1. 1 of 46 Tariff Development II: Developing a Cost of Service Study Energy Regulatory Partnership Program Abuja, Nigeria July 14-18, 2008 Ikechukwu N. Nwabueze, Ph.D. Director, Regulated Energy Division Michigan Public Service Commission

2. 2 of 46 Why Is a Cost of Service Study Needed? Regulators are mandated by statue to establish just and reasonable rates for utilities under their jurisdiction. Most industry experts agree that proper rates must be designed and implemented to recover costs incurred by a utility to provide the service required by the customers. The objective of a cost of service study is to apportion all costs required to serve customers among each customer class in a fair and equitable manner.

3. 3 of 46 Principles of Rate Regulation Fairness to both the regulated utility (its owners (or stockholders)) and the ratepayers Avoidance of unjust or undue discrimination between rate classes or customers –Cost causation - the concept of the cost causer pays the costs it imposed on the utility system

4. 4 of 46 Principles of Rate Regulation (Continued) Cost allocation calculated through a cost of service study determines how many dollars to collect from various classes or rates allowing the proper total revenue requirement to be collected through rates Rate design determines how to collect dollars from various customer groups

5. 5 of 46 The purpose of a cost of service analysis: –Allocation of revenue recovery Determining the proper rate level for each group of customers for which rates are designed –Identifying variable and fixed costs Determining the variable and fixed costs associated with service provided to each group of customers –Component pricing Cost information for determining the most efficient design (especially important when designing unbundled rates) Cost of Service

6. 6 of 46 Important Definitions to Understand Customer Class or Class of Service – A set of customers with similar characteristics who have been grouped for the purpose of setting an applicable rate for electric service –Common classifications include residential, commercial, primary service and industrial Energy – kilowatt-hours (kWh) supplied to or used by an individual customer, group of customers or class of service Demand – rate at which electric energy is used at a given instant or averaged over a designated time interval. –Typically demand is expressed in kilowatts (kW) or megawatts (MW), one megawatt equals 1,000 kilowatts. –Company uses average hourly demands in the development of allocation schedules

7. 7 of 46 System Peak Demand – The highest total hourly demand (MW) for all customers served on the utility’s distribution system within a specific period (day, month, year). Typically referred to as the ‘system peak’. Coincident Peak Demand – The demand of any class within a specific period (day, month, year) that occurs at the same time as the system peak demand for the same period. Coincident MH4CP Demand – The demand value derived by averaging the actual demand values for hours beginning 12 noon through 8 p.m. registered on the monthly peak days for June, July, August and September. Coincident 12 CP Demand – The demand value derived by averaging the actual demand values registered on the monthly peak days for January through December. Important Definitions (Continued)

8. 8 of 46 Non-Coincident Peak Demand – The maximum demand of any class within a specific period but not necessarily occurring at the time of the system peak demand for that period. Losses – A term used to define the difference between the electrical energy delivered to a customer (or a given point on the electrical distribution system) and the amount of electrical energy that must be generated at the power plant to serve that customer. In other words, losses refer to the amount of power lost in transferring power from the power plant to the point of delivery (often referred to as line loss). Line losses will vary by rate class based upon the voltage level at which each class is served. Important Definitions (Continued)

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11. 11 of 46 Types of Cost of Service Approaches Embedded Cost Basis - Used by MPSC –Determine apportionment of accounting-based revenue requirement using functionalization, classification and allocation process –A fully allocated embedded unbundled cost of service study allocates all items of utility property and cost to determine the fully allocated embedded cost of service for each customer class of service and shows each customer class’ share of costs by major function (Power Supply and Distribution) Marginal Cost Basis –Estimate the additional cost in providing increments of service to each service function –Reconcile to embedded Rate of Return if used so that allowed Revenue Requirement is possible

12. 12 of 46 Basic Steps to Rate Base Regulation Determine test period Total Revenue Requirements Calculate part of Revenue Requirement to be recovered by Jurisdictional retail rates (Total revenue less amounts from other sources) Allocate Revenue Requirements to Various Classes of Service Determine Rate Structure (Prices) for Each Customer Rate Class – Design Rates

13. 13 of 46 Reminder: Determining Revenue Requirements Revenue Requirement is defined as: That level of revenues sufficient to cover a utility’s cost of service including a return on its investment The formula to determine Revenue Requirement is: R = (V-D) r + E

14. 14 of 46 Reminder: Revenue Requirement Formula: R = (V-D) r + E R = Revenue Requirements V = Value of Rate Base (Plant in Service plus Working Capital) D = Accumulated Depreciation r = Rate of Return on investment E = Operating Expenses

15. 15 of 46 Emphasis on Proper Cost Accounting on Which to Set Regulated Tariffs Uniform System of Accounts Functional accounting system comprised of specific accounts in which all transactions are recorded at cost. Rate Case Filing Requirements Test Year Rate Case Audit

16. 16 of 46 MPSC Cost of Service Allocation Methods (Case No. U-4771 dated 5/10/76) The Order requires exhibits detailing a fully-distributed cost of service by rate schedules to be submitted. This cost of service data shall be based upon the following apportionment methods: Average twelve month peak demand responsibility. Production and transmission plant assigned as 75% demand related and 25% energy related. Specific distribution plant such as meters and service drops used exclusively for a given customer shall be treated as customer related. All other distribution plant shall be treated as demand related. The separations studies must correspond to the proposed test year and consider all of the adjustments made to rate base and net operating income. It should show a breakdown by major functional groupings of the various apportionments along with a verbal description of the full procedure used.

17. 17 of 46 Embedded Cost Studies – Methods of Allocation, Functionalization, and Classification Functionalization assigns all costs to the major functions, i.e. Power Supply and Distribution. Classification divides these costs into customer-related costs, demand related costs, and energy-related costs. –The sum of these three types of costs within a given class is the cost to serve that class. –In some cases, formally classifying the costs is not necessary because the allocation methods employed within the cost of service recognize and properly account for whether the item being allocated is customer, demand, or energy related. Allocation apportions the cost classifications to the respective classes of service, sometimes comprised of one or more individual rate schedules, based upon the class’ responsibility for the incurrence of these costs.

18. 18 of 46 Cost Study Functions The major utility functions used in Michigan cost studies are Power Supply (Generation and Transmission), and Distribution. Power Supply includes costs associated with a utility’s generating plant, fuel, purchased power and the expense associated with transmission services provided to the utility by its regional transmission operator, MISO and the International Transmission Company, the transmission system owner. Distribution includes the costs associated with the utility’s distribution system, that generally operates at voltages of 40 kV and below and includes customer service expenses.

19. 19 of 46 Unbundled Cost of Service Study Fully allocated embedded Unbundled Cost of Service Study is developed for the utility, that is consistent with the service components (functions), which are Generation, Transmission, and Distribution. The total jurisdictional revenue requirement of the cost of service equals the jurisdictional revenue requirement. A fully allocated embedded cost of service study allocates all items of utility property and cost, taken from the books and records of the Company, to determine the fully allocated embedded cost of service for each customer class of service.

20. 20 of 46 Costs are separated by all functions: Production Transmission Distribution Customer Accounts and Customer Service Administrative and General

21. 21 of 46 Functionalized costs are classified: Capacity – Costs associated with meeting system throughput and demand requirements. Energy – Costs that vary with the volume of energy sold. Customer – Costs resulting from having a customer connected to the utility.

22. 22 of 46 Another way to look at classifying costs: –Variable costs: costs that vary with output (e.g., commodity costs such as fuel, purchased gas for combustion turbines, etc.) –Fixed costs: costs that remain constant across a range of output (e.g., demand and customer costs, depreciation) –Common costs: costs incurred jointly for two or more types of operation or the provision of two or more services (e.g., capital cost of a power plant serving residential, commercial, and industrial customers)

23. 23 of 46 Allocation of Revenue Requirements to Various Classes of Service Group customers into rate classes Rate classifications should produce homogeneous groups based upon characteristics of each group –Residential –Commercial – Secondary and Primary –Industrial – Secondary and Primary –Retail Open Access – ROA

24. 24 of 46 Allocation factors are developed that reflect the nature of the classified and functionalized costs. Cost allocation determines Revenues, and Consequently, average price, to be collected from each class of customers (or each rate) Factors applied to the utility’s costs to allocate them to each rate class. Some costs are directly assigned such as lamp fixture costs for a street lighting rate.

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26. 26 of 46 Cost of Service Process The process also includes determining the “jurisdictional” amount of each base input. –Jurisdictionalization means separating the costs associated with providing electric service to retail customers, which falls under MPSC jurisdiction, from those costs associated with providing service at wholesale, which is subject to FERC jurisdiction. This is typically accomplished within the cost of service study by applying allocation schedules that include the loads associated with FERC jurisdictional sales to customers in apportioning total electric utility costs.

27. 27 of 46 Jurisdictional Separation Jurisdictional separation is a product of the allocation process whereby the revenue and costs associated with the utility’s wholesale for resale sales to wholesale requirements customers (regulated by the FERC) are separated from those associated with sales that fall under the jurisdiction of the MPSC. These wholesale for resale customers are Michigan municipal and cooperative utilities that purchase their power supply requirements from the utility for resale to Michigan retail customers. The jurisdictional electric columns within a filing contain the portion of the utility’s total electric costs that fall under the MPSC jurisdiction.

28. 28 of 46 Allocation Schedules The allocation schedules are calculated using established principles and methods, and industry recognized and accepted load research principles supported by Edison Electric Institute and Association of Edison Illuminating Companies. The methods used also conform to nationally recognized standards for developing allocation schedules and are consistent with the methods used in all electric case filings.

29. 29 of 46 Allocation Schedules (Continued) Allocation Schedules are developed, using customer class sales, load research samples and quantitative models, to determine the extent (expressed as a percentage) that each customer class uses the various portions of the electrical system. –System loss studies are updated periodically to establish up-to- date loss multipliers to be applied to sales to determine each class (or rate’s) generation requirements. Percentages determined in the Allocation Schedules are used by the Cost of Service witness to determine rate class cost responsibility. Because all customer classes do not utilize the full distribution system to take delivery of electrical service, the Allocation Schedules are developed to assign only the portions of the system actually used by each customer class.

30. 30 of 46 Determination of Allocation Factors

31. 31 of 46 Determination of Allocation Factors (Continued)

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33. 33 of 46 Uniform System of Accounts MPSC Uniform System of Accounts governs utility accounting for ratemaking purposes and serves as the basis for functionalizing costs, e.g., the USA requires utilities to record generating plant costs in accounts 310 - 359 and the associated O&M expense in accounts 500 - 557. These costs are directly assigned to the power supply function. Similarly, there are accounts in which the USA requires utilities to record distribution plant and O&M costs that are directly assigned to the distribution function. The O&M cost in accounts associated with providing customer service are directly assigned to distribution because they apply whether a customer receives power supply from the utility or an alternative electric supplier. Because Michigan utilities have divested transmission plant, all that remains in the USA’s accounts designated for transmission are the plant costs associated with generator step up transformers. These costs are directly assigned to power supply. In addition, power supply includes the expense charged to account 565, “Transmission of Electricity by Others” including MISO charges.

34. 34 of 46 Production Plant MPSC Order in Case U-4771 that established standard filing requirements which included the traditional method used in the Cost of Service to allocate production plant costs. –It is weighted 75 percent based on the average of the 12 coincident peak demands and 25 percent based on energy. FERC uses a coincident peak methodology (usually 12 CP or 4 CP) for allocating production costs within cost of service studies. –Recently, Michigan began using the ‘Multi-Hour 4 Coincident Peak (MH4CP) Methodology’ for Detroit Edison and Consumers Energy. –It is used in Detroit Edison’s current rate case to develop the historic 2006 allocation schedules using the hourly rate class demands for the hours of 12 noon through 8 p.m. were averaged for the monthly system peak days of June, July, August and September to determine the peak contribution of each rate class.

35. 35 of 46 Power Supply Allocators First, production plant and the demand component of purchased power expense are to be allocated using an allocation schedule consisting of 3 weighted components: 1.Average of the 4 monthly coincident peak multi-hour demand (“4CPMH”) weighted 25% where the 4 peak months are June, July, August, and September and the multi-hour peak consists of an 8-hour period (noon – 8 pm) on the peak day of each month 2.Energy use at point of system output coincident to the MISO's on-peak period (7 am –11 pm) weighted 50% 3.Total energy use at point of system output weighted 25% Second, the portion of each production O&M expense account that was originally allocated using the average of the 12 monthly coincident peak (“CP”) single hour demands is changed to 33% allocated based on the average of the 4 monthly CP multi-hour demands and 67% allocated on energy use at point of system output during MISO’s on-peak period. Third, 10% of fuel expense is to be allocated using the average of the 4CPMH with the remaining 90% allocated using energy.

36. 36 of 46 Other Production Costs Allocation Methods Coincident peak methods –1 CP –Average 12 CP –Seasonal CP or 4CP(4 summer months when load is highest) –Multiple CP Energy allocators –Total Energy –Seasonal Energy –Time of Day Energy (on-peak or off-peak) Average and excess –Essentially allocates based on load factor –Measures of demand may vary –Seasonal application

37. 37 of 46 Transmission Plant Transmission plant is a group of highly integrated bulk power supply facilities consisting of high voltage power lines and substations –Principle differences between utility systems include voltage levels and system configurations. Transmission plant is sometimes broken down into: –Backbone and Inter-tie Transmission Facilities –Generation Step-up Facilities –Subtransmission – 25 KV to 115 KV –Radial Facilities –Plant reclassifications Recently the sales of transmission plant have been made by Michigan utilities to regional owners, who provide transmission service to all under FERC approved charges

38. 38 of 46 Allocation of Transmission Plant Allocation of Transmission plant is related to the production plant that it is connected to. –Because of this, Michigan allocates transmission plant generally on a similar demand related basis as its traditional production plant allocation of 75% on a12 coincident peak demand and 25% energy basis. Other allocation methods recommended by the NARUC Cost Allocation Manual include: –1 Coincident Peak Demand using single highest peak –Average Seasonal System Coincident Peak –12 Coincident Peak Demand –1 Non- coincident Peak –Monthly Average Non- coincident Peak –Average and Excess –Or direct assignment

39. 39 of 46 Distribution Plant Distribution plant includes facilities that provide service at primary and secondary voltages. Distribution line, transformers, substations, metering, service drops and poles are all considered components of a utility’s distribution system. Distribution plant is classified as either demand or customer related after functionalization as overhead or underground, and primary or secondary voltage related.

40. 40 of 46 Distribution Plant (Continued) Distribution plant is classified depending on what facility it is by the following methods: –Minimum-Size Method - assumes minimum system sizing for the minimum service requirements of customers –Minimum-Intercept Method – identifies plant related to hypothetical no-load situation –Distribution plant classified as demand related is allocated on customer class non-coincident demands and individual customer maximum demands –Distribution plant classified as customer related is allocated based on the number of customers sometimes weighted for differing characteristics such as differences in metering.

41. 41 of 46 One Time Costs: Connection Tariffs At times customers require significant amounts of plant investment be added to the utility system in order to provide adequate service to them. A large industrial manufacturing customer may need to have a line, substation or transformation equipment specifically design and operated exclusively for their use (dedicated service). A hospital may need to have a redundant service to provide adequate backup during emergencies. Costs such as these may be directly assigned in a cost of service study to a particular class or rate.

42. 42 of 46 Customer Related Costs Customer related costs include billing, collections, information, customer service, and advertising and promotion. –Uncollectible accounts are included and are sometimes directly assigned to specific classes. These costs may be functionalized and classified as part of the distribution function related to customers. –Sometimes these are functionalized on a plant/labor based method. Customer account costs, sales costs and customer service costs are generally considered customer related, while load management and conservation efforts maybe allocated based on program goals.

43. 43 of 46 Common and General Plant and Administrative Costs Administrative and General costs are costs not included elsewhere such as general salaries, insurance, general office building and expenses or transportation equipment. These costs are allocated either on the sum of the other operating and maintenance costs or based on whether they are labor related, plant related or can be directly assigned. The property tax associated with production plant is directly assigned to power supply based on tax information provided by the Property Tax Department. –A share of the property tax associated with general and software plant is allocated to power supply in proportion to the power supply-related general and software plant and the remaining balance is assigned to distribution.

44. 44 of 46 Plant and Administrative Costs (Continued) Indirect costs are comprised of general and intangible (software) plant costs recorded in accounts 303 and 389 - 399, O&M expense in accounts 920 - 935, taxes, and working capital. The cost study also includes a credit for miscellaneous revenue, which is applied to the appropriate functional component based on a combination of direct assignment and allocation. Indirect costs are functionalized using various methods depending on the type of cost. –General and software plant costs are functionalized using a combination of direct assignment and allocation. –Direct assignment of general and software plant costs is based on the “business unit” field found in the Company’s property records. –General and software plant for which there is no assigned business unit is functionalized in proportion to direct labor cost.

45. 45 of 46 Plant and Administrative Costs (Continued) Administrative and general (“A&G”) expense is functionalized using the same method as General plant and software. –A&G expense includes costs associated with corporate support. –Working capital is functionalized using allocators appropriate to each of the current asset and liability line items, e.g., fuel inventory is directly assigned to power supply and accounts receivable is functionalized based on net plant. Miscellaneous revenue is functionalized using a combination of direct assignment and allocation.

46. 46 of 46 Plant and Administrative Costs (Continued) The National Association of Regulatory Utility Commissioners’ 1992 Electric Utility Cost Allocation Manual offers some alternative methods for allocating general plant: –“ One approach to the functionalization, classification, and allocation of general plant is to assign the total dollar investment on the same basis as the sum of the allocated investments in production, transmission and distribution plant. This type of allocation rests on the theory that general plant supports the other plant functions… Another suggested basis is the use of operating labor ratios.” (National Association of Regulatory Utility Commissioners, January, 1992, page 105.) Another method sometimes employed directly assigns general and software plant based on property records and uses labor ratios to assign the balance. A&G costs are functionalized by use of the allocator developed for general plant and software functionalization.

47. 47 of 46 Plant and Administrative Costs (Continued) Indirect costs are comprised of general and software plant costs recorded in accounts 303 and 389 - 399, O&M expense in accounts 920 - 935 (A&G), taxes, and working capital. The functionalized general and software plant costs are allocated based on the corresponding functional plant in service. –The general and software plant costs associated with power supply are allocated based on production plant in service and the general and software costs associated with distribution are allocated based on distribution plant in service. –The functionalized A&G is allocated based on the corresponding functional labor ratios. Property taxes are allocated based on the corresponding functional plant in service. –Payroll taxes are allocated based on the corresponding functional labor ratios. The working capital allocations are driven by the numerous allocators associated with each of the line items that comprise working capital, many of which are the sum of several other lines.

48. 48 of 46 Reduction and Elimination of Cross-Subsidies Deskewing or Rate Realignment (Rationalization of Tariffs) Historically in Michigan, residential customers’ rates have been subsidized by commercial and industrial customers. –This is maintaining residential rates at levels too low to achieve required rates of return. Recent Commission Order in Consumers Energy rate case U-15245 initiated the rate alignment process to bring all customers to cost of service. –Current legislation proposes to eliminate subsidization through rate design over a period of years. –This will allow reduced rate shock to customers currently paying rates less than their cost to serve.

49. 49 of 46 Rate Realignment Detroit Edison is proposing in its current rate processing to reduce inter-class rate subsidies included in existing rates by 20%. Edison believes that all subsidies should eventually be eliminated. It is not practical to remove the entire subsidy at one time because of the impact on customers. The current rate subsidy was implemented over a long period of time. To minimize rate shock, it would be more prudent to phase-out the subsidy over a period of time.

50. 50 of 46 Cost of Service Summary Example

51. 51 of 46 Rate Realignment (Continued) A rate subsidy exists when there is a difference between a tariff’s current rate level and what the tariff’s rate level would be if that tariff’s rate level were based only on full cost of service. Subsidies can be either positive or negative and an inter-class rate subsidy is created when tariff rate levels are set at a level above or below cost to serve. A tariff whose average rate is less than the cost to serve would include a negative subsidy indicating that other tariffs are subsidizing this tariff by having rates set at a level higher than cost to serve. For example, Detroit Edison’s current rates are such that full- service commercial and industrial customers pay rates that are in excess of the cost of service while residential customers pay rates that are less than cost of service. In short, full-service commercial and industrial customers are subsidizing residential customers.

52. 52 of 46 Why would a utility be concerned about inter-class subsidies as long as it’s allowed to collect its total revenue requirement? Even with rates designed to collect the utility’s full revenue requirement, subsidies in any form send the wrong economic signal to customers. Residential rates set below cost send incorrect price signals to the residential customer where, arguably, the residential customer is not aware of the true cost of electric service. All other things being equal, commercial and industrial rates set above cost to serve have a negative effect on those customers’ abilities to compete. While utility rates are only one factor that affect business development decisions, electric rates set above the actual cost-to- serve negatively affects Michigan’s competitive position as measured against other states and may discourage commercial and industrial customers from investing in Michigan.

53. 53 of 46 MPSC 21st Century Energy Plan The 21st CEP recognizes the current inter-class rate subsidy issue and recommends that the Commission move towards rates based on the actual cost of serving customers. Supporting its recommendation, the 21st CEP states: –“Residential service is heavily subsidized by commercial customers and may be subsidized by industrial customers. In order to subsidize residential service, regulated utilities must maintain non-competitive rates for commercial and industrial customers’ rates, giving those customers an incentive to leave the regulated market for the competitive market. Thus, customers are denied an accurate cost comparison, and the utilities may be denied their most valuable customers for reasons not based on cost.” (21st CEP, page 21)

54. 54 of 46 MPSC 21st Century Energy Plan (Continued) The 21st CEP also recommends that Power Supply rates should be based on cost stating: –“If utility generation rates are not based on cost, migration of high margin customers occurs for reasons having nothing to do with the parties’ competitive advantages in providing service. The Commission is then faced with a continuing need to consider raising rates for customers who remain with the incumbent utility due to diminished revenues caused by departing customers.” (21st CEP Page 22)

55. 55 of 46 Changes in Cost of Service Generation –Quality of information regarding marginal costs and hourly loads with better metering (AMI) have led to increased use of this measure for allocation and pricing purposes Transmission –Many utilities have joined an ISO / RTO and filed FERC rates based on embedded costs –Marginal cost measurement used to determine short-run congestion costs Distribution –Marginal cost methods have been developed and are most useful for utilities with significant cost differences by location –Embedded cost allocation methods still most prevalent Customer Services –Marginal cost methods have become more well developed and provide useful pricing signals –Difficult to bring fixed charges up to full marginal costs particularly for mass markets

56. 56 of 46 Questions?