Regulation by Formula


Tools to facilitate changing utility economics.

Tools to facilitate changing utility economics.

Fortnightly Magazine - March 2010

These are challenging times for the electric and gas utilities. Reliability projects, renewable portfolio standards, greenhouse-gas emissions control, AMI, smart-grid investments, and conservation programs—all these things add to costs, but might bring in no additional revenue. Moreover, there will be unprecedented capital investment in transmission, renewable generation projects, and replacement of old facilities from the 1950s and 1960s. Thus, earnings likely will be more closely watched and traditional general rate cases might not be able to keep up.

Regulatory Options

There are a number of regulatory tools available to address rapid changes in utility operating and capital costs. First is the possibility of using a projected test year instead of a historical test year; but there’s nothing really new here, and it still requires a general rate case. A full blown general rate case is time consuming and costly for the utility, the regulator, and intervenors. Cost estimates for a projected test year add to disputes among the parties.

A second option, decoupling commodity sales from base rate revenues serves to tie base rates to the number of customers, equivalent to allowing the utility to recover a fixed amount of money per customer regardless of sales. A balancing account tracks any over or under-collections during the year. The balancing account is closed out by adjusting base rates in the next year. Any commodity costs ( e.g., fuel, purchased power, natural gas) are billed to the customer as a separate line item on the bill. However, decoupling does nothing to incorporate increased operating costs or increases in rate base.

A third option, performance-based regulation or ratemaking (PBR) attempts to adjust rates annually in response to a pre-specified escalation factor reduced by a productivity factor. The formula for PBR is: Pt = Pt-1 ((1 + esc.) – X) , where Pt equals the new price in time period t after adjustment; Pt-1 equals the old price in the prior time period t-1 before adjustment; esc. equals a predetermined escalator, for example the consumer price index (CPI); and X equals a predetermined productivity factor that serves to reduce the escalator and account for productivity improvements in the time period t-1.

PBR, although it provides for a rate increase each year, might or might not cover all operating cost increases, cost of capital increases, or significant increases in rate base. Moreover, absent decoupling, declines in sales likely will result in a revenue requirement shortfall. In addition, the X factor is difficult to establish and the escalator not necessarily correlated with utility cost increases. Finally, the PBR usually has a three- to five-year time limit before another full-blown rate case is triggered.

A fourth option, ratemaking by formula, allows for changes in rates to reduce or increase rates in response to changes in earnings and rate base.