1 THE RATE CASE PROCESS A Blend of Science and Superstition Presentation to the Mongolian Energy Regulatory Board By Burl Haar Executive Secretary Minnesota Public Utilities Commission September 30 - October 2, 2002 Ulaanbaatar, Mongolia

2 RATE PROCEEDINGS Regulatory tool to evaluate major rate changes: General Rate Case - Most comprehensive tool for determining just and reasonable rates Review of all company revenues and costs. There must be a showing that the overall level of rates is too low or too high. Company bears the burden of proof that rate request is reasonable. Commission will suspend rate change until final decision reached. May allow interim rates.

3 RATE MAKING PROCESS: Three important perspectives: 1.Consumer’s interest - Obtain quality service at the lowest rate 2.Utility’s interest - Obtain sufficient revenues and profits to attract investments and support efficient operations 3.Public interest - What is needed to provide the greatest benefit for the community as a whole. “Provide safe, adequate and reliable service at just and reasonable rates” Role of Regulatory Commission - act as an umpire.

4 GENERAL CONTENT OF A RATE CASE 1. Historical information 2. Rate Tariff material 3. Rate Base material 4. Operating statistics 5. Economic factors

5 OVERALL OBJECTIVES OF THE RATE-MAKING PROCESS: 1.DETERMINING THE LEVEL OF REVENUES (REVENUE REQUIREMENT + RATE BASE) 2. DETERMINING HOW REVENUES WILL BE COLLECTED (RATE DESIGN)

6 LEVEL OF REVENUES - REVENUE REQUIREMENT COMPONENTS OF REVENUE REQUIREMENT Operating Expenses - expenses related to the utility’s operation Depreciation Expenses - charges to reflect the loss in value of assets due to physical causes, functional causes and contingent casualties. Taxes - taxes paid by the utility on earned income, gross receipts, franchise fees, capital stock, and unemployment and social security taxes on employees. Allowed Return (Rate base X Rate of Return) Rate Base - The value of utility plant used and useful in providing utility service minus accumulated depreciation Rate of return - Allowed return to investors stated as a percentage of profit per dollar invested.

7 LEVEL OF REVENUES - RATE OF RETURN Rate of return determined by evaluating return of companies with comparable business risk, rate of inflation, overall growth in dividends, unusual business risks, etc. Subjective decision. Authorized rate of return not a guaranteed rate of return.

8 HOW REVENUES WILL BE COLLECTED - RATE DESIGN Two major decisions: u How to allocate authorized costs among customer classes. uHow to design rates within customer classes to assure reasonably revenue recovery, efficient energy use and equitable treatment of ratepayers.

9 RATE DESIGN CONTINUUM Differential pricing Distribution of rates on the basis of different characteristics of service cost and usage. One set of rates for all customers Individual price for each customer

10 DIFFERENTIAL RATE-MAKING - THE UNITED STATES ELECTRIC UTILITY INDUSTRY (Year 2000)

11 RATE DESIGN DECISION-MAKING CRITERIA Criteria for rate design decision-making: !Cost of service !Value of service !Avoidance of unreasonable discrimination !Rate structure continuity !Appropriate rate relationship !Ease of understanding and administration !Customer impact !Competitive impact !Incentives for efficient use of service

12 TYPES OF COSTS BY CLASSIFICATION There are several broad classifications of costs: !Customer costs - the fixed costs incurred in serving each customer (e.g., meter reading, billing, collecting, etc.). Allocated by number of customers. !Energy costs - the variable costs connected with plant operation (e.g., plant expenses and fuel). Allocated according to usage. !Demand costs - the costs related to the investment in plant and facilities needed to meet a customer and class of customers’ demand on the system’s total capacity to serve. These are mostly fixed costs covering such items as interest on funds borrowed to build plant, depreciation, returns on equity capital. Allocated according to relative demand on system capacity. !Common costs - Costs of capacity necessary for production but not directly associated with the number of customers, energy usage, service on system peak, or administrative functions.

13 NON-COST FACTORS !Simplicity, understandability, public acceptability, and feasibility of application !Stability; i.e., avoiding “rate shock” !Fairness - value of service !Avoidance of undue discrimination in rate relationships

14 RATE STRUCTURES Rate Design has evolved over the years ?Meter Rates ?Step Rates ?Block Rates ?Declining Block Rates ?Inverted Block Rates ?Two-part Rates

15 RATE - MAKING Final Comment: The difference between “reasonable” rates and “unreasonable” rates is not absolutely clear. What is needed is a deliberate and open process for examining all the factors that affect rates. Through such a process the distinction between reasonable and unreasonable will become clearer.