1. Incentive Regulation Topics Scott A. Struck, CPA Financial Analysis Division Public Utilities Bureau Illinois Commerce Commission

2. Overview Definition of Incentive Regulation. Discussion of Various Topics and Consideration of Incentive Regulation. Energy Efficiency and Demand Response Programs. Infrastructure Investment and Improvement. Operating Efficiency. 2

3. Incentive Regulation - Definition Incentive Regulation: Incentive regulation is use of ratemaking mechanisms that reward or penalize the utility through the adjustment of rates based on utility performance. I would like us to expand our basic definition to include ratemaking mechanisms that promote, or at least reduce barriers to, desired outcomes. This would include things like the following: Revenue Decoupling Riders Feed-in-Tariffs ROR Adders CWIP in Rate Base 3

4. Energy Efficiency and Demand Response The Illinois legislature has set targets it requires electric utilities to achieve regarding energy efficiency programs and demand response programs, but limits their implementation to the extent it would cause customer rates to increase above certain levels. This is essentially a renewable portfolio standard approach (RPS).

5. Energy Efficiency Program Targets The Illinois Legislature requires electric utilities to implement cost- effective energy efficiency measures to meet the following environmental annual energy savings goals: 0.2% of energy delivered in the year commencing 1 June, 2008. 0.4% of energy delivered in the year commencing 1 June, 2009. 0.6% of energy delivered in the year commencing 1 June, 2010. 0.8% of energy delivered in the year commencing 1 June, 2011. 1.0% of energy delivered in the year commencing 1 June, 2012. 1.4% of energy delivered in the year commencing 1 June, 2013. 1.8% of energy delivered in the year commencing 1 June, 2014. 2.0% of energy delivered in the year commencing 1 June, 2015 and every year thereafter. 5

6. Demand Response Program Targets The Illinois Legislature also requires electric utilities to implement cost-effective demand response measures to reduce peak demand by 0.1% each year beginning 1 June, 2008 and continuing for the next 10 years. 6

7. Limit on Rate Impacts Electric utilities shall limit implementation of these energy efficiency and demand response measures to the extent they cause an increase in the amount paid per kWh greater than the following: In 2008, no more than 0.5% of the amount paid during the year ended 31 May, 2008. In 2009, no more than the greater of 0.5% or a cumulative 1.0%. In 2010, no more than the greater of 0.5% or a cumulative 1.5%. In 2011, no more than the greater of 0.5% or a cumulative 2.0%. After 2011, the greater of the incremental amount in 2011 or 2.015% of the amount paid during the year ended 31 May, 2008. 7

8. Recovery of Energy Efficiency Program Costs Electric utilities providing approved energy efficiency and demand response measures are permitted to recover the costs of these measures through an automatic adjustment clause tariff (Rider). A Rider is a tariff with a rate that changes periodically in between rate cases and allows dollar-for-dollar recovery for a specific line item. The Commission has also approved decoupling mechanisms for natural gas utilities. 8

9. Comparison to Feed-in-Tariffs This RPS approach is different than the one used with feed-in- tariffs. The feed in tariff approach requires the utility to enter into long- term premium price contracts with providers of renewable energy. The utility’s extra cost is spread over all customers using transmission pricing. Feed in tariffs are not used much in the United States. They are more popular in Europe. This may change if the use of feed in tariffs proves to be more effective and efficient way of promoting the use of renewable energy. 9

10. Energy Efficiency and Decoupling Most rate structures assign some portion of fixed costs to volumetric charges. This creates both an incentive for utilities to increase sales and a disincentive for utilities to encourage energy efficiency. With decoupling, authorized per customer margins are subject to a true-up mechanism to maintain a given level of revenues per customer. The purpose of decoupling is to reduce both the incentive utilities have to increase sales and the disincentive to encourage energy efficiency. This removes some of the disincentive for utilities to promote energy efficiency and demand response. 10

11. Energy Efficiency and Decoupling The Commission has addressed decoupling mechanisms with 2 natural gas utilities and will decide about a decoupling mechanism for a 3 rd natural gas utility in March 2009. The Commission recently approved a decoupling rider for a natural gas utility that adjusts customer prices in a way that the utility's revenues are held constant despite changes in customer consumption. This is a 4-year pilot program. The Commission also recently approved a rate design proposal for another natural gas utility that assigned 80% of the fixed delivery costs to the customer charge. This ratio is expected to remain in place for 4 years. The Commission’s goal is to explore decoupling alternatives on a test basis. 11

12. Infrastructure Investment and Reliability Improvement In Illinois, the reliability challenges we face come from the stress placed on the distribution system by major storms. We also have concerns about system modernization. FERC is addressing issues related to transmission constraints. We have also addressed infrastructure issues for natural gas utilities and water utilities. 12

13. Incentives and Cost Recovery - ICC For the most part, utilities recover costs related to reliability through traditional rate cases. There are times when utilities are allowed to recover infrastructure improvement costs through a rider in between rate cases. Return on Investment at WACC Depreciation Expense Illinois law specifically provides such recovery for water utilities that replace old plant with new “non-revenue-producing” plant. The ICC granted similar recovery to a gas utility that needed to escalate the replacement of aging gas mains. The ICC is exploring rider recovery for system modernization costs. The use of future test years helps reduce regulatory lag with respect to plant investment. 13

14. Incentives and Cost Recovery – FERC FERC uses WACC adders help alleviate transmission constraints. ComEd was granted an extra 150 basis points ROE return on a portion of a new transmission investment. FERC also sometimes includes CWIP in rate base The utility is allowed to include construction projects in rate base (RAB f ) while they are under construction and before they are used and useful in providing utility service. Illinois law restricts the ICC’s ability to do this, however FERC uses this approach to address transmission constraints. FERC recently allowed ComEd to earn a return on a portion of a new transmission investment while the project was still under construction. 14

15. Operating Efficiency Incentive regulation can be used to promote operational efficiency. Examples: Illinois Bell Telephone alternative rate case. Nicor Gas performance based regulation case. 15

16. Illinois Bell Telephone - Proposal The company proposed to substitute pure price regulation for traditional ROR regulation. The company’s ability to change rates would be limited by a price index which reflects inflation in the general economy, offset by the company’s historical productivity growth. This index contained a service quality component that would ensure that service does not degrade over the term of the plan. Under the proposal, there would be no regulation or monitoring of earnings. The proposal contained no provision for the company to seek rate relief in the event its earnings would deteriorate. 16

17. Illinois Bell Telephone - Decision The Commission conducted a traditional rate case analysis to determine an appropriate starting point. Price cap formula equal to GDPPI -4.3% (Gross Domestic Producer Price Index) taking into account certain productivity factors. Prices to be further reduced by 0.25% for each service measure for which the Company failed to meet its benchmark. There was to be no increase for residential customers for the first 3 years. The Commission did not implement earnings sharing. 17

18. Nicor Gas Performance Based Regulation Proposal This proposal related to a natural gas utilities purchases of natural gas for resale to its customers. The utility recovers these purchased gas costs through an automatic adjustment rider. Therefore, the utility merely recovered its costs dollar-for-dollar. The new proposal was for savings or losses on the utility’s purchases compared to a market benchmark would be shared 50/50 with customers. This provided incentive for the utility improve its performance in providing customers with the best gas prices available, while recognizing the need for continued reliability of supply. Program was in effect for 2000-2002, but was terminated in 2002. 18