1. TEEING OFF OUR DISCUSSION ON RETHINKING NATURAL GAS UTILITY RATE DESIGN The National Regulatory Research Institute Ken Costello Senior Institute Economist AGF/NARUC sponsored Executive Forum at Ohio State University Columbus, Ohio May 23, 2006

2. Three Key Features of the Forum Rethinking Rate Design Natural Gas

3. May 23, 2006 The Meaning of Rate Design The third and last stage of ratemaking Involves determining how a utility will recover its revenues in line with (1) a pre- determined revenue requirement and (2) cost allocation to different classes of customers and services Specifies how utility services are priced Four examples – SFV, declining block rate structure, inverted rates, seasonal rates

4. May 23, 2006 Why Rate Design Is Important Helps to achieve important regulatory/social objectives, which prominently include the financial viability of utilities and the efficient use of natural gas Rate design is imperative for promoting economic efficiency (for example, in providing correct incentives for consumer behavior) –As many economists would say, if you price a commodity or service solely on the basis of marginal-cost principles, many of the problems would go away; but few others, including regulators, would agree

5. May 23, 2006 Why Rate Design Is Important -- continued Serious consequences from poor rate design – major ones include –Wasteful consumption –Excessive/deficient utility earnings –Uneconomic bypass –Inequity –Undue price discrimination

6. May 23, 2006 Why Rate Design Is Important -- continued This is recognized by both utilities and regulators, although they may disagree not only over –What is good and bad rate design, but also –The gravity of adverse outcomes

7. May 23, 2006 Two-Part Tariffs: The Foundation for Rate Design Basic Structure: TB i = F + pq i, –Where the total bill for customer i (TB i ) equals the sum of the customer charge (F) and the volumetric charge (p) times the amount of gas consumed (q i ) –Non-linear in the sense that average expenditure per unit consumed (TB i /q i ) falls as q i increases –Can do much better from an efficiency perspective with two-part tariffs than with second-best Ramsey linear pricing

8. May 23, 2006 Two-Part Tariffs -- continued Basic Structure: TB i = F + pq i -- continued –Ideally, from an economic-efficiency perspective At the margin customers would pay a usage price equal to marginal cost, with the difference between revenues generated from usage charges and the utilitys total costs covered with a fixed fee (e.g., customer charge) that acts as a lump sum tax –As long as the fixed fee is less than consumer surplus net of usage expenditures, consumers will pay the fixed fee and consume at the efficient level

9. May 23, 2006 Two-Part Tariffs -- continued Basic Structure: TB i = F + pq i – continued –Non-linear pricing has been used in the pricing of electricity, gas and telephone service since early in the 20th century –Early proponents of non-linear pricing such as Samuel Insull saw this pricing method as a way to expand demand and lower average costs while meeting a break-even constraint –In advancing various social objectives, this rate design has evolved over time to where typically a gas utility recovers much of its fixed costs in the volumetric charge

10. Examples of Rate Designs: Conflicts in Objectives Flat Rate per period, no usage charge Uniform: Flat Rate per unit Declining Block Inverted Block $ Q $ Q $ Q $ Q

11. Examples of Rate Designs -- continued Seasonal or Time of Use $ Period 1 Period 2 Q

12. May 23, 2006 Regulatory Objectives and the Role of Rate Design Changing major regulatory objectives -- priorities change over time, as well as the specification of objectives Rate design from different perspectives – a conflict among stakeholders Tasks for regulators –Listing and prioritizing of rate-design principles –Integrating rate-design principles with regulatory objectives

13. May 23, 2006 Rate-Design Objectives: The Usual List Public acceptability Equitable Revenue sufficiency Efficient competition Rate stability Promotion of specified social goals Efficient consumption Avoidance of undue discrimination

14. May 23, 2006 Why This Forum and the Recent Interest in Natural Gas Utility Rate Design? HIGH GAS PRICES, HIGH GAS PRICES, HIGH GAS PRICES ALONG WITH VOLATILE GAS PRICES!

15. Consequences of High Gas Prices Fewer customers able to afford natural gas for home use Bad-debt expenses increase Energy conservation becomes more important Increased risks to both utilities and consumers Fuel-switching becomes more imminent Greater emphasis on hedging Elasticity effect becomes more pronounced in terms of reducing gas consumption Overall, the industry becomes less stable with outcomes (e.g., consumption and consumer gas bills, utility earnings) more volatile and uncertain

16. Recent Rate Design Proposals and Issues Increases in the level of monthly service or customer charge Low-income rate structures Block rate adjustments (declining, flattening, inverted) Weather normalization adjustment mechanisms System benefits charges (DSM programs, low-income assistance) Budget billing programs Unbundled or ancillary-service rates Revenue decoupling (e.g., conservation tariffs)

17. May 23, 2006 Why This Forum? -- continued This forum is timely –A dialogue on rate design issues is critical to reach consensus and for utilities, regulators and other stakeholders to become better informed Delaying the implementation of new rate designs can inflict a high cost on society –Prevailing rate designs may result in undesirable outcomes from a public-interest perspective (e.g., outcomes inconsistent with regulatory or public policy objectives)

18. May 23, 2006 Things to Keep in Mind Over time, rate design in the utility sector has evolved to accommodate market, technological and regulatory/governmental changes –We have seen this in not only in the public utility industries but in other industries as well Historically, regulators have responded to changed conditions by entertaining and accepting new rate designs when compatible with prevailing objectives

19. May 23, 2006 Things to Keep in Mind -- continued Conditions in the natural gas industry have changed significantly over the past several years, warranting a review of prevailing rate designs Specifically, these changed conditions have shifted priorities of regulatory objectives To repeat from earlier, the status quo in rate design may carry high costs for utilities, consumers and society as a whole

20. May 23, 2006 Things to Keep in Mind -- continued Regulation has many objectives, with some conflicting, and priorities (ranking of objectives) changing over time Rate design in practice reflects a compromise of the multiple objectives such as economic efficiency and equity –The balancing act of regulation or sausage making in applying both basic principles and judgment

21. May 23, 2006 Things to Keep in Mind -- continued We should assume that regulatory objectives differ from utilities objectives –Both in terms of what gets on the list and where on the list each objective ranks (e.g., utility financial viability, promotion of energy efficiency, risk allocation to consumers and the utility) –If this were not so, regulation would have no reason to exist, as the invisible hand of the marketplace would guide a utilitys actions toward the public good

22. May 23, 2006 Things to Keep in Mind -- continued The reasons for regulators reluctant to change rate design –Inertia –Uncertainty over the outcome –Disinformation/deficient information Changed rate design should accommodate the new realities and conditions in the natural gas industry