1. Rethinking Natural Gas Utility Rate Design: A Framework for Change
American Gas Foundation
The NARUC Foundation
Executive Forum at Ohio State University
Russell A. Feingold
Managing Director
May 22-23, 2006

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Today’s Discussion
So, why do we need to “rethink” natural gas rate design?
Natural gas ratemaking fundamentals of the past
How do today’s energy industry challenges provide us with a framework for change?
Is the utility ratemaking paradigm shifting? 2
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3. Why Do We Need to “Rethink” Natural Gas Rate Design?
Changing industry drivers
Supply/demand balance, price dynamics, customer usage, etc.
Changing stakeholder policy objectives
Societal considerations, competitive position, financial goals
The current rate design may not be working as intended
Unexpected stakeholder impacts
Original rate design objectives not being satisfied 3
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To Add Further Complexity to the Equation, “Rate Design is an Art – Not a Science”…
There is no right or wrong answer in deciding upon the “optimal rate design”
The many stakeholders in the process have diverse, and often, conflicting perspectives, opinions, and objectives
No stakeholder has the ability to precisely “forecast” exactly how a group of customers will respond to a change in rate design
How one defines “due” and “undue” discrimination is in the eye of the beholder
There is a natural tension that exists between the residential consumer and industrial customer (with commercial businesses in the middle) when class revenue and rate levels are established 4
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5. Emergence of Natural Gas
Gas Utility Rate Design Tends to Evolve Over Time (an Illustrative Example)
Emergence of Natural Gas
(1950s to Early 1970s)
The Open-Access Era
(Mid 1980s to Early 1990s)
The Competitive Era
(Mid 1990s to Early 2000s)
Declining block rate design
Rate base driven rate cases
Advent of end-user transportation rates
Service and rate unbundling
Flexibly-priced rates
Special contract rates
Interest in PBR plans
Fixed price/bill concepts
Transition from manufactured gas
Building of natural gas infrastructure
Gas pipelines becoming open-access carriers
Competitive wholesale gas commodity market
Competitive pressures across energy sources
LDC bypass threats
Encourage gas consumption
Provide financial support to fund expansion
Facilitate a workably competitive marketplace
Promote non-distortional price signals
Protect residential consumers from price rises
Promote a level playing field among energy sources
Ratemaking Trend
Industry Driver(s)
Policy Rationale 5
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A Fundamental Consideration Over the Years: Declining or Inverted Block Rate Structure?
The declining block rate structure was the predominant rate form in use during the period of adequate gas supplies (1948 through 1971).
As natural gas supplies tightened, and curtailment of supplies became the norm (mid to late 1970s), rate structures were analyzed with conservation in mind.
The most common rate forms were marginal cost rates, incremental cost rates, flat rates, inverted block rates, or lifeline rates.
Declining or inverted block rates? – depends on how the gas supply situation is perceived by stakeholders, and how strongly they desire to influence customer behaviors (encourage or discourage gas use) through rate design. 6
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7. To Borrow From a Popular 1950s Song; “What a Difference a Day Makes”…
THE “GOOD OLE DAYS”
Robust and stable use per customer levels were the norm
Wellhead gas prices represented a small percentage of the burner-tip price of gas to utilities’ residential customers
Utility rate cases were driven more by rate base increases rather than by expense increases
“Normal weather” actually was experienced in some years
Customers generally paid their gas bills
TODAY
Declining use per customer
Purchased gas costs represent upwards of 70% of the customer’s gas bill
Concern over how the utility will recover its approved revenue requirement through rate design
Aging infrastructure and focus on system reliability
“Warmer-than-normal” weather conditions are defining new norms
Bad debt expenses increasing as gas commodity prices increase 7
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8. A Changing Ratemaking Perspective in the Energy Industry
“Then”
“Now”
Rate Design
Pricing
A static process
Fixed prices
Cost-driven
Revenue predictability
A dynamic process
Flexible prices
Market-driven
Revenue uncertainty 8
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9. In the “Good Ole Days,” We Worried About Things Like:
“Should 2 or 3 rate blocks be included in the residential rate structure?”
“Should we increase the residential monthly customer charge by $0.50 or $1.00 per month?”
“Should we establish rate classes and rate structures by end-use or by volume?”
“Do we really need to focus on end-user transportation rates because customer choice and the existence of third-party gas marketers are both temporary market conditions?” 9
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10. And Today, We Worry About Things Like:
How do we promote the efficient use of natural gas through rate design?
How do we develop rates to minimize the utility financial and customer billing impacts of weather variability?
How do we minimize through rate design the impact of declining use per customer on a utility’s financial condition, and on the stability of customers’ bills?
How should varying levels of bad debts be accommodated through rate design?
How do we recover costs associated with aging infrastructure and enhanced system reliability?
Risk
Volatility
Price
Uncertainty 10
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11. Wellhead Price as a Percent of Burner-Tip Price
In Recent Times, the Wellhead Price of Gas Has Surpassed the Price of Transmission and Distribution Delivery Services
Wellhead Price as a Percent of Burner-Tip Price % % %+
Source: U.S. Energy Information Administration (weighted average price levels) 11
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Yet, Both Components Are Equally Important to the Utility and its Customers for Different Reasons
Commodity Cost of Gas – most important to end-use customers because it currently is driving the total price of natural gas and the relative level of their gas bills
It has the greatest impact on the customer’s monthly gas bill
It has the greatest influence on the price signal received by residential customers
Delivery Margin – most important to gas pipeline companies and gas distribution utilities because it directly impacts their current financial performance and ongoing business viability
Utilities do not make money from purchased gas costs incurred to serve their sales customers1
1 Unless they operate under a gas cost PBR plan 12
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13. The “Perfect Storm” is Now Upon Us…
Unpredictable costs and sales levels
Restructured assets
Increased financial stress
Energy Market Conditions
Regulatory Roles and Actions
Increased volatility
Higher commodity prices
Uncertainty
Changing roles
Tough issues to balance
Distribution Utilities
Responses to high prices
Declining gas use
Bill payment problems
End-Use Customer Characteristics 13
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14. Some Threshold Regulatory Considerations
What constitutes a customer’s “efficient use of natural gas?”
How do you define for a gas utility:
“A reasonable opportunity to earn its allowed rate of return?”
“Its normal risks of doing business?”
Which costs and/or business factors for a utility are considered uncontrollable, unpredictable, material, and recurring? - and should they be treated differently for rate design purposes?
What does it mean to achieve a reasonable level of rate equity among a utility’s customer groups?
Should utilities be rewarded for “superior performance?” 14
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However, There is No Clear Consensus Among Utility Executives and Regulators on What is Most Important
The Most Important Objectives for a Utility Regulator to Achieve (Greatest Difference)
Source: 2005 Navigant Consulting Utility Regulatory Survey 15
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16. No Clear Consensus … (continued)
The Most Important Objectives for a Utility to Achieve (Greatest Difference)
Source: 2005 Navigant Consulting Utility Regulatory Survey 16
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17. The Utility Rate Design Process: Balance is Essential
Economic Factors
Cost of service
Value of service
Competitor prices
Price differences and discrimination
System load equalization
Availability of gas supply/capacity
Return and revenue stability
Regulatory Factors
Precedent
Intervenor interests
Historical Factors
Rate perspective
Rate continuity
Social and Political Factors
Customer reaction and acceptance
Public relations aspects
Economic conditions of
service territory
Social obligations to particular
customer groups
Political attention and involvement 17
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For Many Utilities, Their Major Business Drivers Have Prompted the Filing of General Rate Cases…
Unstable margins – leading to earnings stress
Uncontrollable and unpredictable costs
Declining use per customer
Challenges to achieving growth
A “Back to Basics” business strategy
Regulatory lag (process can be slow, costly, inefficient)
Aging infrastructure and focus on system reliability
Regulatory uncertainty 18
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Many Innovative Ratemaking Mechanisms are Being Proposed by Utilities in Rate Cases to Address Their Specific Business Challenges.
Straight Fixed-Variable Rate Design
Revenue Decoupling Mechanisms
Bad Debt Recovery Mechanisms
Infrastructure Replacement Cost Recovery Mechanisms
Revenue (Return) Stabilization Mechanisms 19
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In Addition, the Static Nature of a “Test Year” is Being Challenged Through Utility Rate Design Initiatives in These Rate Cases.
Key Assumptions in the Use of a Test Year:
A test year represents a snapshot in time that attempts to reflect a level of plant and expenses comprising a utility’s total revenue requirement – which will be representative of the period the new rates will be in effect.
Use of a test year assumes that the utility’s costs in a future period can be reasonably represented by its historical costs (often with known and measurable changes) – which means such costs are assumed to be predictable, stable, and controllable.
In today’s highly volatile and unpredictable cost and energy usage environment, are these still realistic assumptions? 20
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21. When Does it Make Sense to Utilize an Automatic Adjustment Mechanism?
An automatic adjustment mechanism should be considered as an appropriate cost recovery method when they address costs and/or business factors (e.g., weather, gas usage) that are:
Uncontrollable by the utility.
Variable and Unpredictable.
Material and of a Recurring nature. 21
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22. Examples of Automatic Adjustment Mechanisms
Purchased gas adjustment (PGAs)
Weather normalization
Revenue decoupling
Bad debt/uncollectible expense
Environmental costs
Property taxes
Infrastructure cost recovery (capital and O&M)
Infrastructure improvement
Pipeline integrity (mandated safety programs)
Public improvement projects
Energy efficiency/DSM costs
Stranded restructuring costs 22
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23. Utility’s Earnings (Revenues) Customers’ Energy Consumption
Why all the interest in the concept of revenue decoupling for gas utilities?
Utility’s Earnings (Revenues)
Customers’ Energy Consumption 23
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Energy Efficiency and Conservation Can Provide Relief for Customers From High Natural Gas Prices…
There is a renewed focus by utilities on promoting cost-effective energy efficiency measures to relieve consumer burdens.
Typical programs include:
Audit – analysis of conservation opportunities
Retrofit/replacement (rebates) – weatherization, programmable thermostats, efficient equipment replacement
New construction – new buildings and expansions
These programs make sense for customer, economic, and public policy reasons, provided that utility financial impacts are addressed:
Lost revenue recovery
Contemporaneous recovery of program costs 24
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25. Decoupling Can Align Stakeholders’ Diverse Interests
A properly designed decoupling mechanism can achieve significant benefits for the utility and its customers:
Mitigates the utility’s disincentives to promote energy efficiency;
Removes the relationship between the utility’s sales volume levels and profits (margin revenues); and
Provides increased opportunities to customers to reduce energy consumption, and to reduce energy bills, created by the various energy efficiency and conservation initiatives supported by the utility.
Customers’ bills will more accurately reflect the margin recovery amounts approved by the regulator.
Improves the ability of the utility to recover its fixed costs of providing service. 25
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26. Bad Debt Recovery Mechanisms
An alternative to recovery as a fixed expense in base rates set in a rate case
The tracker permits recovery of actual bad debt expense through a deferral account - periodically is “zeroed out” through the application of surcharges or credits to base rates.
Recognizes the uncontrollable/unpredictable nature of such costs and close correlation with changes in the price of natural gas
In some states, base rates reflect a “baseline” level of bad debt expense, with variations from baseline used to adjust rate
Others permit separate treatment of gas commodity-related bad debt expense through its Purchased Gas Adjustment (“PGA”) mechanism 26
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27. Infrastructure Replacement Cost Recovery Mechanisms
An alternative to recovery as a fixed expense in base rates set in a rate case, or through deferred accounting treatment.
Reflects costs mandated under:
(1) the Pipeline Safety Improvement Act (“PSIA”) of 2002;
(2) public improvement projects; or
(3) accelerated pipe replacement programs. 27
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28. Revenue (Return) Stabilization Mechanisms
A form of Performance-Based Ratemaking (“PBR”) – periodic rate adjustments are made based on a comparison of achieved vs. approved rate of return, without the need for a full rate case
Some of the mechanisms are based on an “earnings sharing” approach – utility and customers share any increase or decrease in achieved earnings relative to a target earnings level
Approved in Alabama, Louisiana, Mississippi, South Carolina 28
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29. Is the Utility Ratemaking Paradigm Shifting?
YES!
There is an increased recognition of the uncontrollability, variability, and unpredictability of a utility’s costs, and its customers’ usage levels
An increased awareness that a much more dynamic process is needed to ensure a utility’s rates will actually recover the regulator-approved cost of service – the static nature of a “test year” is being challenged.
Increased recognition that the majority of a utility’s costs are fixed, yet they are recovered through the volumetric component of its rate structure – which creates financial instability.
A desire to streamline the regulatory process by reducing the number of general rate cases. 29
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30. Paradigm Shifting (continued)
Innovative ratemaking mechanisms will appear more frequently in utility rate case filings because they:
Address important financial customer needs;
Provide significant benefits to the utility and its customers; and
Streamline the rate case process. 30
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31. For further information, contact:
Russell A. Feingold | Managing Director
direct
mobile 31
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