1. NARUC Energy Regulatory Partnership Program The Georgian National Energy Regulatory Commission and The Vermont Public Service Board by Ann Bishop Vermont Public Service Board June 28, 2008 Tariff Development I: Cost of Service

2. 2 Overview v Legal standards v Definitions v Test year v Cost-of-service analysis –Allowable costs –Special types of costs –Rate base –Cost of capital v Practical considerations v Other rate-setting methods

3. 3 Legal Standards v Just and reasonable rates v Balance ratepayer and shareholder interests v It is the end result that matters, not the specific methodology

4. 4 Definitions v Cost of service = revenue requirement = annual operating expenses + annual capital costs v Test year = period in which expenses are compared to revenues v Adjusted test year = test year adjusted for known and measurable changes, normalizations = rate year

5. 5 Test Year v 12-month period used for measuring costs, loads and revenues v Can be any 12-month period, historic or future –U.S. states differ on the use of historic or future test years –Vermont uses a historic test year, preferably a year that has been audited

6. 6 Historic Test Year v Actual experience for an actual period –Actual facilities, labor costs and taxes v Adjustments are made to the historic test year –Normalizing adjustments –Adjustments for “known and measurable” changes v Use of historic test year implicitly assumes growth in revenues equals growth in costs

7. 7 Normalizing Adjustments v Essentially “restate” non-representative data –Adjust actual test year results to remove effect of unusual occurrences v Some examples: –Unusual weather –Storm damage –Strike during the test year –Major transmission outage during the test year –Major power plant refurbishment during the test year

8. 8 Known-and-Measurable Changes v Update test year results for changes that are “known and measurable” –Changes must be more concrete than simple projections v Some examples: –Union labor contract includes wage increase –New power plant in service –New large factory built at end of test year –Changes in taxes (income or property)

9. 9 Future Test Year v Typically a “budgeted” year –Future facilities, expenses –Assume normal weather and availability v Adjustments based on projections, may include changes that would not be considered “known and measurable” v Attempt to estimate actual economic environment in which the utility will operate when the rates are in place

10. 10 Which Test Year Is Best? v Historical method is free from manipulation v If incremental costs are close to average costs, historical method is much easier v Future test year may be more appropriate if the system is growing rapidly, or if incremental costs are very different from average costs

11. 11 Cost-of-Service Analysis v In practice, the Board must determine three things: –Operating expenses –Rate base –Cost of capital

12. 12 Cost-of-Service Formula v RR = E + d + T + (V-D)r E = Operation and maintenance expense d = Annual depreciation expense T = Taxes V = Original book value of plant D = Accumulated depreciation (V-D = “net rate base”) r = Weighted average cost of capital

13. 13 Allowable Costs v Basic principle: Does it provide benefit to utility ratepayers? –It must be reasonable and necessary to provide service v Two primary tests –Prudence –Used and useful

14. 14 Prudence v Were a utility’s actions, based on all that it knew (or should have known) at the time, reasonable and prudent in light of the circumstances that existed at the time? –Not based on hindsight –Respects the utility’s managerial rights v If not, Board generally will not allow the portion of the costs that it finds were imprudent to be collected from ratepayers

15. 15 Used-and-Useful v Part 1: Is the investment used to provide service to ratepayers? –If not, ratepayers should not pay for it v Part 2: Is the investment economic for the purposes it is serving? Is it expected to yield net present value benefits, after consideration of non-price benefits, over its lifetime? –If not, the Board will share excess costs between ratepayers and shareholders, as appropriate

16. 16 Other Non-Allowable Costs v Non-utility services v Unregulated subsidiaries and parents v Other jurisdictions v Political expenses (both contributions and lobbying costs) v Charitable contributions v Fines and penalties

17. 17 Depreciation v Principle: It represents one year’s value of each class of utility plant v Depreciation rates are based on highly technical depreciation studies –Studies are often performed and reviewed in separate proceeding (outside of a rate case)

18. 18 Depreciation and Amortization v Depreciation and amortization are non- cash expenses –Depreciation applies to plant investments –Amortization applies to regulatory assets and liabilities u Costs (revenues) that regulators have expressly allowed the utility to defer and collect (or return to ratepayers) over a specified period of time u Special case in Vermont: energy efficiency investments

19. 19 Depreciation and Amortization v Ideally, length of depreciation and amortization match the time period of benefit to ratepayers v Fully amortized past expenses are removed from a utility’s cost of service v New investments result in increased depreciation expense

20. 20 Deferred Expenses v One-time expenses amortized in rates over multiple years (extraordinary items only) –Y2K costs –Damage from major storm v Differences in timing of taxes –Utilities keep multiple sets of accounting records, including one for utility regulators and one for tax purposes –Differences in depreciation for utility regulatory and income tax purposes lead to differences in the timing of tax payments

21. 21 Income Taxes v Principle: Represents the normal taxes owed, not necessarily those paid v Expense based on company’s books that they keep for regulatory purposes, not for tax purposes v Expense increases lower taxes; revenue increases raise taxes

22. 22 Rate Base v Rate base = –Original cost of plant now in service –Less accumulated depreciation (sum of past annual depreciation expenses on plant now in service) –Plus or minus other adjustments u Customer deposits u Working capital allowance

23. 23 Other Rate Base Adjustments v Plant removed from service before start of rate year is removed from rate base v Plant added to service before start of rate year is added to rate base v Changes must meet “known and measurable” standard –Not sufficient to state project is budgeted

24. 24 Cost of Capital v Determined by a utility’s cost of debt and equity v Weighted according to proportion in utility’s capital structure –Common elements of capital structure are debt, common equity, preferred equity –Hypothetical capital structure can be substituted for ratemaking purposes

25. 25 Cost of Capital v Costs of debt and preferred equity are based on the actual costs v Cost of equity must be determined by regulators –Should be similar to returns from investments with similar risks –Regulators typically employ multiple methodologies –Authorized return on equity is an opportunity, not a guarantee

26. 26 Revenue Deficiency/Excess v Net operating income at current rates = revenues less expenses (including non-cash expenses) v Required net operating income = rate base times weighted average cost of capital v Net operating income deficiency (or excess) = difference between net operating income at current rates and required net operating income v Net operating income deficiency must be adjusted for income taxes –Increased revenues means increased taxes –Necessary to increase revenues further to cover the increased taxes –Divide net operating income increase by conversion factor to compute revenue increase (or decrease)

27. 27 Practical Considerations v Most tariff filings are not investigated; most investigations are settled; only a few rate cases are fully litigated v What is dollar value involved? Is it worth the cost of litigating? v What important principles are at stake? v Is it consistent with past practice and Board precedent?

28. 28 Other Rate-Setting Methods v Alternative regulation –May include changes to traditional ratemaking procedures u Single-issue ratemaking could be allowed u Mechanisms can be set up to allow periodic adjustments to rates without review of a complete cost of service filing u Purchased power adjustment clause

29. 29 Decoupling Revenues from Sales v “Decoupling” utility revenues from utility sales –Intended to eliminate “throughput” incentive and encourage energy efficiency and customer-sited resources u Normally, utilities earn more profit the more units they sell –Objectives: u To protect the utility from the financial harm associated with least-cost actions u To remove the utility’s incentive to increase profits by increasing sales –Decoupling revenues, rather than earnings directly, rewards the utility for improvements in operational and managerial efficiency

30. 30 Decoupling –Utility “base” revenue requirement determined with a traditional rate case –Each future period has a calculable “allowed” revenue requirement –Differences between the allowed revenues and actual revenues are tracked u Variety of ways of tracking differences –The difference (positive or negative) is flowed back to customers in an adjustment to unit rates

31. 31 Decoupling v Holds class average revenues-per-customer constant –Or may have a periodic increase or decrease in average revenues-per-customer based on inflation, productivity increases or other factors v Can be combined with performance goals and incentives v Adjustments can be “bounded” and/or “shared” with customers