1. Inflation Adjustments for Rates Karl McDermott Ameren Professor of Business and Government and Special Consultant at NERA Presented at 2010 NASUCA Annual Meeting

2. Why are inflation adjustments an issue? The objective of regulation is to provide incentives to control costs at prudent levels Traditional regulation provides incentives through regulatory lag and prudence reviews (both strong incentives) Can inflation adjustments provide similar or better incentives in a transparent way with lower administrative costs?

3. Issues Is this the same as tracker? No. The purpose here is to address controllable costs to provide incentives for cost minimization. Costs might be put in different buckets – Costs that must be reviewed (rate case) – Costs that are policy driven (CWIP for Environmental investments, Trackers for Smart Grid, uncollectable, etc.) – Costs that are large, uncontrollable, volatile (Riders and adjustment clauses) – Costs for which an objective standard may exist (indexes)

4. Issues for Mechanism Approval Improving Consumer Welfare Should be the Ultimate Regulatory Goal – Regulatory policies should be judged on whether or not they lead to benefits (e.g., lower prices, better quality, service innovation, etc.) to consumers. Utility Financial Health Provides a Constraint on Regulatory Action – Utilities must be able to invest in long-term projects that are funded by the capital markets. – Regulators must insure that utilities are not discouraged from prudently pursuing these projects by allowing the recovery of the related expenses. Improving Incentives in Regulation may Best Achieves this Goal – Rules for incentives must be clear and transparent – Incentives must improve performance relative to traditional regulation – Administrative cost efficiency

5. Issues with Mechanism Design Initial prices need to be consistent with quality of service goals Incentive Questions – Labor costs indexed (incentive to cut labor) – Overall indices (provides more flexibly to reduce costs) Index questions – Can you identify an appropriate index (pension costs) Quality of service metrics

6. Conclusion Inflation adjustment just another tool in regulatory tool box – Does not change regulator's (or parties) job to make sure utility keeps costs under control Be careful of unintended consequences by targeting single factors