return on equity, administrative and general expenses, capital structure, and non-fuel related operating expenses. Administrative and general expenses may have made the "most controversial list" since this expense category (which frequently has higher expense levels compared to other direct operating expense categories) often contains costs associated with shared services received from other utility affiliates, salaries and wages of senior management, and other corporate overheads that are not always presented with the same level of detail as other utility expenses. Additionally, the added focus on this expense category by the regulator and other stakeholders is explained, in part, by the fact that many of these common or joint costs must be allocated to the regulated utility, and this creates a concern that cross-subsidies may exist between the various corporate affiliates.
The less controversial components include working capital, income taxes, fuel/purchased gas expenses, and other taxes. Typically fuel and purchased gas expenses are addressed in a separate regulatory proceeding rather than as part of a utility's general rate case, so it follows that it would not be viewed as controversial within that context.
Besides the controversy surrounding a utility's total revenue requirement, other parts of the respondent utilities' rate cases were seen as creating much controversy among interested parties. The most controversial issues include the allocation of the proposed revenue increase by rate class, the level of pension and other post-employment benefits (OPEB) expenses, ratemaking proposals, major capital additions, and review of affiliate transactions.
Interestingly, other parts of the rate case that were not seen as controversial include outsourcing or discontinuing services or functions, fuel/price volatility, risk management, resource planning and portfolio mix, and unregulated operations. Upon further review, however, there may be valid reasons why these topics and issues are not seen as controversial by the respondent utilities. First, as pointed out earlier, these issues may be important, but not always debated and resolved within a utility's general rate-case environment. Second, certain of these issues likely received a great deal of attention in past rate cases because of where we were in the evolution of the energy market, and due to the existence then of market participants that do not exist today (e.g., mega energy marketers, midstream energy suppliers).
Trends in Utility Ratemaking Proposals
Certain ratemaking mechanisms or rate-design concepts appeared frequently as pricing proposals in the respondent utilities' rate case proceedings. These include (in order of frequency):
Disproportionate increases in the level of the monthly service or customer charges; Block rate adjustments (i.e., declining, flattening, inverted, block restructuring); System benefits charges (e.g., energy efficiency or DSM programs, low income assistance); Unbundled or ancillary services and rates; Low income rate structures; Weather normalization adjustment mechanisms; and
Budget billing programs.
These ratemaking proposals seek to address a number of ratemaking objectives, including: (1) recovering the fixed costs of utility service through the fixed components of its rate structure; (2) achieving cost-based rates; (3) providing energy choices and service options to customers; (4) addressing social considerations through rate design; (5) stabilizing the volatility that exists in utility margins due to weather; and (6) addressing volatility in customers' monthly energy bills.
A number of regulatory proceedings other than general rate cases also have addressed important issues ().
Improving Stakeholder Acceptance
Utilities that had filed rate cases over the last 24 months were asked to indicate the single most important change to the rate case process that would improve stakeholder acceptance of the utilities' rate increase request and related proposals. The changes cross a wide range of topics, and consist of:
1. Acceptance of post-test year adjustments;
2. Better recognition of cost changes and cost causation;
3. Recognition of return on equity models other than Discounted Cash Flow (DCF) and the Capital Asset Pricing Model (CAPM);
4. A balanced position from the regulatory staff;
5. Recognition of a proxy capital structure;
6. A better understanding of the risks inherent in providing service as it translates into an appropriate cost of equity;
7. Recognition of a forward-looking test year; and
8. The allocation of revenues among classes of service, and between state and FERC jurisdictions.
Three clear themes emerge from these responses. Changes are needed: (1) to the techniques used to derive the numbers, (2) to recognize certain principles, and (3) to the rate case process. The first theme addresses the need for adjustments to the utility's actual or per-book plant and expenses levels to reflect any known and measurable changes that are expected to occur in the first year in which rates are implemented. The allowance of such changes may also address the age-old problem of regulatory lag-the setting of rates based on costs that are outdated by the time the rates are approved by the regulator. Clearly, the use of a forward-looking or future test year can directly address this concern. Similarly, respondents recommended that certain changes be made to the techniques relied upon to derive the utility's cost of equity and capital structure.
Regarding the "principles" theme, the respondents seem to be suggesting that it is important to view the broader aspects of the utility's business (e.g., the level and change to the cost of serving customers, the risks of doing business) when examining the detailed numbers supporting changes to its allowed revenues and rates.
Finally, and perhaps most importantly, the process of conducting a utility rate case needs to be examined more closely, with an objective view toward understanding and better managing the inherent adversarial roles and resulting conflicts that invariably arise between the utility, regulator, and other stakeholders. However, the notion that each of these parties would take a balanced position in the rate case is easier to conceive of in theory, but much harder to achieve in practice. In certain jurisdictions, most notably in Canada, regulators have been working hard to implement Alternative Dispute Resolution (ADR) and other less adversarial processes in an attempt to minimize the often polarized positions of parties that drive the review and ultimate resolution of rate case issues. At the same time, it is in the public interest that there be a more complete recognition of the delicate balance that must be struck between protecting the utility customers' energy interests and ensuring that the utility has a reasonable opportunity to achieve financial health if it manages its business in an effective and responsible manner. A more complete disclosure to the regulator of the "facts that matter" by the utility, both in and outside of rate cases, can foster the open discussions and eventual building of trust that can make these ideals a reality.
Regulatory Uncertainty: Here to Stay
The message heard loud and clear from survey respondents is that the concept of regulatory uncertainty is real, that it is here to stay for the foreseeable future, and that it must be better managed. Managing regulatory uncertainty will involve finding new ways to promote: (1) greater clarity in the energy policies of the state and federal governments; (2) more specificity and consistency in how regulators implement such policies, and in their related decisions that impact the operations of regulated utilities; and (3) continuing efforts of utilities to interact with regulators and other stakeholders outside the rate case environment to communicate, educate, and build trust.
And with the increased frequency of rate-case filings expected in the next few years, there will be ample opportunity to explore such remedies. Therefore, the utility, regulator, and other stakeholders must all work hard to establish collective objectives that will point the process in the right direction. With all the other major business uncertainties that exist today in the energy industry that cannot as easily be influenced and managed, it is incumbent upon all interested parties to address this most important issue now to ensure the continued viability of gas and electric distribution utilities to meet the future energy needs of their customers.
- Survey respondents represented gas utility companies (52 percent), electric utility companies (13 percent), and combination utility companies (35 percent) from 26 states and 2 Canadian provinces.
- For example, see the Resolution on Gas and Electric Energy Efficiency adopted by The National Association of Regulatory Utility Commissioners (NARUC) board of directors on July 14, 2004, and the Joint Statement of the American Gas Association and the National Resources Defense Council submitted to NARUC in July 2004.
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