WRITTEN TESTIMONY OF
MR. ROBERT McCULLOUGH
ON BEHALF OF
THE GRAND COUNCIL OF THE CREES
(EEYOU ISTCHEE) /
CREE REGIONAL AUTHORITY
before
THE RÉGIE DE L’ÉNERGIE
MAY 5, 1998
Mr. Robert McCullough’s written testimony
Page 1
McCullough Research been retained by the Grand Council of the Crees (Eeyou
Istchee) / Cree Regional Authority to review Hydro-Québec’s unusual new approach to
regulation.
McCullough Research has been active in Québec on Hydro-Québec issues for many
years. We have also been active on behalf of Canadian utilities and consumers in other
Canadian provinces including Ontario, Alberta, and British Columbia. We have worked
on issues of bulk power supply and contracting in across the U.S. including active
participation in restructuring across the U.S. McCullough Research has also exported
energy for a Canadian utility (Edmonton Power) and purchased power for utilities and
industrial customers.
In twenty years of practice in the electric business, we have never reviewed a more
primitive, inefficient, and inequitable proposal than that Hydro-Québec has put forward
for this proceeding. We recommend that the Régie reject the proposal in its entirety
and require Hydro-Québec to adopt standard rate making practices in use elsewhere in
the United States and Canada.
Hydro-Québec’s proposal is very, very simple. Hydro-Québec is asking the Régie to
use the existing Rate L as the base for transfer prices from Hydro-Québec’s generation
for distribution to its customers. While Hydro-Québec believes that this is new, the
practice of gaining regulatory approval for the cost of generation is a common step in
many, many jurisdictions. For utilities with a clear institutional division between the
generation and distribution business, this step is a standard part of regulatory review.
Many other utilities face regulation in their wholesale transactions.
Hydro-Québec’s proposal is only innovative in one way. The proposal asks the Régie
to abandon its regulatory responsibilities by accepting the price Hydro-Québec
proposes without exercising due diligence or oversight. Hydro-Québec has refused to
answer all questions that might provide information that would allow the Régie to judge
whether the application of a retail rate, adopted without public review, and lacking any
justification, should be used for this purpose.
The proposal is primitive in that it neglects to consider the interests of the people of
Québec. A wide literature exists concerning the appropriate level of costs and their
application to rates. Hydro-Québec’s proposal fails to utilize a single tool developed
anywhere over the past century. The word primitive is chosen carefully to make it clear
that such a proposal would be viewed as amateurish if brought forward elsewhere in
Canada or the United States.
The two standard monographs on utility regulation, Alfred Kahn’s “The Economics of
Regulation”, MIT Press, Cambridge, Massachusetts, 1988 and “Principles of Utility
Rates”, James Bonbright, Public Utility Reports, Arlington, Virginia 1988 do not
Mr. Robert McCullough’s written testimony
Page 2
reference Hydro-Québec’s approach in whole or in part. The omission reflects the
mature state of the regulatory debate.
Hydro-Québec’s approach simply isn’t
sophisticated enough to be present elsewhere in the regulatory, legal, or economic
literature.
The proposal is inefficient because it allows Hydro-Québec to continue with inefficient
pricing in contravention to utility practice. Hydro-Québec has chosen arbitrary values
for the prices – prices that may or may not reflect their actual economics. When
Hydro-Québec asks consumers to pay the wrong prices, they make the wrong
economic decisions – causing losses for society as a whole.
The proposal is inequitable because it continues the process of overcharging Québec
ratepayers for losses in the export and the subsidized aluminum markets. While
Hydro-Québec admits that income is increasing over the next few years, rates will be
kept fixed to cover the losses in other markets. In effect, Hydro-Québec plans to
overcharge its own citizens to fund sales to the citizen’s of other provinces and
countries and provide subsidized power to industries owned by companies from
Europe, the United States, and Japan.
Hydro-Québec’s responses to the parties’ discovery requests amply illustrates the fear
Hydro-Québec has of an open and honest intellectual exchange.
Since
Hydro-Québec’s overall finances are readily available to investors – the only secrets
that are being kept are being kept from the citizens of Québec.
My testimony addresses three broad issues:
1.
The overall purpose of regulation and the application of universally accepted tools to
hydro-Québec’s costs and rates.
2.
The appropriateness of keeping rates fixed when costs are falling.
3.
The use of Hydro-Québec revenues to support losses in other markets – and the inclusion
of these losses in cross-subsidies from Rate L to other customers.
I will close with a few comments on Hydro-Québec’s continuing role as the continent’s most
secretive utility and the relevance of their secrets in today’s business climate.
The Origin and Application of Regulation
The U.S. and Canada have a long history of public utility regulation. Regulation was a logical
choice for society in industries where a single producer appeared to be more efficient than
multiple, smaller, producers. In electricity, the logic was based on the expense of the
Mr. Robert McCullough’s written testimony
Page 3
infrastructure – competing electric utilities would each have to build distribution systems to serve
the consumer. Logically, one utility could build the distribution lines and society would avoid
the cost of duplicate distribution systems.
Unfortunately, this efficiency came at a high price. Without the discipline of the market, the
single monopolistic utility often asked for higher tariffs than were necessary. Also, and equally
important, the utility tended to be inefficient and to have higher costs than were necessary – often
because the costs could be passed on to the consumers.
In both Canada and the U.S. regulatory boards were established to curb both the abuse of
monopoly power and the inefficiency that comes from the absence of competition. Such boards
are active in many Canadian provinces including Alberta and British Columbia and all U.S.
states.
Interestingly, regulation is often applied to both public and private utilities. The logic is
straightforward. While a desire for excess profit is more likely with private ownership,
inefficiency can occur whenever the discipline of the market is absent.
In Hydro-Québec’s case, surplus profit is simply another form of taxes. The current proposal
raises tax rates higher than they would be without the rate freeze. The issue of raising general
government revenues through a tax on electricity is a policy decision. The public debate
concerning this form of taxation should take place with complete information. Hydro-Québec’s
proposal is inadequate because it attempts to choke off this discussion by keeping information
concerning this tax from the public, the interveners and the Régie.
Inefficiency is also an issue. With competition, rates for industrial customers in the western
U.S. are now considerably lower than those in Québec. In states with industries competing with
those in Québec, industrial rates have fallen to the 20 to 25 mill (US) range – corresponding to
Canadian prices in the 26 to 33 mill range. Several McCullough Research clients are served at
rates lower than these.
The purpose of regulation is to allow an open and frank discussion of these issues. Given
Hydro-Québec’s secrecy in this proceeding, it is impossible to know why Hydro-Québec rates are
higher than those in the U.S. for comparable industries. Is Hydro-Québec’s allocation of costs
biased against industry? Perhaps Hydro-Québec’s costs and subsidies for other markets are too
high. Only an active investigation of the issue will reveal the answer.
The basic approach to evaluate rates is a three step process. The first step is to evaluate the
appropriate level of cost. The standard formula used throughout the industry is:
Total Costs
Equals
Plus
Return To Investors
Depreciation
Mr. Robert McCullough’s written testimony
Plus
Minus
Page 4
O&M Costs
Net Income From External Markets.
For a publically owned utility, such as Hydro-Québec, the return to investors is equal to the cost
of the debt issued to build the system and a margin above that cost required as a reserve against
risk.
Depreciation is the accounting cost corresponding to wear and tear on equipment over time.
O&M – operations and maintenance costs include salaries, general expenses, and equipment that
is expensed in the current year.
The final component, Net Income From External Markets, reflects the net income that may be
available from off-system sales. Since the system paid for by consumers provides the
opportunity for such sales, the net income is netted against the costs to the benefit of consumers.
The second step is to apportion the costs between consumers. The division of costs is usually
undertaken on the basis of energy – the actual amount of kilowatt-hours used – and capacity – the
maximum consumption of kilowatt-hours at any given moment in time. Hydro-Québec has
always had a very simple cost allocation methodology. This has reflected the absence of a
public discussion concerning the allocation of costs. Hydro-Québec has openly admitted the
weakness of its current methodology:
“Hydro-Quebec must periodically review the principles applied in the calculation
of supply costs to ensure they adequately reflect the system's operating reality and
customer consumption characteristics. It is also important to take into account the
improvements in the methodology generally used by electric utilities. These
improvements provide more accurate data on the specific supply costs for each
market sector based on its use of the system.
Hydro-Quebec is currently conducting a full review of its method of determining
supply costs to ensure that cause-and-effect relationships are correctly reflected.
The changes being contemplated at the present time concern, specifically the
apportionment of costs between power demand and energy. as well as their
allocation to the various rate categories. Demand costs would be associated with
capacity to meet maximum demand. which is a determining factor for rate
categories present during the system's peak period.
An analysis of the method has confirmed and even strengthened the Conclusions
for the domestic rate category. According to preliminary results obtained with the
method currently used, which is by no means the most penalizing, the profit
margin has swung to the negative side, reaching approximately -8% in 1995.
Mr. Robert McCullough’s written testimony
Page 5
The first step in the revision process has been completed and the principals
concerned at Hydro-Quebec have been consulted regarding calculation method
principles that need to be changed. Validation is now being conducted by
independent experts who are evaluating the changes to be made to the method
and comparing them with those that other electric utilities are planning.
Meanwhile, Hydro-Quebec has begun an information-and-discussion process
with the Natural Resources Minister and will then inform its external partners.”1
Unfortunately, Hydro-Québec has not taken the steps they proposed two years ago. The rate L
proposed in this proceeding is based on the 1996 Rates Proposal. If the calculations behind Rate
L were not secret, it would be possible for the Régie and the participants in this hearing to
examine the cost allocation methodology and determine whether it is appropriate for Québec.
The final step in traditional utility rate making is to take the allocated costs and to assign them to
specific billing determinants. Again, Hydro-Québec maintains that this information is secret,
and no clear evaluation can be made whether this step has been carried out appropriately.
Overall, the problem with secrecy is simply that it defeats the purpose of regulation.
Hydro-Québec’s arguments to the contrary, eliminating data from this proceeding simply
removes the checks and balances that the Régie is supposed to set on Hydro-Québec. The losers
are the citizens of Québec. They will certainly pay higher rates without an effective review.
Another loser is Hydro-Québec. Since competition is not allowed in Québec, the only
competitive discipline on Hydro-Québec comes from regulatory review. If this review is absent
– or ineffective – Hydro-Québec will continue to impose rates that are increasingly
uncompetitive with rates across the border in the U.S.
Hydro-Québec’s Proposed Rate Freeze
In this proceeding Hydro-Québec is arguing for a five year freeze. This step is unusual during a
period when Hydro-Québec has announced rapidly increased earnings. Put simply, the standard
regulatory approach would confer rate decreases over the next five years. Approval of a rate
freeze will transfer hundreds of million of dollars from Québec’s citizens and businesses to
Hydro-Québec.
1Hydro-Québec,
1996 Rates Proposal, Page 20.
Mr. Robert McCullough’s written testimony
Page 6
The Strategic Plan indicates that net income will more than double over the period of the freeze.2
The net income does not increase because additional investments have been made which require
an additional return to investors. Assets net of depreciation only increase by 6% over this
period.
If the rates proposed in this proceeding are appropriate for 1998, the levels after 1998 reflect
levels of return that are inappropriate and unjustified in this proceeding.
If we assume that the use of Rate L the basis for rates was correct, and we adjust the
transportation and distribution costs in a consistent fashion by load factor, total costs by rate class
would be:
2Stategic
Plan 1998-2002, Table2, Page 53.
Mr. Robert McCullough’s written testimony
Rate D Cost
Rate G Cost
Rate M Cost
Rate L Cost
Other Costs
All Rates Bylaw Costs
Exports Costs
Special Contracts Costs
All Sales Costs
HQ Forecasted Revenues
Total Cost
Cents/kWh
7.04
6.31
5.82
3.79
4.50
5.60
4.33
3.67
Generation
Cents/kWh
3.22
2.94
2.75
2.52
2.93
2.87
2.83
2.45
Page 7
Transmission
Cents/kWh
1.79
1.58
1.44
1.27
1.57
1.53
1.50
1.22
Distribution
Cents/kWh
2.03
1.79
1.63
1.20
Total Cost
Millions
3,745
730
1,103
1,861
261
7,762
867
822
9,450
9,821
Source: Strategic Plan, pages 24 and 25, and Proposal To The Régie, Appendix F. 3
This table shows the costs that Hydro-Québec believes should be recovered from all of
its customers. These costs contain all of the necessary components including return
on investment, depreciation, and operating costs. Any revenues above these costs are
surplus to hydro-Québec’s needs and would normally be returned to ratepayers.
We can use the loads forecasted by Hydro-Québec in their Strategic Plan to estimate
the forecasted costs in 2002, $9,450,000,000, and the revenues $9,821,000,000. The
difference, $371,000,000, are earnings not required by Hydro-Québec and should be
returned to ratepayers. This would be equivalent to a 4.78% reduction in rates for
Québec customers. The exact level of the rate discount varies by year. Of course,
Hydro-Québec’s insistence to maintain secrecy over numbers used to calculate costs
make these calculations subject to adjustment when additional materials become
available. It should be noted that this table reflects information that Hydro-Québec has
traditionally made available to its customers in its Rate proceedings consultations, and
through discovery meetings with Québec groups, like the Cree.
From the materials presented by Hydro-Québec we cannot know whether this surplus
profit is taken from overcharging Québec customers or speculative sales in export
markets and Risk and Profit Sharing customers. Only a careful review based on the
actual cost data will give us the answer to this question.
If the additional income is the product of speculative undertakings, the ratepayers who
bear the burden should expect recompense.
Revenues from exports and the
aluminum smelters are volatile. The ratepayers pay for the equipment that makes
these speculations possible. It is manifestly unfair for the ratepayers to bear the risk of
3Transmission
and distribution charges have been interpolated by capacity.
Mr. Robert McCullough’s written testimony
Page 8
the speculations but not to receive the benefits. If the extra revenues come from an
incorrect assignment of costs to ratepayers, the costs should be applied to the correct
areas and not surcharged to ratepayers.
All of the above calculations are taken directly from Hydro-Québec materials. They
presume that Hydro-Québec will make significant profits in serving aluminum smelters
and the U.S. export market. If they do, the forecasts contained in the Strategic Plan
show that the revenues will not be returned to ratepayers. If they don’t, as we discuss
below, ratepayers are not insulated from the losses and the ratepayers may well bear
the brunt of such losses.
Subsidies To Exports And Risk And Profit Sharing Customers
Since Hydro-Québec has chosen to hide materials that they traditionally made available
to the public, it is impossible to precisely estimate the degree that losses in other
markets have been added to Rate L. The following table shows the results for 1994.
Rate Category
Rate D
Rate G
Rate M
Rate L
Other
Standard Rates
Exports
Special
Contracts
Total Sales
Other
Grand Total
Source:
TWh
46.6
12.2
20.0
34.8
4.5
118.1
19.2
20.9
%
29.4%
7.7%
12.6%
22.0%
2.9%
74.7%
12.1%
13.2%
%
10.0%
32.9%
35.0%
17.2%
-17.8%
18.6%
-56.3%
-69.9%
158.2 100.0%
8.8%
Relative
Contribution
To Profits
%
42.8%
47.7%
66.8%
35.1%
-6.0%
-46.6%
-39.8%
100.0%
Profit
Margin
Profits
2722.0
923.0
1216.0
1301.0
215.0
6377.0
527.0
363.0
272.6
303.9
425.4
223.8
-38.2
1187.5
-296.9
-253.6
7267.0
30.0
7297.0
637.0
30.0
667.0
Average
Rate
Mills
58.4
75.6
60.9
37.4
47.4
54.0
27.5
17.4
Revenue
Cost
Ratio
111.13%
149.09%
153.80%
120.78%
84.92%
122.88%
63.96%
58.87%
45.9
Internal McCullough Research estimates based on publically available
materials
The losses from the Risk and Profit Sharing program do not disappear. Since bond
holders continue to be paid, rates must be raised to offset these losses. Over the
years, Hydro-Québec has had to shoulder enormous losses. These losses have
reduced Hydro-Québec’s liquidity and affected its financial health. Over time, these
losses have forced Hydro-Québec to increase rates to all of its customers.
The current proposal argues that ratepayers are to be protected against such losses
because the rates will not be raised until 2002. Unfortunately, the losses do not go
away. If Hydro-Québec loses $240,000,00 per year over the next five years, this will
Mr. Robert McCullough’s written testimony
Page 9
reduce Hydro-Québec’s retained earnings. The lower level of retained earnings will
require future rate increases to maintain Hydro-Québec’s ability to finance future
projects.
Hydro-Québec has traditionally overestimated the potential revenues in both the export
markets and the Risk and Profit Sharing Program. While most industry analysts feel
that aluminum prices tend around the $.75 per pound level, Hydro-Québec has
assumed that they will reach levels over 20% higher than that level. The importance of
the $.75 per pound level is that this price will allow a producer to build a new greenfield
smelter. Prices higher than that, held for any length of time, would be driven down by
the construction of new smelters.
The Strategic Plan indicates that aluminum prices will rapidly reach new highs and stay
at those levels.4 The following chart shows the relationship between Hydro-Québec’s
forecasts and actual prices for the 1997 and 1998.
As can readily be seen, Hydro-Québec’s forecasts weren’t even very realistic when they
4Strategic
Plan, Table 4, Page 56
Mr. Robert McCullough’s written testimony
Page 10
were released – let alone today.
Revenues from Hydro-Québec’s sales subject to the Rates policy will be
$7,402,000,000 in 2002. Hydro-Québec estimates additional revenues from exports
and the Risk and Profit Sharing contracts to contribute an additional $2,418,200,000 in
2002 – approximately 5.7 cents per kilowatthour. These are very, very high levels.
Assuming aluminum prices are in the $.75 range (1998 U.S. dollars), Québec’s
revenues from the 18.8 TWH aluminum load will be only $445 million. Hydro-Québec
assumes that they will be receiving $509 million for the same load. 5
Similarly, Hydro-Québec assumes that export prices will be 125% of their 1997 levels
by 2002. Hydro-Québec traditionally overestimates potential future revenues from the
U.S. market.
Preliminary 1997 figures indicate that 1997 prices received by
Hydro-Québec are 38.41 mills.6 This would push 2002 revenues to 48 mills Canadian
or 38 mills U.S. A full GE frame 7F combined cycle turbine is currently available at 25
mills U.S. including both capital costs and the cost of natural gas. In a world where
recent McCullough Research long term purchases for the same period of ranged from
16 mills U.S. to 20 mills U.S. these values appear theoretical at best.
It is straightforward to enter these prices into Hydro-Québec’s cost analysis. The
following chart uses Hydro-Québec’s rate L methodology and applies it to reasonable
export and aluminum forecasts for 2002. We have used the cost of a Frame 7F
turbine as an indication of the potential prices in the export markets.
Exports
Aluminum
Contracts
TWH
20.0
18.8
%
11.05%
10.39%
Revenue
712.5
445.5
Average
Rate
3.6
2.4
Cost/Revenue
Level
121.67%
154.79%
Cost
4.33
3.67
Profits
-154.4
-244.1
We have also conducted forecasts of the NEPOOL market using the Aurora model. The
forecasts reflect a full analysis of New England power markets over the next five years. The
following charts shows our forecasts on a month by month basis.
of Hydro-Québec’s Risk and Profit Sharing contracts has indicated
that the contracts receive revenues equal to 15% of smelter revenues.
5Coverage
61998
Third Quarter Hydro-Québec report.
Mr. Robert McCullough’s written testimony
Page 11
Using these forecasts, the table shows a smaller level of losses:
Exports
Aluminum
Contracts
TWH
20.0
18.8
%
11.05%
10.39%
Revenue
712.5
445.5
Average
Rate
4.1
2.4
Cost/Revenue
Level
121.67%
154.79%
Cost
4.33
3.67
Profits
-38.9
-244.1
It should be noted that this table reflects the limited materials available in the Strategic
Plan. Hydro-Québec now maintains that commonly available materials traditionally
made available are subject to secrecy. These values assume, for example, that no
additional Risk and profit Sharing loads have been added by 2002. Since several of
the contracts have options, this assumption simply reflects the fact that Rate L is higher
than comparable tariffs in the U.S.
The cross-subsidy required to cover exports and sales to aluminum smelters in 2002 is
an additional $398,500,000 dollars. If these sales were eliminated – or renegotiated to
cost – Québec ratepayers would see an additional rate reduction of 5.38%.
Unfortunately, these two rate reductions are not additive. If the rate reduction in 2002
from the excess earnings is 4.78% and the subsidy to exports and aluminum smelters
would provide an additional 5.38% reduction, the total reduction would be in excess of
Mr. Robert McCullough’s written testimony
Page 12
10%.
In reality, the substantial earning predicted by Hydro-Québec are based on the
unrealistic sales assumptions described above. If Hydro-Québec realized its sales
price predictions, it should return the surplus to Québec’s rate payers. If it does not, it
should not pass on the losses.
The critical issue is where these revenues and losses are coming from. Hydro-Québec
has not provided any information on these issues. Moreover, it has refused to answer
questions on these calculations.
For the Régie to address the propriety of
Hydro-Québec’s approach we need a full cost study to find out the source of the
revenues and to justify the assignment of costs.
The proposal by Hydro-Québec does not allow us to check whether there are
cross-subsidies between Rate L and other markets. Cross-subsidization leads to
inefficiency in the economy and does not lead Québecois to make the correct economic
choices.
For example, cross-subsidies between external markets and Québec
consumers reduces the competitiveness of Quebec industry and creates incentives for
industry to relocated to other regions where such cross-subsidies do not occur. In
addition, the actual consumption decisions of ratepayers are driven towards choices
that do not make the best use of available energy. Low costs for home heating in
electricity tend to encourage consumers to heat with electricity instead of gas.
Secrecy In Québec
Unlike other major utilities in the U.S. and Canada, Hydro-Québec has always followed
a path of secrecy in its business dealings with its ratepayers. The strong surmise is
that this secrecy is designed to shield Hydro-Québec from its losses in speculative
markets like exports and aluminum.
Hydro-Québec now argues that the need for secrecy will be even more intense in a
competitive environment. The theory seems somehow tied to the idea that export
customers will take advantage of Hydro-Québec if they new Hydro-Québec’s
information.
This idea is made even more bizarre when one considers that
Hydro-Québec releases detailed forecasts to Wall Street even while keeping them
secret from this proceeding in Québec. Since the competitive U.S. market is very
open, Hydro-Québec appears to be taking a path where their finances are known only
to their competitors and the secrecy is reserved for the people of Québec.
In truly competitive markets the price is set in the market. Competitors can observe
the market and make a decision concerning their desire to buy or sell energy and
capacity. McCullough Research represents both utilities (Canadian and U.S.) In the
U.S. market as well as large customers. It is difficult to understand what our clients
Mr. Robert McCullough’s written testimony
Page 13
would do with Hydro-Québec’s secrets even if they were, in fact, secret. We have
evaluated competitive bids to which Hydro-Québec has responded and the question of
Hydro-Québec’s “secrets” has never been raised. In fact, in an extensive practice
reviewing bulk power marketing issues from Québec to California, the question of the
secrecy of accounting data has never been raised -- primarily because all of such data
is publicly available -- as it is in a number of Canadian provinces.
In part, it is possible that Hydro-Québec’s concerns simply reflect their inexperience
with competitive markets. True competitive markets are transparent. Prices are
reported publically and market participants have a very good idea of the behavior of
both customers and suppliers. Hydro-Québec’s poor showing in contract negotiations
has often been caused by their very desire to maintain secrecy -- allowing the other
participants without these disadvantages to simply outmaneuver Hydro-Québec’s
negotiators. This is one reason why the Risk and Profit Sharing contracts turned out to
be so disadvantageous to Hydro-Québec.
Almost every document requested by the Grand Council of the Crees (Eeyou Istchee) /
Cree Regional Authority have been publically available
in past proceedings,
Hydro-Québec’s consultations with its customers, or within the context of negotiations.
For example, rate design documents have been made available to Hydro-Québec’s
customers on a number of occasions since the late 1980s. Detailed revenue/cost
review information was part of every Rates Proposal. Detailed load forecast materials
– including the Risk and profit Sharing customers – was made available in the context
of each Development Plan.
Specific financial information has been made available publically and directly to the
Cree. Review of specific export information has also been made available directly to
the Cree.
Simply stated, Hydro-Québec’s current position is inconsistent with its own past policy
and practice elsewhere in North America. As stated above, the current level of secrecy
makes a mockery out of the responsibilities of the Régie and ignores the legitimate
interests of the interveners.
*****