1. 1 of 27 Tariff Development I: Overview of Rate Regulation and Basic Ratemaking Process 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 27 Rate Making Principles Principles of Rate Regulation Fairness to both the regulated utility and the ratepayers Avoidance of unjust or undue discrimination between rate classes or customers

3. 3 of 27 Rate Making Principles (Continued) Objectives in Setting Rates Protect the ratepayer’s interest by assuring safe, reliable and reasonably priced services Fairly apportioning cost among customers Protect the shareholder’s interest by allowing the utility a reasonable opportunity to earn a fair rate of return on its investment

4. 4 of 27 Determining Revenue Requirements Revenue Requirement = r(RB) + Expense + Depreciation & Depletion Expense + Taxes R(RB) = Income Requirement = Rate of Return multiply by Rate Base –Rate Base represents the investor-supplied plant facilities and other investments required in supplying utility service to consumers –Rate of Return can be defined as a judgmentally determined percentage that, when multiplied by an established rate base amount, provides a return that is intended to allow a utility (1) to meet its obligations to present capital investors (interest and dividends) and (2) to compete on reasonable terms in the financial markets for future capital requirements –REVENUE REQUIREMENT must be sufficient to cover the COSTS OF SERVICE, which are comprised of TOTAL OPERATING EXPENSES (including all taxes and depreciation charges), and a FAIR RETURN on the net plant rate base authorized for the utility

5. 5 of 27 Utility Company Case No. U-### Calculation of Revenue Requirement Total LineDescriptionAmount Revenue Requirement = r(RB) + E + D + T r(RB) = Income Requirement = Rate of Return times Rate Base 1Rate Base$1,904,152 2Rate of Return7.1924% 3Income Requirement (Line 1 x Line 2)$136,954 Expenses (from Page 3 of 6) 4Company Use and Lost Gas Expense$32,313 5Operation and Maintenance (O&M) Expense$298,316 6Uncollectibles Expense$24,274 7Depreciation and Depletion Expense$90,546 8Federal and Other Income Tax Expense$8,041 9Other Taxes$53,216 10Other Items (Amortization of Debt Discount)$1,500 11Allowance for Funds Used During Construction (AFUDC)-$1,400 12Other Revenue (Column D, From Non-Ratepayer Sources)-$103,014 13Additional Income Taxes from Page 1 (the Revenue Multiplier)$18,400 14Other (not reconciled)-$1 15Total Revenue Requirement$559,145 Revenue Requirement Calculation - Commission 16Revenue Deficiency (from Page 1 of 6)$50,160 17Gas Sales Revenue (from Page 3 of 6)$417,788 18Transportation Revenues (from Page 3 of 6)$91,197 19 Total Revenue Requirement $559,145

6. 6 of 27 Expenses Operations and Maintenance Expenses –Booked O&M Expense –Remove Disallowances –Remove Items Adjusted Elsewhere –Apply Inflation Factor Employee Benefits Depreciation and Amortization Federal and City Income Tax Property Tax

7. 7 of 27 Utility Plant Used and Useful For property to be classified as PLANT, it must be in use and useful Property not in use or not useful is placed in Construction Work in Progress or Held for Future use

8. 8 of 27 Cost of Capital and Associated Issues

9. 9 of 27 Cost of Capital Concept Defined as the minimum rate of return that is necessary to attract capital to an investment. Forward looking concept Opportunity cost – it is the cost of alternative investments that were forgone Determined in the markets – it is demand for and supply of capital that determines the price for capital Depends on the risk of an investment Goal is to allow the utility to earn a rate of return which is fair and consistent with its investment in plant and equipment Utility’s cost of capital is the return investors expect, or require, in order to provide the utility with capital Equity consists of shares that are issued to the public and any applicable premiums and retained earnings

10. 10 of 27 Types of Return Authorized: The rate of return regulators have determined to be the company’s overall cost of capital, including the rate of return investors require on common equity in a rate proceeding. Required: What investors desire as a return for investing their money in the common stock of a company. Expected: What investors believe the investment will return. Actual: What the books of account reflect at the end of the accounting cycle.

11. 11 of 27 Capital Structure The overall rate of return of a utility company depends on the capital structure that is used to finance its investment. The permanent capital structure or capitalization of a firm is represented by long-term debt, preferred stock and common equity.

12. 12 of 27 Capital Structure (Continued) The correct mix of debt and equity in a utility’s capitalization is important because debt is cheaper than equity. The tax advantage of debt makes equity about twice as expensive as debt. Long-term Goal for Permanent Capital Structure –Debt:50% –Preferred Stock:0-5% –Common Equity:45-50%

13. 13 of 27 Ratemaking Capital Structure Components –Long-term Debt –Preferred Stock –Common Equity –Short-term Debt –Customer Deposits –Other Interest Bearing Items –Deferred Income Taxes –Deferred Federal Income Taxes –Job Development Investment Tax Credits

14. 14 of 27 Overall Rate of Return

15. 15 of 27 Capital Costs To determine the cost of debt we look at the interest rate or coupon rate that the utility paid to finance that debt. Preferred stock carries a fixed commitment and its cost is calculated the same way as debt. Determining the cost of common equity is more complex than determining the cost of debt. Since a stockholder is not guaranteed a cash flow or a return, there is higher risk involved in holding the stock of a company.

16. 16 of 27 Determining a company’s required rate of return on its common equity is defined by a general equation. Required Rate of Return = Risk-free Rate + Risk Premium - Risk-free Rate: Real rate of return on riskless security + inflation. - Risk Premium is composed of: Interest Rate Risk PremiumMarket Risk Premium Business Risk PremiumRegulatory Risk Premium Financial Risk PremiumLiquidity Risk Premium Common Equity Cost Rate

17. 17 of 27 In the Bluefield Water Works and Improvement Co. vs. Public Service Commission, 262 U.S. 679, 692-693 (1923) case, the Court stated: “A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures.” Legal Guidelines

18. 18 of 27 In the Federal Power Commission vs. Hope Natural Gas Company, 320 U.S. 591, 603 (1944) case, the Court stated: “From the investor or company point of view, it is important that there be enough revenue not only for operating expenses but also for the capital costs of the business. These include service on the debt and dividends on the stock. By that standard the return to the equity owner should be commensurate with returns on investment in other enterprises having corresponding risks. That return, moreover, should be sufficient to assure confidence in the financial integrity of the enterprise, so as to maintain its credit and to attract capital.” Supreme Court established an “end result” doctrine which surmised that how a capital structure and rate of return is determined is not important so long as end result is appropriate and reasonable for the case at hand. Legal Guidelines (Continued)

19. 19 of 27 1.Comparable Earnings: Return commensurate with those investments in enterprises of comparable risk. Historical Approach. 2.Discounted Cash Flow Method (DCF): Return based on hypothesis that the market price of stock will equal the discounted value (present value) of all future earnings. DCF model equation is: K = (D 1 / P) + g Cost of Equity Approaches

20. 20 of 27 3.Capital Asset Pricing Model (CAPM): - K S = R F + B (K m -R F ) where - K S = Cost rate on equity capital of the firm - R F = Risk free rate of return - K m = Market rate of return - B = Market risk of the stock Risk of a portfolio of assets is less than the average of the risks of individual assets. 4.Risk-Premium Approach: K S = R F + Risk Premium Cost of Equity Approaches (Continued)

21. 21 of 27 Moody’s – Fitch – Standard and Poor’s Non-Financial CriteriaFinancial Criteria Market/Service TerritoryLeverage Fuel SupplyCash Flow Operating EfficiencyEarnings Protection Regulatory TreatmentFinancial Flexibility ManagementAccounting Quality CompetitionConstruction Spending Bond Rating Agencies

22. 22 of 27 S&PMoody’s Fitch DTE EnergyBBB-Baa2BBB Detroit EdisonA-A3A- MichConBBB+A3A- CMS EnergyBBB-Ba1BB+ Consumers EnergyBBBBaa1BBB- Ratings of Michigan’s Two Largest Utility Company’s

23. 23 of 27 Rate Base Determination Balance Sheet –Plant Remove Depreciation Reserves –Related Account Balances Working Capital

24. 24 of 27 Test Year and Adjustments O&M adjustment (remove known & measurable, and add in inflation) –Uncollectibles –Disallowances Plant adjustment –Recalculate depreciation –Construction Work in Progress –Held for Future Use Tax adjustment –To take in affect the above adjustments

25. 25 of 27 Data Collection and Processing, Monitoring Commission ordered periodic filings Audit requests Discovery questions Motion to Compel

26. 26 of 27 Developing Chart of Accounts and Instructions for Regulated Utilities We use the Uniform System of Accounts (USoA) (Generally accepted or applied by all the states) –USoA is a set of rules that prescribe the types of accounting records that must be kept by utilities. There are USoAs for both electric and gas utilities. –USoA prescribe a uniform set of account numbers for all balance sheet and income statement accounts –USoA also provides detailed descriptions of the types of items that should be included in each account. –USoA prescribes the accounting period. Income Statement detail must be segregated on a monthly basis, and balance sheet accounts must be measured at the end of each month. Utilities must close their books at the end of each year. –Finally, USoA has instructions to aid utilities in properly recording transactions.

27. 27 of 27 Questions?