GAZIFÈRE INC.
PROPOSAL FOR COMPREHENSIVE PERFORMANCE BASED
REGULATION
PREPARED BY:
RICHARD J. CAMPBELL
MAY 31, 2006
Original: 2005-05-31
GI-9
Document 1
Page 1 de 12
Requête 3587-2005
CONTENTS
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INTRODUCTION
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OBJECTIVES
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DESCRIPTION OF MECHANISM
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Total Factor Productivity and the CPI-X Approach
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Revenue Adjustment Formula
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Reference Year
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Growth
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Inflation
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d: Inflation Discount Coefficient
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R: Cost of Capital Adjustment
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Y Factors
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Z: Exogenous Factors
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Earnings Sharing Formula
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Service Quality Indices
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TERM AND RENEWAL
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OFF-RAMP REVIEW FOR MAJOR EVENTS
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ONE TIME ADJUSTMENT FOR THE YEAR 2006
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GAZIFÈRE INC.
PROPOSAL FOR COMPREHENSIVE PERFORMANCE BASED
REGULATION
INTRODUCTION
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In its decision D-2000-48, rendered with respect to Gazifère's 2000 Rate Case, the
Régie asked Gazifère to propose a consultation process for the renewal of its
incentive mechanism and that it include consideration of a more comprehensive
performance based regulation (“CPBR”) plan (including capital investments). In
phase I of the 2006 Rate Case, Gazifère proposed a consultation process that the
Régie approved in its decision D-2005-214. Consequently, Gazifère met with the
stakeholders on 5 occasions to discuss the elements of a CPBR proposal and take
note of their comments.
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Gazifère proposes a rate setting mechanism which is lighter handed than annual
cost of service reviews and one that serves both ratepayer and shareholder
interests. The mechanism is a comprehensive revenue cap, for a 5-year period,
and determines the annual distribution revenue requirement to be recovered in
rates by means of a formula. The proposal is similar to the O&M targeted plan
but is extended to the total revenue requirement.
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OBJECTIVES
Gazifère is a small natural gas distributor with 31,000 customers and annual
distribution costs of under $20 million, yet it is subject to the same regulatory
process as much larger energy distributors operating in Québec. The regulatory
process requires considerable resources and generates disproportionately high
costs for a small utility. This rate-setting method proposed is designed to lighten
the regulatory process, give the distributor an incentive to improve performance,
while serving customer interests and providing sufficient regulatory oversight.
The Company believes that the simple adjustment mechanism proposed is easy to
understand, easy to apply and will result in stable and predictable rates for the
term of the plan.
DESCRIPTION OF THE MECHANISM
The proposed mechanism indexes distribution revenues to reflect system growth
and inflation. A productivity challenge is provided by means of a discount of the
rate of inflation and this provides an annual benefit to ratepayers. The proposal
provides additional benefits to ratepayers by including an earnings sharing
mechanism, an earnings cap and minimum service quality requirements.
Original: 2005-05-31
GI-9
Document 1
Page 3 de 12
Requête 3587-2005
Before presenting the details of the revenue adjustment formula, the section below
reviews the results of a total factor productivity study conducted for Gazifère and
considers how it might be applied in a “CPI-X” form of revenue adjustment.
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Total Factor Productivity and the CPI-X Approach
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A common type of rate or revenue adjustment mechanism is in the form of “CPIX”, where CPI represents the consumer price index or some other index of the
rate of inflation, and X is a factor representing expected productivity
improvement. In order to determine an appropriate X factor, a common first step
is to understand the historic productivity experience of the utility. For this
purpose, Gazifère engaged a consultant to conduct an analysis of the utility’s total
factor productivity. The consultant’s report is filed as GI-9, document 2.
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Recent reviews of PBR regimes1 demonstrate that a consensus has not developed
among regulators on the application of Total Factor Productivity studies to PBR
formula and the application of TFP analysis in energy distribution PBR plans is
far from consistent. A consensus has not emerged, for instance, on which
indicator of output (the number of customers or sales) is most appropriate, on
which estimate of capital inputs (accounting capital or physical capital) is most
appropriate and on the length of the historic series that is most appropriate. A
frequent consequence is that protracted “X factor” debates take extensive time
and resources in regulatory proceedings as consultant reports are tabled, examined
and argued.
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In order to highlight the problem, the consultant’s report, GI-9, document 2, may
be used to support significantly different conclusions, dependent on the
assumptions and the data series chosen. For instance, looking at Table 4 of the
report, the productivity experience of Gazifère can be cited as:
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2.6%
if the average of the last 10 years is used, the number of
customers is the output, and accounting capital is an input.
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0.2%
if the average of the last 5 years is used, the number of
customers is the output, and physical capital is an input.
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See for example Lowry and Kaufman, Performance-Based Regulation of Utilities, Energy Law Journal,
Volume 23, No.2, 2002, The Energy Bar Association, Tulsa, Oklahoma., and
Michael R. Schmidt, Performance-Based Ratemaking: Theory and Practice, Public Utility Reports,
Vienna, Virginia, 2000.
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-4.2%
if the average of the last 15 years is used, actual volumes is
the output, and accounting capital is an input.
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-14.8%
if the average of the last 5 years is used, normalized
volumes is the output, and physical capital is an input.
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Which of these numbers is reasonable? Opinions often turn on the point of view
of the advocate. Utilities find reasons to support low productivity data, and
therefore a low X factor. At least one major Canadian natural gas utility has
advanced evidence supporting negative productivity and consequently a negative
X factor. (Gazifère could well make the same submissions in view of the very
significant negative productivity trend demonstrated when volumes are used as
the measure of output in the productivity analysis.) Customer representatives, on
the other hand, find reasons to support high productivity data, resulting in a higher
X factor. Obviously, the choice of the X factor has a significant impact on the
reasonableness and sustainability of a PBR plan. At the forecast rate of inflation
of 1.8% for 2006 referenced in this application, substituting the citations above in
a CPI – X formula yields potential revenue adjustment factors that range between
-0.8% and +16.6%
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Gazifère provides the study of total factor productivity in GI-9, document 2 for
the information of the Régie and stakeholders. If an adjustment formula in the
form of CPI-X were to be used, Gazifère would propose that the productivity
index that is most appropriate includes labour, materials and physical capital as
inputs and the number of customers as the output. Looking at Table 4 of GI-9,
document 2, the average annual productivity for this reference is reported as
follows:
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2005-2001
0.2%
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2005-1996
0.9%
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2005-1991
1.5%
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This series of averages, and the indices on which the averages are based,
demonstrate that actual annual productivity gains at Gazifère are in decline. In
light of this trend, Gazifère submits that the most recent experience, that of the
last five years is the most appropriate predictor of the productivity gains that are
attainable by the utility over the next 5 years. This suggests that an X factor of
0.2% is appropriate.
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Nevertheless, this application does not propose an adjustment mechanism in the
form of CPI-X. Given the adversarial and very subjective nature of the total
factor productivity and X factor debates, Gazifère proposes to provide an annual
benefit to ratepayers by means of a discount factor against the rate of inflation.
This approach is simple and easy for customers to understand. From the
perspective of regulatory review, a complex debate about inputs, outputs, data
time series, and the assumptions associated with total factor productivity is
reduced to a single question: by what portion of the forecast rate of inflation
should total revenues be adjusted?
Revenue Adjustment Formula
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The proposed formula adjusts the annual distribution revenue requirement,
expressed on a per customer basis, by a portion of the forecast rate of inflation,
and provides for adjustments for cost of capital, for certain pass throughs, for
exogenous factors, if they occur, and earnings sharing. That is:
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RRt =
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Where;
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RR
C
d
CPI
R
Y
Z
ES
( )* (1 + d (CPI )* C
RRt −1
Ct −1
Q
t
+ R + Y + Z + ES
= revenue requirement
= average number of customers
= is a discount coefficient which serves as a productivity challenge
= forecast rate of inflation using the Quebec Consumer Price Index
= cost of capital adjustment
= pass throughs
= exogenous factors
= earnings sharing adjustment
The revenue requirement for the test year is equal to the revenue requirement of
the previous year divided by the average number of customers in the previous
year, multiplied by a portion of the forecast rate of inflation for the test year,
multiplied by the forecast average number of customers for the test year, plus
adjustments for the cost of capital, pass throughs, exogenous factors and earnings
sharing.
Reference Year
The mechanism is based on the revenue requirements of the 2005 rate case,
determined according to the cost of service in the context of the application
R-3537-2004, excluding the cost of gas and the deferral accounts (DSM, LRAM
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and regulatory expenses). The cost of gas will be settled through the quarterly
rate adjustment mechanism.
Growth
The costs of a distribution utility are very closely aligned with the number of
customers it serves. Each new customer represents new capital costs associated
with attachment to the system (mains, lines, metres) and new operations and
maintenance costs associated with customer care, meter reading, billing and
collection. It is appropriate therefore that a revenue adjustment mechanism
recognize the increase in the number of customers. In the proposed formula,
growth is recognized by expressing the revenue requirement on a per customer
basis. It is also proposed that the number of customers used will be the average
number of customers for the rate year.
Inflation
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The inflation index used in the formula is the Quebec Consumer Price Index
(QCPI). The QCPI may not exactly reflect the index of the distributor’s inputs,
but the choice is appropriate for several reasons: (1) objective forecasts are
published; (2) customers are familiar with the index; and finally, (3) of the
inflation indices considered, it most closely correlates to the utility cost
experience.
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Gazifère proposes to survey the forecasts available from the seven sources
referenced in the table below on the first business day of the month in which the
formula is applied for rate setting purposes. We expect this to be in the month of
August of each year. The forecast used in the formula will be the average (mean)
of the seven forecasts in the survey. The Quebec CPI average forecast for 2006,
as at May 1, 2006, is 1.8% and is shown in the table below.
Québec CPI/Average Inflation Forecast (% Change) As of May 1 2006
Forecaster
Bank of Montreal
Royal Bank of Canada
Conference Board of Canada
Desjardins
Toronto Dominion Bank
CIBC World Markets
BMO Nesbitt Burns
Average
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Forecast Date
March-06
March-06
Spring 2006
April-06
October-05
February-06
2006 Q1
2006F
1.8
1.0
2.3
2.1
1.8
1.7
2.0
1.8
2007F
1.4
0.8
1.9
2.3
na
2.2
2.0
1.8
In order to avoid the accumulation of projection errors, the previous year’s
distribution revenue requirements will be updated to reflect the rate of inflation
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according to the latest projections. The revenue requirements thus calculated will
be used to determine the current year’s distribution revenue requirements. This
operation (true-up) was also used in Gazifère’s former mechanism.
d: Inflation Discount Coefficient
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Gazifère proposes that the discount coefficient be established at 0.89. At this
level, the revenue requirement per customer will be adjusted by 89% of the
forecast rate of inflation while Gazifère will be required to manage its business
in an environment where many of its costs will reflect the full impact of inflation
and more. Customers benefit since the utility must seek productivity
improvements rather than passing on the full impact of inflation in rates.
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Why set the discount at 0.89? Essentially the decision about the level of the
productivity challenge comes down to a judgment about what seems to be
appropriate given all the elements of the plan. For instance, in PBR plans where
there is no provision for earnings sharing, the productivity challenge is the
primary annual benefit for ratepayers and may be set at a higher level than a
similar plan which also shares earnings with customers.
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In the discussion of the CPI - X approach on pages 4-5 of this exhibit, it is
proposed that if the Régie were to adopt that approach, then an X factor of 0.2
would be appropriate given the total factor productivity evidence. What discount
factor relates to this level of productivity challenge? At the average forecast rate
of inflation of 1.8% for 2006, that formula yields CPI - X = 1.8-0.2 = 1.6. This
value is achieved in the d(CPI) approach when d = 0 .89, that is, 0.89*(1.8) =1.6.
The rationale for the choice of 0.89 is that it approximates the CPI - X result,
when inflation is forecast at 1.8% and X = 0.2.
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R: Cost of Capital Adjustment
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The detailed cost of capital adjustment is provided in GI-10,
document 2.2. The adjustment is proposed in order to more accurately reflect the
annual cost of capital throughout the CPBR plan. The adjustment recognizes that
the main drivers of the cost of capital, that is, the allowed rate of return on equity
and market rates of interest are beyond the control of utility management.
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Over earning at year end will be calculated using the allowed rate of return on
equity derived from the approved ROE formula and reflected in the distribution
revenue requirement calculation through this adjustment.
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Y Factors
The following items are calculated outside of the adjustment formula:
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Upstream expenses: gas supply, transportation and balancing (These costs
will be settled through the quarterly rate adjustment mechanism)
Deferral accounts (regulatory expenses, energy efficiency program expenses,
LRAM, PBR, EnVision) (These costs will be added to the result of the
formula at cost of service.)
Cost of service impact of major investment projects over $450,000 approved
separately by the Régie. (Gazifère will calculate the impact of the major
investment project on the cost of service in the first year and add it to the
result of the formula. In the second year, it will be an integral part of the
distribution revenue requirements that will serve as the base to which the
indexing will be applied.)
Impact of the weather normalization account (Gazifère will calculate the
impact on cost of service of the variation of the weather normalization
account included in rate base.)
Z: Exogenous Factors
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Z factors are completely beyond the distributor’s control, and are defined as
follows:
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Impact of regulatory decisions and orders, for example, a change in
amortization rates
Impact of changes in accounting requirements
These factors may or may not occur within the plan. Should they occur, the cost
consequences will be recorded in a deferral account and will be added to the
revenue requirement at the next annual determination of rates when the balance of
the deferral account exceeds $100,000.
Earnings Sharing Formula
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Gazifère proposes an earnings sharing formula. The proposal is not symmetrical;
no sharing is proposed on the downside. That is, the risk of actual earnings falling
below allowed ROE, is entirely that of the shareholder.
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Gazifère proposes a sharing of over earnings, in three bands, as follows. Earnings
above the allowed ROE would be fully retained by the utility for the first 100
basis points. After the first 100 basis points, earnings will be shared 50/50 with
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ratepayers for the next 250 basis points. Finally, any earnings exceeding the
allowed ROE plus 350 basis points will be fully credited to ratepayers. For
example, if allowed ROE is 10%:
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Allowed ROE
10.0%
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First 100 bpts
10.0% to 11.0%
fully retained by utility
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Next 250 bpts
11.0% to 13.5%
shared 50/50
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Beyond 350 bpts
13.5%
fully credited to ratepayers
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In the event that earnings are at a level to be shared with ratepayers, the amount
would be applied to reduce the revenue requirement on the next application of the
formula. For example, corporate earnings for 2006 will be determined in the first
quarter of 2007 and the earnings to be credited to ratepayers, if any, would be
applied to reduce the revenue requirement for 2008.
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This earnings sharing proposal provides three distinct benefits:
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(i)
the 100 basis points dead band provides an effective incentive for the
utility to manage costs and seek efficiencies;
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(ii)
the 250 basis points 50/50 sharing band continues to provide incentive to
the utility while providing an opportunity for ratepayers to further share in
efficiency gains (in addition to the annual benefit of the productivity
challenge); and,
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(iii)
the final band, where all earnings are credited to ratepayers provides a
safeguard for the regulator and ratepayers against so called “over earning”
by the utility. The mechanism works to provide an effective cap on actual
earnings of the utility, within the plan of the allowed ROE plus 225 basis
points.
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Service Quality Indices
Gazifère has been operating for a number of years under an incentive system that
requires certain service quality indices to be met. The meeting of service quality
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indices guarantees to customers that any savings realized by the distributor are not
realized at their expense.
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Gazifère is keeping the same service quality indices:
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The sharing mechanism remains the same and works as follows:
Preventive maintenance
Emergency response
Meter reading
Response to telephone calls
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(1) Gazifère’s overall performance must be at least 90% for it to be able to
apply the earning sharing formula.
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(2) If overall performance is between 80% and 90%, Gazifère can keep a
percentage determined using the following formula: actual overall performance X
earning sharing formula.
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(3) If overall performance is below 80%, customers share 100% of the
overearning.
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The following table shows the service quality indices and the corresponding
performance thresholds.
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Quality Indices
Preventive maintenance
Performance Thresholds
Adherence to preventive
maintenance program
Emergency response time
Response within a maximum
period of 35 minutes
Frequency of meter reading Percentage of meters read
according to the policy (1)
Call response time
Response to telephone calls
within a period of 30 seconds
Overall index (arithmetic
average)
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(1) Except for industrial meters that are read every month, Gazifère’s policy is to read meters
every 2 months (6 times per year).
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TERM AND RENEWAL
The proposed mechanism will be applied over an initial 5-year period (2006 to
2010). As soon as possible in the fourth year (2009), once 3 years of results are
available, the mechanism will be evaluated with a view to its renewal. The
Company will file a Report which will review the operation of the plan and
indicate if it wishes to extend or renew the term of the plan.
OFF-RAMP REVIEW FOR MAJOR EVENTS
An off-ramp is provided for when conditions are such that continued use of the
mechanism produces results that threaten the financial viability of the company.
If conditions warrant, the Company will make application to the Régie explaining
the circumstances and request an opportunity to make a cost of service
application.
ONE-TIME ADJUSTMENT FOR THE YEAR 2006
Since 2006 is a special year, Gazifère will add to the result of the formula the
exceptional expenses that are not part of the distribution revenue requirements
approved in the 2005 rate application. These expenses are: rent increase (Gazifère
moved in December 2005), dispatch 24/7 (operational change), moving expenses,
EnVision costs, and the increase in amortization due to the fact there are no more
contributions (account 475) to be amortized in 2006. In year 2 (2007), these
expenses will be an integral part of the distribution revenue requirements that will
serve as the base to which the indexing will be applied; the one-time moving cost
will, however, be excluded.
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