July 14-15, 2005
Chicago, IL

 Institute
 Instructors
 Binders
 Schedule
 Logistics – security, bathrooms, cellphones, etc.
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David G. Loomis, Ph.D.
Executive Director, Institute for Regulatory Policy Studies

 Efficiency in Production – PC gives firms the incentive to produce at the lowest possible cost
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 Efficiency in Allocation – PC provides society with the right amount of good is produced since the marginal cost to produce equals marginal willingness to pay since both equal price
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 Social Surplus is maximized –
 Consumer Surplus - the difference between the price that the consumer was willing to pay and what they had to pay
 Producer Surplus - the difference between the price that the producer was willing to sell at and what they had to pay
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

Firm charges a higher price than perfect competition. This results in lower output.
There exists X-inefficiency firm doesn’t work hard to cut costs
 There is a misallocation of society resources
 Social Surplus is not maximized
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 When it is more efficient to have one firm produce all the output than for two or more firms to produce
 Usually caused by high capital (fixed) costs
 Often associated with the public interest
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

Restrain the monopolist to mimic the perfectly competitive market
Set the firms’ prices such that total revenue equals total economic cost (TR=TC)
 Rate Design deals with prices that lead to TR; quantity is determined by consumers (TR=P*Q)
 Revenue Requirement deals with the total economic cost of the firm
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 Uphold the rights of customers to dependable and reliable service at reasonable rates
 Preserve the financial integrity of the utility
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 The regulated utility is entitled to an opportunity to recover all costs prudently incurred in providing services
 The customer has an obligation to reimburse the utility at rates that will provide such an opportunity
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 Rates should be high enough to provide the utility with a reasonable opportunity to recover the total cost of providing service and to sustain its financial integrity while maintaining dependable and reliable service
 Rates should not be higher than the minimum necessary to achieve the objective stated above
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 The amount of money a utility must collect from its customers to pay expenses and provide a fair return to investors
 Incremental revenue requirement is positive if current revenues are insufficient; negative if current revenues are excessive
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 Revenue Requirement = OC + T + d + r(V-D)
 OC = Operating Costs
 T = Taxes
 d = Annual depreciation expense
 r = Rate of return
 V = Value of physical and financial capital


D = Accumulated depreciation r(VD) is called the “return portion” and V-D is called
“rate base”
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The Revenue Requirement Approach
 Basic Principle provide the company with a reasonable opportunity to earn a reasonable return on its “used and useful” investment dedicated to utility service
 Basic Method periodically adjust price levels so they are in line with costs
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 Determine the allowed expenses, allowed rate base and allowed rate of return
(revenue requirements)
 Determine mix of prices that will achieve that revenue requirement (rate design)
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 Total economic cost includes a fair return on invested capital. This fair return is also called accounting profit.
 Regulated firm should earn their total economic cost but no economic profit.
 Economic profit is a return in excess of the fair return on invested capital.
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

When rates are functioning properly, the utility recovers the cost of service (including capital costs) and no economic profit or loss is produced
Although from the viewpoint of economic welfare, the optimal result of the rate of return regulation “reproduces” the outcome of the perfectly competitive market, traditional regulatory pricing objectives and the forces of the free market differ in significant ways.
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 Select a test year
 Determine the revenue requirement
 Determine whether existing prices would yield more or less that the revenue requirement
 Adjust prices accordingly
 Rates set for the future no “retroactive” rate making
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 Any 12 month period used for evaluating the revenues, operating expenses, depreciation, taxes, and rate base for purposes of setting rates.
 Current (or historical) Test Year – A 12 month period which reflects the actual results of current operations could be adjusted for known and measurable changes.
 Future or Forecasted Test Year - A future 12 month period which reflect the anticipated results of normal operations.
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 To establish the relationship between revenues, expenses and rate base that is expected to exist during the year rates are in effect
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 Pro-Forma Adjustments – known and measurable changes
 Non-recurring expenses
 One-time basis, irregular intervals
 Amortized over the time period between rate cases
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Separation and Verification Issues
Above Vs Below the Line
 Separate utility revenues and costs from non-utility revenues and costs
 Separate jurisdictional utility revenues and costs from non-jurisdictional utility revenues and costs
 Verify that jurisdictional utility costs are prudent and necessary
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 Items that have nothing to do with the provision of safe and adequate utility service and may represent either nonjurisdictional or non-regulated costs.
Examples of expenses include charitable contributions or political contributions.
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 Revenue Requirement = OC + T + d + r(V-D)
 OC = Operating Costs
 T = Taxes
 d = Annual depreciation expense
 r = Rate of return
 V = Value of physical and financial capital


D = Accumulated depreciation r(VD) is called the “return portion” and V-D is called
“rate base”
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Revenue Requirement =
OC + T + d + r(V-D)
 Operating Cost - Non-tax and non-capital costs of utility service
 Issues
 necessary?
 prudent?
 affiliate transaction concerns?
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Revenue Requirement =
OC + T + d + r(V-D)
 Taxes - All forms of payment to federal, state, and local governments
 Utilities have been an easy target for taxation
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 Does the tax component equal taxes actually paid in the test year – are the tax benefits “flowed through” or
“normalized”
 interest on construction bonds
 accelerated depreciation

 investment tax credit
“phantom tax”
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Revenue Requirement =
OC + T + d + r(V-D)
 Depreciation - provides for the return of invested capital in “installment payments” over the years of useful life of the plant and equipment

Compensation for the “using up” of capital due to wear and tear, obsolescence, etc...
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 Cost $100,000
 Salvage 20,000
 Life 20 years d =
$100,000 - $20,000
20 years
= $4,000 / year
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Year
1
2
…
20
+ Salvage
Recovered
Depreciation per Year
Accrued
Depreciation
4,000
4,000
4,000
8,000
4,000 80,000
20,000
100,000
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 Return of capital versus Return on Capital
 Accounting depreciation methods
 straight line
 accelerated
 Years of useful life
 Anticipated future market conditions
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Revenue Requirement =
OC + T + d +
 r = rate of return
 (V-D) = rate base
V = value of plant and equipment, etc.
D = occurred depreciation

Payment for the “use” of capital: interest payments, dividends, and retained earnings
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 How to determine rate base?
 Net original cost (i.e., book) rate base (net means V-D)
 Fair market value
 Reproduction cost - the cost of duplicating the existing plant and equipment at current prices
 Replacement cost - the cost of duplicating the old plant with the modern technology version
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 End of period rate base - Value of the rate base at the end of the test year. This concept typically is used in conjunction with a current or historical test year.
 Average (normalized) rate base - Average rate base throughout the test (i.e., typical) year. This concept typically is used in conjunction with a future or projected test year.
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 Plant in Service
 Construction Work in Progress (CWIP)
 Materials and Supplies
 Cash Working Capital
 Prepayments
 Typical Deductions:
» Accumulated Depreciation
» Deferred Taxes
» Contributions in Aid of Construction
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Rate Base
 Includes value of plant and equipment, materials balances, land held for future use
 Issues
 valuation methods
 treatment of “excess” or unused facilities
(used and useful criteria)
 treatment of plant under construction
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Fuel
Salaries
Other Expenses
Total Operating Costs
Depreciation Exp
Federal Income Taxes
State Income Taxes
Other Taxes
Total Taxes
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$100 M
$150 M
$ 50 M
$10 M
$7 M
$43 M
$300 M
$50 M
$60 M
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Plant in Service
CWIP
Other Capital
Value of Plant
Acc. Depreciation
Rate Base
Rate of Return
Return on Investment
$900 M
$15 M
$35 M
$950 M
($250 M)
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$700 M
10%
$70 M
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Total Operating Costs
Depreciation Expense
Taxes
Return on Investment
Total Revenue Requirement
$300 M
$50 M
$60 M
$70 M
$480 M
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The revenue deficiency in a rate case is equal to the difference between the revenue requirement and the actual revenue during the test year:
Revenue Requirement
- Test-Year Revenue
Revenue Deficiency
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Total Revenue Requirement
Test-year Revenue (given)
Revenue Deficiency
$480 M
(400 M)
$80 M
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