Hydro- Québec
Distribution
R-3677-2008 Application
MECHANISM FOR THE RECOVERY OF
OPERATING COSTS ASSOCIATED WITH
MAJOR OUTAGES
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TABLE OF CONTENTS
1. CONTEXT.........................................................................................................5
2. STEPS TAKEN BY THE DISTRIBUTOR ........................................................7
2. STEPS TAKEN BY THE DISTRIBUTOR ........................................................7
2.1 COMPARABLE SITUATIONS IN THE INDUSTRY....................................................8
2.1.1 Canadian Industry.................................................................................8
- B.C. Hydro ...................................................................................................8
- Ontario.........................................................................................................9
2.1.2 American Industry .................................................................................9
2.2 THE DISTRIBUTOR’S TREATMENT OF MAJOR OUTAGES ..................................10
2.2.1 Definition of Major Outage ..................................................................10
2.2.2 Accounting for Costs Associated with Major Outages ........................11
3. RECOVERY MECHANISMS ANALYSED......................................................12
3.1 AMOUNTS BUDGETED IN THE AFFECTED COST CATEGORIES ...........................12
3.2 PROVISION ..................................................................................................13
3.3 DEFERRAL ACCOUNT ...................................................................................13
4. SELECTING A MECHANISM – THE DISTRIBUTOR’S PROPOSAL............14
4.1 PROVISION FOR MAJOR OUTAGES ................................................................14
4.2 MECHANISM FOR EXCEPTIONAL COSTS .........................................................16
4.3 DEMONSTRATING THE “HYBRID” APPROACH PROPOSED BY THE DISTRIBUTOR 17
5. REQUEST FOR A REGULATORY PRINCIPLE ............................................18
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1. CONTEXT
In the budgetary process to set its rates, the Distributor has included, to this day,
a separate amount in its revenue requirement for a set of provisions as a whole
that were aimed at guarding against operating cost variances. These annual
provisions have generally but not specifically sought to account for uncertainties
related to activities or events like taking charge of a new distribution network,
new human resource plans (e.g. contingency plans for retirements), the
bankruptcy of Large Power customers and major outages. In fact, the occurrence
of major outages, for which no amount was specifically budgeted in revenue
requirements given the sporadic nature and variable degree of such events, also
fell within the perimeter of these provisions.
In decisions D-2005-34 and D-2006-34, the Régie recognized the need for such
provisions to ensure that the Distributor was able to guard against multiple
variances that can occur throughout the year.1 According to the Régie, this
practice was consistent with prudent budgetary management.
Over the period 2005 to 2008, the provisions for operating cost variances totalled
amounts that ranged between $5.6 million and $8.6 million. During the hearings
held during the months of December 2006 and 2007 respectively, the Distributor
highlighted the importance of including major outages in operating cost variances
for 2006 and 2007.2 In decision D-2007-12, the Régie questioned the
appropriateness of setting such provisions, generic in nature, on the basis of
specific events.
Moreover, in the same hearings held in December 2006 and 2007, the Régie
expressed its concerns regarding the follow-up on the use of these provisions. In
actual fact, and as the Distributor mentioned in the evidence for each of the rate
applications, the costs associated with operating cost variances were directly
1
D-2005-34, R-3541-2004, page 74 and D-2006-34, R-3579-2005, page 44.
R-3610-2006, transcriptions for December 1, 2006, pages 269 to 275.
R-3644-2007, transcriptions for December 5, 2007, pages 189 and 190.
2
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recorded, depending on their nature, in the different cost categories identified,
based on their nature. There is no denying the difficulty the Distributor
encountered to provide precise budgetary reports that make it possible to
establish a link between forecasts and actual costs. The Distributor nonetheless
stated that it was able to produce a follow-up based on the actual occurrence of
elements or events covered by the provisions. With that aim, the Distributor
pointed to major outages as key elements that justified the use of provisions in
2005 and 2006.3 The Distributor also noted, by this very fact, that the other
elements or events had not significantly required the financial resources that had
been set aside for them.
In decision D-2008-024, the Régie formally ordered the Distributor to provide
details on the actual use of the provision for operating cost variances in its
annual report. In addition, in its 2007 annual report the Distributor stated that it
intended, in the course of 2008, to find a solution to its incapacity to provide the
required follow-up regarding the use of these provisions. With that aim, the
proposal outlined in section 4 of this document makes it possible to comply with
the Régie’s order.
3
R-3610-2006, HQD-19, document 11, response to Undertaking #11.
R-3644-2007, transcriptions for December 5, 2007, page 190.
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2. STEPS TAKEN BY THE DISTRIBUTOR
Considering:

The variable frequency and degree of climate events that have lead to
outages on the system over the past few years;

The Distributor’s exposure to the monetary impacts associated with major
outages;

The absence of a specific budget for anticipated costs caused by major
outages;

The doubt expressed by the Régie regarding the validity of setting
provisions, generic in nature, related to operating cost variances which
are, in actual fact, based on specific events;

That the importance of variances associated with certain elements
covered by the provisions is lesser than expected;4

The reporting requirements regarding the use of provisions,
the Distributor has taken steps to reposition its needs in terms of the budgetary
provisions that are integrated in the revenue requirement in order to face these
variances. These steps have led the Distributor to give priority to the recovery of
costs associated with the re-establishment of service on the system as a result of
a major outage.
To do so, the Distributor began by looking into existing practices in the industry.
4
R-3610-2006, HQD-19, Document 11, response to Undertaking #11.
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2.1 COMPARABLE SITUATIONS IN THE INDUSTRY
2.1.1 Canadian Industry
- B.C. Hydro
On July 6, 2007, BC Hydro received the approval of the British Columbia Utilities
Commission (BCUC) to create an account for regulatory assets to recover costs
exceeding $30 million associated with restoration work that took place following
major storms between October 2006 and January 2007.
In that account, the costs of major outages are associated with major weather
events that are characterised by one or several of the following criteria:

More than 100 000 customers are affected at once;

A large geographic area, if not the entire province, is affected;

A period to re-establish service that exceeds two days or the need to
resort to resources that are external to the affected region;

The costs of re-establishing supply to customers exceed $1 million.
The terms for cost-recovery associated with this account were proposed by BC
Hydro in its 2009/2010 rate application and are currently being examined by the
BCUC.5
5
See chapter 6 on page 13 of BC Hydro’s rate application at the following address:
http://www.bchydro.com/rx_files/info/info55162.pdf
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- Ontario
On July 31 2007, four distributors in Ontario (Canadian Niagara Power Inc.-Fort
Erie, Canadian Niagara Power Inc.-Port Colborne, Peterborough Distribution Inc.
and Lakeland Power Distribution Ltd.) obtained authorisation from the Ontario
Energy Board to recover costs incurred to repair damages caused by major
storms. The costs incurred were respectively $1.7 million, $0.3 million, $0.4
million and $0.2 million. The criteria used to define major weather events are:
 Costs must be directly related to the event and must be incremental to the
costs used for the establishment of rates.
 The materiality of costs. In other words, expenses must total at least 0.2%
of total distribution expenses before taxes and investments must
represent at least 0.2% of net fixed assets.
 The reasonabless of the amounts claimed relative to other options for the
re-establishment of service, with the aim of efficiency.
The requests of these distributors were carried out within the framework of
incentive regulation.
Cost-recovery will take place via the implementation of a rider applied over a 12
month period (24 months in the case of Fort Erie).
2.1.2 American Industry
In the midst of natural disasters that have afflicted the United States, several
companies have requested the recovery of costs generated by major storms.
Different cost recovery mechanisms as regards provisions for outages and
deferral accounts were authorized and put in place depending on each of their
needs. A survey conducted by Edison lists the mechanisms applied by different
companies. The results of the survey can be accessed on the Internet at the
following address:
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http://www.eei.org/industry_issues/reliability/nonav_reliability/Utility_Restoration_
Cost_Recovery.pdf
2.2 THE DISTRIBUTOR’S TREATMENT OF MAJOR OUTAGES
As a second step, the Distributor examined its treatment of major outages, in
terms of identification and accounting, so that it could then develop a mechanism
for the recovery of related costs.
2.2.1 Definition of Major Outage
To identify the days in which major events occurred, the Distributor bases itself
on its normalization methodology for the continuity of service index (CI).6
This statistical methodology makes it possible to set a threshold based on gross
daily continuity indexes (CI) for the overall medium voltage network of the five
preceding years (excluding catastrophic events such as the 1998 ice storm). This
threshold, set at 2.5 typical logarithmic variances (2,5,ß), is based on
observations made by several companies that have joined the IEEE (Institute of
Electrical and Electronics Engineers, Inc.). Beyond this level distributors resort to
more major means for the re-establishment of service.
When the service interruptions within a day exceed the 2,5,ß threshold they are
considered major whereas interruptions below the 2,5,ß threshold are considered
normal and are included in the normalized CI.
6
See R-3677-2008, HQD-03, Document 1, Appendix D, page 49.
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2.2.2 Accounting for Costs Associated with Major Outages
A major outage on the system triggers an emergency plan for the reestablishment of service, thereby activating a management process of human
and financial resources. Two different cost centers (internal orders) are then
created so as to assign, respectively, the charges and investments pertaining to
the re-establishment of service.
As previously mentioned, the revenue requirements for given test years did not
include any specific amount to cover the eventual costs of major outages. Also,
cost recovery remains uncertain because its only vehicle is the provision for
operating cost variances, which is shared with other variances and which
amounts do not necessarily reflect the cost of these outages. The portion of
these costs that is associated with required investments is less problematic. In
fact, the investments incurred are included in the rate base once the
corresponding assets are put into use. They will therefore be included in rates
because the actual rate base is used as a starting point to establish the projected
rate base of a subsequent test year, and they will be integrated into the revenue
requirement via depreciation costs. Also, the Distributor reduces the scope of its
approach to cost recovery for major outages in the operating costs component.
To this effect, some mechanisms were considered. These are presented in the
following section
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3. RECOVERY MECHANISMS ANALYSED
3.1 AMOUNTS BUDGETED IN THE AFFECTED COST CATEGORIES
For this option, the different cost line-items of which the revenue requirement is
comprised are forecast by including estimated costs that will eventually result
from major outages. This process thereby consists of integrating the amounts
associated with major outages in the normal budgetary process.
Under this option, the cost recovery associated with outages is limited to the
amounts budgeted based on the nature of the costs and it can lead to
overearnings or shortfalls. During exceptional years, shortfalls can be significant.
This option also ascribes to intergenerational equity and it has the advantage of
allocating the costs to customers that benefit from the services up to the
budgeted amounts while minimizing the financial costs that would be associated
with cost deferral.
Nonetheless, the Distributor rejects this option for the following reasons:

The difficulty of forecasting costs associated with major outages;

Spreading out the forecast costs of outages in different line-items (working
benefits, labour expenditures, bonuses, contractors’ fees, fees for services
rendered by public utilities) makes it impossible to include the total budget
associated with major outages as a separate item in the revenue
requirement. In actual fact, a cost center gathers all of the costs
associated with these outages.
Therefore, the Distributor considers it preferable to integrate in the regulatory
framework the overall costs associated with major outages as a separate item
taken as a whole.
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3.2 PROVISION
As an option that follows a similar principle to the previous one, the provision for
major outages would consist of including a separate line-item in the revenue
requirement in which the overall budgeted costs for major outages are assigned.
This option would facilitate a better match between the forecast and actual costs
in a separate cost center (see paragraph 2.2.2).
As with the previous option, a provision for major outages makes it possible to
allocate the costs to customers that benefit from the services, up to the budgeted
amounts, while minimizing the financial costs associated to the delay between
the time the costs are incurred to the time those costs are recovered through
rates.
However, this mechanism has the same disadvantages as the preceding option,
which are the risks of overearnings or shortfalls in cost recovery and the difficulty
of forecasting costs given that major outages remain very variable in frequency
and degree over time.
3.3 DEFERRAL ACCOUNT
A deferral account makes it possible to recover the costs incurred a posteriori.
Under this option, the actual costs associated with the restoration of the system
following a major outage are accumulated in an account so that they may
subsequently be recovered through rates.
This option is removed from the budgetary process and from the principle of a
revenue requirement that is based on projected costs. However, this departure is
justified by the variable frequency and degree of outages. Moreover, the deferral
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account has the advantage recovering all but no more than the actual costs
incurred and it facilitates the task of budgetary follow-up.
Nonetheless, the deferral account option does not respect the principle of
intergenerational equity and it generates financial costs associated with cost
deferral. These costs remain subject to the terms that are agreed upon.
4. SELECTING A MECHANISM – THE DISTRIBUTOR’S PROPOSAL
Following the analysis of the three options, which were examined by considering
the advantages and disadvantages in a regulatory context, and given the context
described in section 1 of this document, the Distributor proposes a “hybrid”
approach that links two regulatory mechanisms in order to recover the operating
costs associated with major outages. Therefore it proposes, first, to replace the
provisions for operating cost variances with a provision reserved for major
outages. Moreover, because the frequency of major outages can be very variable
as can be the degree of resulting damages, costs generated in this way can
reach exceptional proportions. As a complementary measure, the Distributor also
proposes the creation of a deferral account which would make it possible to
recover costs that are considered exceptional. The following paragraphs explain
the Distributor’s dual proposal in greater detail.
4.1 PROVISION FOR MAJOR OUTAGES
Considering the variable frequency and degree of major outages, the Distributor
considers it relevant to apply an objective method to set the amount of its
provision for major outages that differs from an approach based on a percentage
of operating costs. To support this argument, in decision D-2007-12, the Régie
disapproved of that approach in these terms: “the threshold of 1.5% of operating
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costs used to limit the amount of provisions is based more on an empirical
approach than on a systematic evaluation”.7
The Distributor proposes instead to establish the amount of the provision for
major outages on the basis of actual average costs incurred in previous historic
years.
This method has the following advantages:
 It minimizes the risk of overearnings or shortfalls over a period of a few
years since it is based on an average of actual costs;
 It consists of an objective method;
 It makes it possible to avoid significant annual fluctuations of the provision
since it is based on an average.
Table 1 below shows the annual costs that resulted from major outages over the
period 2001-2007.
Table 1
Historic Costs Resulting from Major Outages
Charges ($M)
Days of major
events
2001
10.8
2002
5.6
2003
4.8
2004
1.2
2005
7.6
2006
34.1
2007
9.6
9
9
7
3
8
17
7
Reference
7.7
8
1
Average data between 2001 and 2007 excluding 2004 and 2006, which were exceptional years, the first of
them due to the low number of major outages, the other due to its high number.
By excluding 2004 and 2006, so as to establish an average that is more
representative of the annual costs incurred over this period, the average over the
period examined is almost $8 million. Therefore, the Distributor proposes to
maintain a yearly provision of $8 million for major outages, which could be
revised as required.
7
D-2007-12, R-3610-2006, page 45.
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This method, which is based on a cost average, makes it possible to anticipate
that, statistically, over a sufficiently long period of time, the Distributor will recover
its costs without overearnings or shortfalls.
4.2 MECHANISM FOR EXCEPTIONAL COSTS
When the extreme values over the period 2001-2007 are considered, it becomes
evident that costs can at times reach exceptional proportions. The costs incurred
as a result of major outages in 2006 are a good example of this reality. In a case
such as that one, the provision would be insufficient to recover the costs
associated with the re-establishment of service on the system following a major
outage. In fact, the methodology used to set a provision that is based on an
average, as described above, shows that a provision set at $8 million would lead
to a statistic variation in costs that ranges between 0 and $16 million, as a normal
rule. Above that threshold, in principle, the costs would not be recovered. It is for
this reason that the Distributor proposes a mechanism that is complementary to
the provision, which seeks to recover the portion of the costs associated with
major outages that are considered exceptional, given their magnitude.
To this effect, the Distributor proposes to set a threshold of $16 million beyond
which the costs associated to major outages would be included in a deferral
account so that they may subsequently be recovered through rates. Eventually,
the cost recovery mechanism that is complementary to the provision could be
based on a technical characterization criterion associated to major outages. The
Distributor is pursuing its analyses to this effect.
The costs included in the deferral account would bear interest at the weighted
average cost of capital until they are recovered through rates. The terms to
dispose of the deferral account remain to be determined. Moreover, these could
be determined on a case by case basis, based on the level of the deferred
charges.
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4.3 DEMONSTRATING THE “HYBRID” APPROACH PROPOSED BY THE DISTRIBUTOR
Table 2 provides an example which seeks to show the complete cost recovery
based on different levels of costs, applying a provision set at $8 million and a
threshold of $16 million beyond which costs would be included in a deferral
account for major outages. The Provision component is recovered in the
projected test year while the Deferral Account component would be integrated in
rates according to the terms that will be determined.
Table 2
Example of Cost-Recovery Based on Level of Costs incurred
Recovery
Cost of outages
$0 M
$3 M
$8 M
$12 M
$16 M
$17 M
$20 M
$35 M
Provision
Deferral
Account
Total
Recovery
Overearnings
Shortfall
$8 M
$8 M
$8 M
$8 M
$8 M
$8 M
$8 M
$8 M
$0 M
$0 M
$0 M
$0 M
$0 M
$1 M
$4 M
$19 M
$8 M
$8 M
$8 M
$8 M
$8 M
$9 M
$12 M
$27 M
$8 M
$5 M
-
$4 M
$8 M
$8 M
$8 M
$8 M
This example shows that, as soon as costs for a given year exceed the level of
the provision, the Distributor is subject to shortfalls which are limited by the level
of the provision. Conversely, a cost level that is below the threshold for the
provision generates surpluses that are capped to the amount of the provision.
The Distributor’s proposal generates a symmetrical risk of overearnings and
shortfalls by which the limit for overearnings is equal to the limit for shortfalls.
Table 3 illustrates the cost recovery that would have taken place under the new
proposal on the basis of historical data from 2001 to 2007.
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Table 3
Demonstration of the Cost-Recovery Based on 2001 to 2007 Data ($M)
Recovery
Years
2001
2002
2003
2004
2005
2006
2007
Total (7 years)
Cost of major
outages
Provision
10.8
5.6
4.8
1.2
7.6
34.1
9.6
73.7
8.0
8.0
8.0
8.0
8.0
8.0
8.0
56.0
Impact
DCA(threshold $16M)
0
0
0
0
0
18.1
0
18.1
Total
8.0
8.0
8.0
8.0
8.0
26.1
8.0
74.1
Overearnings
2.4
3.2
6.8
0.4
-
shortfall
2.8
8.0
1.6
+0.4
This last example shows the neutrality of the hybrid approach proposed by the
Distributor over a relatively long period of time. Therefore, over the seven year
period examined, that is to say between 2001 and 2007, the overearnings and
shortfalls tend to cancel each other out so as to result in a consolidated overall
impact of $0.4 million in overearnings.
5. REQUEST FOR A REGULATORY PRINCIPLE
Considering the preceding proposals and their supporting arguments, the
Distributor asks the Régie to recognize the principle for the recovery of costs
associated with major outages in compliance with the following joint
mechanisms:
 Creation of a provision for major outages for an amount of $8 million,
which is set on the basis of the average historical average between 2001
and 2007, excluding the two extreme values. This provision replaces the
provision for operating cost variances which, as a result, is not renewed.
 Creation of a deferral account to record the costs associated with major
outages that exceed a threshold of $16 million. The terms associated to
this deferral account will be determined based on the level of the costs
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incurred. This account will bear interest at the average weighted cost of
capital.
The Distributor considers this an optimal proposal because it allows for a fair
trade-off between different principles. It thereby favours the principle of
intergenerational equity and the smoothing out of costs while limiting the risks of
overearnings or shortfalls and minimizing financial costs.
As per the Régie’s request, The Distributor will provide a yearly account of the
provision for major outages in its annual report.
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