RÉGIE DE L’ÉNERGIE
FILE R-3405-98
REGULATORY PRINCIPLES
AND ELECTRICITY TRANSMISSION RATES
EVIDENCE OF
JOHN TODD
ON BEHALF OF
OPTION CONSOMMATEURS
ET
ACTION RESEAU CONSOMMATEUR
APRIL 9, 1999
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BACKGROUND TO THE HEARING
The Régie de l’énergie (the «Régie») initiated this proceeding (R-3405-98) with procedural
decision D-98-391 to assist it in establishing certain aspects of the methodology to be used
in determining transmission rates for Hydro-Québec in future rate hearings. The mandate
of the Régie with respect to transmission rate determination is set out in section 48 of the
«Act respecting the Régie de l’énergie».
«48. The Régie shall, on the application of an interested person or on its
own initiative, fix or modify the rates and conditions for the transmission or
supply of electric power by Hydro-Québec or for the transmission, delivery
or supply of natural gas by a natural gas distributor or for the storage of
natural gas. The Régie may ask Hydro-Québec or a natural gas distributor
to file a modification proposal...»
In accordance with s. 48 of the Act, Hydro-Québec requested a determination of an
average unit transmission price and modification of transmission rates.2 Following this
submission, Hydro-Québec submitted a further document3 containing seven issues that
it proposed should be examined by the Régie. Concurrent with D-98-39, the Régie
1
Décision procédurale, D-98-39 R-3405-98, le 12 juin 1998.
2
Within the context of Régie-3401-98, le 1er mai 1998.
3
Enoncé de principes réglementaires, Direction des Affaires réglementaires d’Hydro-Québec,
le 8 mai 1998.
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ordered Hydro-Québec to file a formal request related to these issues. In this request4,
Hydro-Québec reduced the number of issues to be examined to three:
1.
projected test year;
2.
the establishment of a rate base and capital structure using the 13-month average; and
3.
the recognition of transmission assets in operation and under construction, as well as existing
contracts affecting transmission service.
4
Hydro-Québec Direction Affaires réglementaires, Principes généraux pour la détermination
et l’application des tarifs de transport d’électricité, le 17 juin 1998.
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At the September 1998 preparatory meeting to determine the issues to be examined, intervenors
requested that the Régie expand the scope of the proceeding. Consequently in D-98-885, the Régie
decided that two additional issues should be addressed:
4.
the choice of the test period to be used by Hydro-Québec for rate and regulatory matters with
respect to its fiscal year; and
5.
the determination of the principal criteria to be used to identify and separating regulated
activities from non-regulated activities.
On January 27, the Quebec government issued a Decree from the Ministry of Natural Resources
(Decree no 53-99, Directive no 1), which directed the Régie to recognize Hydro-Québec’s existing
transmission assets as well as those under construction. In effect, the Decree eliminated the issue of
recognizing transmission assets in operation and under construction.6
This evidence therefore
comments only on Issues 1,2, 4 and 5:
Issue 1: the use of the projected test year for determining transmission rates;
Issue 2: the establishment of a rate base and capital structure using a 13 month average;
Issue 4: the choice of a test period to be used by Hydro-Québec for rate and regulatory matters with
respect to its fiscal year;
Issue 5: the determination of principal criteria to be used to identify and separate regulated activities
from non-regulated activities.
5
Décision procédurale, D-98-88 R-3405-98, le 24 septembre 1998, p 8.
6
The legality of this decree is not addressed in this evidence. In Décision procédurale, D-99-34
R-3405-98, le 9 mars 1999, p 11 the Régie indicated that administrative acts should be
presumed valid unless they are found to be illegal by the courts.
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Option consommateurs and Action Réseau Consommateur have engaged me7 to assist them in their
intervention in this proceeding by providing evidence on these four issues. My comments are divided
into four corresponding sections.
1. COMMENTS ON THE ISSUES
1.1
Issue 1: the use of the projected test year for determining rates
The standard approach in North American jurisdictions that rely on rate-base rate of return (RBROR) methodologies is to use a future, or projected, test year to determine rates.8 Interestingly, the
performance-based regulation (PBR) schemes that have been adopted by West Kootenay Power and
BC Gas, under British Columbia Utilities Commission jurisdiction, and more recently proposed by
Enbridge Consumers Gas to the Ontario Energy Board (E.B.R.O. 497-01), involve what is essentially
an adjusted historic test year methodology. In these PBR schemes, test year costs that are subject to
PBR are not based on forecasts; hence, they do not exhibit the primary characteristic of RB-ROR
7
John Todd, President of Econalysis Consulting Services, Inc., has specialized in the theory
and practice of government regulation, re-regulation and de-regulation for 20 years. He has
participated as an advisor or witness in over 100 proceedings before regulators including the
Ontario Energy Board, the Public Utility Board of Manitoba, the British Columbia Utilities
Commission, the Régie de l’énergie and the Canadian Radio-television and
Telecommunications Commission. See Appendix 2 for Mr. Todd’s full curriculum vitae.
8
Centra Gas Manitoba, which I believe was the last Canadian utility using an Historic Test
Year, with «known and measurable adjustments» converted to a Future Test Year in 1994.
See Manitoba Public Utilities Board, Order No. 89/94, May 26, 1994.
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future test year regimes – they are based essentially on adjusted historic year actual costs and
revenues.
Given that Hydro-Québec will be regulated with a rate-base rate of return methodology, the use of
the projected test year is acceptable, in my view, subject to the following minimum conditions that
are necessary to enable the Régie and intervenors to test the reasonableness of the company’s cost
and revenue forecasts.
(i)
Cost and revenue data should be provided on a consistent and comparable basis for the
projected test year, the bridge year and at least one historic year; it is common in other
Canadian jurisdictions to require up to five years of historic data.
(ii)
Data for historic years should be provided on both a normalized and actual basis to permit
trend analysis using comparable annual data.
(iii)
The methodology used for developing all forecast expenditures and revenues, (including the
weather normalization methodology, trends in use per customer, loss calculations, etc.)
should be fully transparent.
Put simply, sufficient information should be on the record, or available through information requests,
to enable the Régie, or intervenors to replicate the company’s forecasts. As Hydro-Québec’s SaintAix expert testimony (HQPR-7, Document 2, p. 3) states:
In order to judge the relevancy and accuracy of the forecasted data, most
jurisdictions require upon filing, that the utility to (sic) provide a comparison and
an explanation of variances between historic, current and projected data.
Where forecast, rather than actual, cost information is being relied on, the company has the
obligation, or burden of proof, to demonstrate that its forecasts are reasonable. This implies that the
«explanations» must be complete, comprehensive and clear.
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Other Canadian regulators recognize that when a projected test year RB-ROR regime is used, it is
essential to ensure that the utility reports cost and revenue data on a consistent basis to allow the
regulator and interested parties to make meaningful comparison between the forecast for the future
test year and actual historic data years. An examination of cost and revenue trends, with explanations
for any trends that are unusual, is a key element of the review of the forecasts. In other jurisdictions
(including for example, Ontario, Manitoba and B.C.), a minimum of five years of data (3 historic
years, the current year, and the projected year) is required in order to test whether the forecast is a
reasonable extrapolation of the past. For example, if transmission rates are being set for the year 2000
in 1999, then, at a minimum, cost and revenue data should be required for the following years:
·
1996 to 1998 (historic years), using actual historic data;
·
1999 (bridge year), using available actual cost and revenue data, supplemented by estimating
data for the balance of the year; and
·
2000 (projected test year) using the best available and most recent forecast.
In addition, in cases where three years of historic data are insufficient to demonstrate an acceptable
trend, a longer time series of historic data may be required. Furthermore, detailed breakdowns of the
budget are often required to allow for meaningful comparisons and adequate scrutiny of forecast costs
and revenues. For example, if spending in a category, such as information technology capital, is
volatile, a detailed breakdown showing categories of expenditures (e.g., telecommunications,
computer hardware, computer software, etc.) may be needed to explain the historic pattern and
demonstrate that the forecast is reasonable.
If the utility has undergone restructuring, costs and revenues for all the data must be provided on a
consistent basis (e.g., adjust historic data to reflect the new structure) so that meaningful comparisons
can be made between the projected test year and the previous years. Consequently, if Hydro-Québec
is planning on using a projected test year, it is important that the utility has the accounting capability
to present historic data on a basis that is consistent with the future test year data that it provides.
A standard approach to facilitating meaningful comparisons is to use a weather normalization
methodology (normal temperatures as measured in heating and cooling degree-days and normal
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rainfall conditions). Weather normalization is particularly important in the case of a hydroelectric
utility since revenues are so heavily dependent on weather both from a supply and demand
perspective. Cold weather in winter or hot weather in summer increases the demand for electricity
and hence the revenues derived from sales. Heavy rainfall increases the supply and hence may
increase export sales revenues. Revenues are typically forecast based on normal weather and rainfall.
It is therefore important to rely on a credible and consistent weather normalization methodology and
to compare the «weather normal» forecast with «weather normal» historic data.
Given the critical role that historic cost and revenue information plays in assessing the reasonableness
of forecast data, it is essential that the current rate freeze not be used as a rationale for delaying the
development of systems to ensure that the necessary historic data will be available in the next rate
case. Detailed actual revenue and cost data could be provided to the Régie and intervenors on an
annual basis until the next rate case. Furthermore, it may also be appropriate for the Régie to review
cost and revenue information during the current rate freeze period because these financial results
affect the company’s rate stabilization reserves. Given that a regulatory system is now in place, the
Régie should review these costs on an annual basis to ensure that they are reasonable and prudent.
Hydro-Québec’s interrogatory responses relating to the use of the projected test year raise concerns
that the utility does not appreciate the importance of consistent and comparable reporting of historic
data. In response R14.1 to ARC-OC’s interrogatory relating to the utility’s plans to provide, in
addition to the projected test year forecast, comparable information for the bridge year and five
historic years on a consistent basis, Hydro-Québec states that:
Si le principe de l’année témoin projetée est adopté, Hydro-Québec soumettra
également les informations nécessaires de l’année de base. De plus, une
comparaison sommaire des résultats réels d’une année précédente avec les
projections déjà soumises sera également fournie lors d’audiences tarifaires, sauf
lors des premières audiences où seuls les résultats réels seront disponibles.9
[emphasis added]
9
Réponses d’Hydro-Québec aux questions de ARC/OC, HQPR-11 Document 5, p. 7.
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This response raises doubts as to whether Hydro-Québec will voluntarily meet the conditions
described above.
In addition, Hydro-Québec’s responses to interrogatories relating to forecasting methodology provide
very limited information on weather normalization methodology (see R15.1 and R15.310);
methodologies to develop forecast costs for capital and operation budget (see R2.1-2.311); and
methodologies for determining the capital structure and the cost of equity for rate setting purposes
(see R3.212). In order for Hydro-Québec to meet the third condition identified above (transparent
methodology), the utility will have to provide detailed information on the methodologies it uses to
develop its forecasts.
1.2
Issue 2: The establishment of a rate base and capital structure using a 13 month
average
In my view, use of a thirteen-month average of end of month balances (or average-of-averages) to
calculate the average rate base is appropriate. The Saint-Aix Group notes (HQPR-7, Document 2,
p. 3):
The use of a mid-year average methodology is appropriate to utilities in a stable
growth or declining rate base environment, i.e., where variations from month to
month are consistent and comparable, while a twelve or thirteen-month average of
end of month balances is accepted, with the latter considered a more appropriate,
10
Réponses d’Hydro-Québec aux questions de ARC/OC, HQPR-11 Document 5.1, p. 2.
11
Réponses d’Hydro-Québec aux questions de ARC/OC, HQPR-11 Document 5, pp. 2-3.
12
Réponses d’Hydro-Québec aux questions de ARC/OC, HQPR-11 Document 5, p. 3.
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and fair methodology to both consumers and investors, since more accurate when
important monthly fluctuations in customers and investments are recorded.
In my experience, the mid-year average methodology can result in a significant bias, in part because
it creates an incentive for utilities to «game the regulatory system» by delaying spending within the
year, thus overstating the average rate base. At the other extreme, monthly or daily averages are
impractical since utilities’ accounting reporting generally takes place on a monthly basis. The
additional precision gained by a more precise calculation than the thirteen month average is unlikely
to justify the additional cost. For these reasons, the thirteen-month average is generally considered
as a simple, practical and acceptably accurate solution for determining the average rate base.
1.3
Issue 4: the choice of a test period to be used by Hydro-Québec for rate and regulatory
matters with respect to its fiscal year
The standard approach in utility regulation is to use matching fiscal, test and rate years so as to
minimize administrative complexity and resulting regulatory burden. If the fiscal and test periods do
not coincide, significant effort can be required in reconciling accounting statements. Without a
detailed reconciliation of publicly available financial information, based on the company’s fiscal year,
and the information provided in the regulatory forum, transparency is compromised. Given that
Hydro-Québec’s fiscal year is January 1 to December 31, there are clear advantages to using the same
period for regulatory purposes.
Further, if the rate year does not match the test period, administrative procedures must be put in place
to ensure that the mis-match does not result in inadvertent over- or under-recovery of costs in the
event that a rate hearing is not required. One way to avoid this problem would be to increase rates
effective January 1, instead of on May 1, as has traditionally been done. The disadvantage of this
approach in the case of Hydro-Québec, which has customers with significant heating load, is that
January 1 rate increases (when consumption is high) are less palatable to consumers than May 1 rate
increases.
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If the Regie decides to maintain the status quo, it is essential that a May 1 increase is not implemented
in such a way as to result in over-recovery of costs during the following fiscal year. The problem is
illustrated in Figure 1 (see Appendix 1).
In Figure 1, the gray shaded area represents the revenue requirement. For illustrative simplicity, it
is assumed that the revenue requirement is the same in year 1 and year 2, with sales also being
constant so that the rates that would be required to recover the revenue requirement are the same in
each year. The rate in the previous year (R0) is assumed to be insufficient to recover this revenue
requirement, however. As a result, a rate increase is needed in year 1.
If the rate increase does not go into effect until May 1, and the total revenue in the year is to be equal
to the revenue requirement, then the increased rates will exceed the annualized rate that would be
appropriate. If the full rate increase were to remain in effect throughout year 2, the company would
be over-recovering its revenue requirement in that year. This over-recovery is shown in Figure 1.
One way to avoid this problem would be to require rates to be reviewed by the Régie every year.
Annual rate reviews by the Régie could adjust rates in on May 1 of each year so that the total forecast
revenues for the year neither exceed nor fall short of the approved revenue requirement. Figure 2
(see Appendix 1) shows this case. Over-recovery in year 2 is avoided by decreasing rates as of May
1 in the second year.
This approach has two disadvantages, however. First, it could result in unstable rates even if the
annualized rates needed to recover the revenue requirement were constant. Second, if stable rates
can be justified, it would be undesirable to adopt a mechanism that forces the Régie to hold a hearing
every year.
An alternate solution to the problem, illustrated in Figure 3 (see Appendix 1), would be to implement
rates to generate annualized revenue sufficient to recover the year 1 revenue requirement. That is,
the rate implemented as of May 1 of the first year would be the rate that would recover the revenue
requirement if it were in effect for the full year. The disadvantage of this approach is that while it
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would avoid the over-recovery problem in year 2, it would under-recover revenue in year 1.
Furthermore, if rates were generally increasing from year-to-year, there would be an on-going
problem of under-recovery.
In my view, the best solution to the problem of over-recovery in year 2 would be to use a rate rider,
as shown in Figure 4 (see Appendix 1). A rate rider is a temporary surcharge, added to the base rate,
designed to offset the revenue shortfall incurred from January 1 to May 1, over the balance of the
fiscal year (i.e. by December 31).
In the case of a rate reduction, the rate rider would, of course,
be negative. The rate rider would only be in effect for the May to December period. With this
approach, the base rate is the annualized rate that would recover the company’s year 1 revenue
requirement.
Since the rate rider is not applied beyond December 31, the effective rate would automatically decline
to the correct annualized rate in January of year 2. No further rate changes would be required unless
costs were rising to the point that an increase in the annualized rate was justified. In that event, the
company would have to request an increase from the Régie.
It is unclear from Hydro-Québec’s evidence and interrogatory responses (R18.1-18.413) exactly how
the utility intends to put in place a solution that addresses the annualized effect of a May 1 rate
increase.
In Régie de l’énergie (Demande de renseignement no. 1 - 99-02-11), R8.214, Hydro-
Québec states the following:
Hydro-Québec est cependant consciente que l’application de l’écart entre les
revenus requis totaux de l’année témoin et les revenus générés par les tarifs existants
13
Réponses d’Hydro-Québec aux questions de ARC/OC, HQPR-11 Document 5, pp. 8-9.
14
Réponses d’Hydro-Québec aux questions de la Régie de l’énergie, HQPR-11 Document 2,
pp. 5-6.
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s’effectue sur une période résiduelle de huit mois. Néanmoins, l’application
systématique de ce modèle en assure un contrôle adéquat et une stabilité tarifaire en
période de forte consommation hivernale, tel que plus amplement détaillé à la pièce
HQPR-5, document 1.
According to this response, Hydro-Québec is aware of the problem and is applying «a model which
ensures adequate control and rate stability» during the winter period. The utility goes on to state that
this model is more amply described in HQPR-5, document 1.15 However, the level of detail about
the mechanism provided in this document is insufficient to allow outside observers to understand how
the problem is being addressed.16
15
HQPR-5, Document 1, p. 16.
16
In Régie de l’énergie (Demande de renseignement no. 1 - 99-02-11), R5.1, Réponses
d’Hydro-Québec aux questions de la Régie de l’énergie, HQPR-11 Document 2.1, p. 2,
Hydro-Québec explains its position against retroactive rate-making. This position should not
be confused with a solution to compensate for the problem described here resulting from
increasing rates during the rate year.
Rates are set on a test year basis, using an approved forecast of revenues and
costs. It is a well-established regulatory principle that if the company subsequently overearns or under-earns in the year for which final rates have been approved, no attempt is
made to recover the excess earnings or compensate for the shortfall, except in the case of
a pre-approved variance account. Compensating for unforseen variances from forecast for
a test year is considered to be retroactive rate-making, which is not an acceptable standard
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practice.
The solution sought here to compensate for over- or under-recovery due to the
annualized effect of a May 1 increase, however, is not one of unforeseen forecasting errors.
This is a foreseeable consequence of adopting a methodology with a test period that does
not match the rate year. Taking this into account would not be retroactive rate-making.
Failure to take it into account would constitute a violation of the regulatory principle of setting
rates so that total revenue equals revenue requirement in each test year.
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If Hydro-Québec is unwilling to fully disclose and use an acceptable mechanism to address the overrecovery of rates due to the annualized effect, the Régie may wish to consider the option of having
the rate year period coincide with the test year. There are several considerations that may limit the
negative effect of a January 1 rate increase on customers. One, if the rate increases are expected to
be fairly small, then the negative effects of the abandonment of the status quo will be limited. On the
other hand, if forecast rate increases are more substantial, the negative effects could be mitigated if
customers are encouraged to adopt the equal billing plan, which smooths monthly payments over the
year. In this case, the Regie may consider using incentives to encourage Hydro-Québec to promote
equal billing plans to customers. To make a more informed decision regarding the possible use of the
equal billing plan to mitigate the negative effects of January rate increases, the Régie would need to
more closely examine the level of customer participation in Hydro-Québec’s existing equal billing
plan, as well as the possibility of increasing this participation.17
1.4
Issue 5: Determination of principal criteria to be used to identify and separate regulated
activities from non-regulated activities
Transmission activities, in general, should be regulated since transmission is a natural monopoly.
However, there may be a few situations where transmission activities should not be regulated, if it
can be shown that such activities are competitive. It is currently unclear which, if any, transmission
activities in Quebec should not be regulated.18 At the moment, other jurisdictions are considering
how to impute costs for such activities. A current regulatory view is that utilities should be expected
17
This explains the purpose of the ARC/OC interrogatory Q8.2 which asked how many
residential clients were subscribed to the equal billing plan. Hydro-Québec’s answer was
that quantitative numbers are not part of this proceeding. However, our goal was simply to
determine an approximate level of participation in this program in order to recommend
options to the Régie. (See HQPR-11 Document 5, p. 5)
18
Hydro-Québec’s interrogatory responses R9.1 and R10.1 (See HQPR-11, Document 5, pp.
5-6) provide no indication about which transmission activities should and should not be
regulated, save the example of international consulting in the transmission field, which the
utility cites as a non-regulated transmission activity.
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to recover the full costs of non-regulated activities, so that the regulated customers are not unfairly
subsidizing such activities.19
Given that there is no experience in the separation of regulated and non-regulated activities in
Quebec, in my view it would be premature to espouse binding principles at this time. Every situation
is unique and as such, it would be better to develop, at most, some guidelines for the identification
and activities for which separation might be considered. Specific criteria cannot be established on a
generic basis. In fact, there should be no criteria that allows an activity to become exempt from
regulation without a hearing. In other jurisdictions, case-by-case hearings to deregulate activities are
common practice.
If there is to be a guideline to be used for establishing when consideration might be given to
separating an activity that will not be regulated, it should be that the activity is subject to effective
competition.
SUMMARY OF CONCLUSIONS
Issue 1: the use of the projected test year for determining transmission rates
Given that Hydro-Québec will be regulated with a rate-base rate of return methodology, the use of
the projected test year is acceptable, subject to the following minimum conditions that are necessary
19
In the case of (Enbridge) Consumers Gas, the Ontario Energy Board ruled that the utility
should apply a fully allocated costing methodology to ancillary and non-affiliate programs and
activities. See Ontario Energy Board, EBRO 495, Decision with Reasons, August 21 1997,
pp. 29-34. This Decision was reconfirmed in the current Enbridge Consumers Gas Decision.
See Ontario Energy Board, EBRO 497, Decision with Reasons, August 31 1998, pp. 13-14,
27-30.
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to enable the Régie and intervenors to test the reasonableness of the company’s cost and revenue
forecasts.
(i)
Cost and revenue data should be provided on a consistent and comparable basis for the
projected test year, the bridge year and at least one historic year; it is common in other
Canadian jurisdictions to require up to five years of historic data.
(ii)
Data for historic years should be provided on both a normalized and actual basis to permit
trend analysis using comparable annual data.
(iii)
The methodology used for developing all forecast expenditures and revenues, (including the
weather normalization methodology, trends in use per customer, loss calculations, etc.)
should be fully transparent.
Put simply, sufficient information should be on the record, or available through information requests,
to enable the Régie, or intervenors to replicate the company’s forecasts.
Issue 2: the establishment of a rate base and capital structure using a 13 month average
The thirteen-month average is generally considered as a simple, practical and acceptably accurate
solution for determining the average rate base. In my view, the use of this methodology to calculate
the average rate base is appropriate.
Issue 4: the choice of a test period to be used by Hydro-Québec for rate and regulatory matters with
respect to its fiscal year
The standard approach in utility regulation is to use matching fiscal, test and rate years so as to
minimize administrative complexity and resulting regulatory burden. If the fiscal and test periods do
not coincide, significant effort can be required in reconciling accounting statements. Without a
detailed reconciliation of publicly available financial information, based on the company’s fiscal year,
and the information provided in the regulatory forum, transparency is compromised.
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If the Regie decides to maintain Hydro-Québec’s status quo (which results in a mis-match between
the rate year and the test year), it is essential that a May 1 increase is not implemented in such a way
as to result in over-recovery of costs during the following fiscal year. In my view, the best solution
to the problem of over-recovery in year 2 would be to use a rate rider, as explained in section 1.3.
A rate rider is a temporary surcharge, added to the base rate, designed to offset the revenue shortfall
incurred from January 1 to May 1, over the balance of the fiscal year (i.e. by December 31).
If Hydro-Québec is unwilling to fully disclose and use an acceptable mechanism to address the overrecovery of rates due to the annualized effect, the Régie may wish to consider the option of having
the rate year period coincide with the test year. The negative effect of a January 1 rate increase may
be mitigated if (i) rate increases are small; or (ii) in the case of more substantial increases, the equal
billing plan is more widely used.
Issue 5: the determination of principal criteria to be used to identify and separate regulated activities
from non-regulated activities.
Transmission activities, in general, should be regulated since transmission is a natural monopoly.
However, there may be a few situations where transmission activities should not be regulated, if it
can be shown that such activities are subject to effective competition. Given that there is no
experience in the separation of regulated and non-regulated activities in Quebec, in my view it would
be premature to espouse binding principles at this time. Specific criteria cannot be established on a
generic basis. In fact, there should be no criteria that allows an activity to become exempt from
regulation without a hearing.