Rethinking Natural Gas
Utility Rate Design:
A Framework for Change
American Gas Foundation
The NARUC Foundation
Executive Forum at Ohio State University
Russell A. Feingold
Managing Director
May 22-23, 2006
Today’s Discussion
»
So, why do we need to “rethink” natural gas rate design?
»
Natural gas ratemaking fundamentals of the past
»
How do today’s energy industry challenges provide us
with a framework for change?
»
Is the utility ratemaking paradigm shifting?
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Why Do We Need to “Rethink” Natural Gas Rate
Design?
» Changing industry drivers
−
Supply/demand balance, price dynamics, customer usage, etc.
» Changing stakeholder policy objectives
−
Societal considerations, competitive position, financial goals
» The current rate design may not be working as intended
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−
Unexpected stakeholder impacts
−
Original rate design objectives not being satisfied
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To Add Further Complexity to the Equation, “Rate
Design is an Art – Not a Science”…
» There is no right or wrong answer in deciding upon the “optimal
rate design”
» The many stakeholders in the process have diverse, and often,
conflicting perspectives, opinions, and objectives
» No stakeholder has the ability to precisely “forecast” exactly how a
group of customers will respond to a change in rate design
» How one defines “due” and “undue” discrimination is in the eye of
the beholder
» There is a natural tension that exists between the residential
consumer and industrial customer (with commercial businesses in
the middle) when class revenue and rate levels are established
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Gas Utility Rate Design Tends to Evolve Over Time
(an Illustrative Example)
Ratemaking
Trend
Emergence of Natural Gas
The Open-Access Era
The Competitive Era
(1950s to Early 1970s)
(Mid 1980s to Early 1990s)
(Mid 1990s to Early 2000s)
•Declining block rate
design
•Advent of end-user
transportation rates
•Rate base driven rate
cases
•Service and rate
unbundling
•Flexibly-priced rates
•Special contract rates
•Interest in PBR plans
•Fixed price/bill concepts
Industry
Driver(s)
Policy
Rationale
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•Transition from
manufactured gas
•Gas pipelines becoming
open-access carriers
•Competitive pressures
across energy sources
•Building of natural gas
infrastructure
•Competitive wholesale
gas commodity market
•LDC bypass threats
•Encourage gas
consumption
•Facilitate a workably
competitive marketplace
•Protect residential
consumers from price rises
•Provide financial support
to fund expansion
•Promote non-distortional
price signals
•Promote a level playing
field among energy sources
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A Fundamental Consideration Over the Years:
Declining or Inverted Block Rate Structure?
» The declining block rate structure was the predominant rate form in
use during the period of adequate gas supplies (1948 through 1971).
» As natural gas supplies tightened, and curtailment of supplies
became the norm (mid to late 1970s), rate structures were analyzed
with conservation in mind.
» The most common rate forms were marginal cost rates, incremental
cost rates, flat rates, inverted block rates, or lifeline rates.
» Declining or inverted block rates? – depends on how the gas supply
situation is perceived by stakeholders, and how strongly they desire
to influence customer behaviors (encourage or discourage gas use)
through rate design.
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To Borrow From a Popular 1950s Song;
“What a Difference a Day Makes”…
THE “GOOD OLE DAYS”
Robust and stable use per customer
levels were the norm
Wellhead gas prices represented a small
percentage of the burner-tip price of gas to
utilities’ residential customers
Utility rate cases were driven more by
rate base increases rather than by expense
increases
“Normal weather” actually was
experienced in some years
 Customers generally paid their gas bills
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TODAY
Declining use per customer
Purchased gas costs represent upwards
of 70% of the customer’s gas bill
Concern over how the utility will
recover its approved revenue requirement
through rate design
Aging infrastructure and focus on
system reliability
“Warmer-than-normal” weather
conditions are defining new norms
Bad debt expenses increasing as gas
commodity prices increase
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A Changing Ratemaking Perspective in the Energy
Industry
“Then”
Rate Design
“Now”
Pricing
• A static process
• A dynamic process
• Fixed prices
• Flexible prices
• Cost-driven
• Market-driven
• Revenue predictability
• Revenue uncertainty
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In the “Good Ole Days,” We Worried About Things
Like:
» “Should 2 or 3 rate blocks be included in the residential rate
structure?”
» “Should we increase the residential monthly customer charge by
$0.50 or $1.00 per month?”
» “Should we establish rate classes and rate structures by end-use or
by volume?”
» “Do we really need to focus on end-user transportation rates
because customer choice and the existence of third-party gas
marketers are both temporary market conditions?”
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And Today, We Worry About Things Like:
» How do we promote the efficient use of
natural gas through rate design?
» How do we develop rates to minimize the
utility financial and customer billing
impacts of weather variability?
» How do we minimize through rate design
the impact of declining use per customer
on a utility’s financial condition, and on the
stability of customers’ bills?
» How should varying levels of bad debts be
accommodated through rate design?
» How do we recover costs associated with
aging infrastructure and enhanced system
reliability?
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In Recent Times, the Wellhead Price of Gas Has
Surpassed the Price of Transmission and Distribution
Delivery Services
U. S. Natural Gas Price Trends
$14.00
$12.00
Wellhead Price
as a Percent of
Burner-Tip
Price
Price per Mcf
$10.00
$8.00
$6.00
1967 - 15%
$4.00
2005 - 59%
$0.00
2006 - 70%+
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67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
$2.00
Gas Wellhead Price
Residential Delivery Price
Residential Burner-Tip Price
Source: U.S. Energy Information Administration
(weighted average price levels)
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Yet, Both Components Are Equally Important to the
Utility and its Customers for Different Reasons
 Commodity Cost of Gas – most important to end-use customers
because it currently is driving the total price of natural gas and the
relative level of their gas bills
•
It has the greatest impact on the customer’s monthly gas bill
•
It has the greatest influence on the price signal received by
residential customers
 Delivery Margin – most important to gas pipeline companies and
gas distribution utilities because it directly impacts their current
financial performance and ongoing business viability
•
1
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Utilities do not make money from purchased gas costs incurred to
serve their sales customers1
Unless they operate under a gas cost PBR plan
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The “Perfect Storm” is Now Upon Us…
Energy
Market
Conditions
» Unpredictable costs
and sales levels
» Restructured assets
» Increased financial stress
» Increased volatility
» Higher commodity
prices
» Responses to high prices
» Declining gas use
» Bill payment problems
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Regulatory
Roles and
Actions
» Uncertainty
Distribution
Utilities
End-Use
Customer
Characteristics
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» Changing roles
» Tough issues to balance
Some Threshold Regulatory Considerations
» What constitutes a customer’s “efficient use of natural gas?”
» How do you define for a gas utility:
1. “A reasonable opportunity to earn its allowed rate of return?”
2. “Its normal risks of doing business?”
» Which costs and/or business factors for a utility are considered
uncontrollable, unpredictable, material, and recurring? - and should
they be treated differently for rate design purposes?
» What does it mean to achieve a reasonable level of rate equity
among a utility’s customer groups?
»
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Should utilities be rewarded for “superior performance?”
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However, There is No Clear Consensus Among Utility
Executives and Regulators on What is Most Important
The Most Important Objectives for a Utility Regulator to Achieve (Greatest Difference)
Utility
40%
40%
Regulator
20%
60%
40%
Promoting innovative utility ratemaking solutions .
Utility
33%
Regulator
40%
50%
27%
33%
17%
Promoting the efficient use of energy by a utility's customers.
Utility
33%
27%
Regulator
40%
67%
33%
Promoting energy solutions that are beneficial to society
Utility
Regulator
7%
40%
53%
67%
Minimizing the level of utility rates to consumers.
17%
Most/More Important
Source: 2005 Navigant Consulting Utility Regulatory Survey
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Important
16%
Least/Less Important
No Clear Consensus … (continued)
The Most Important Objectives for a Utility to Achieve (Greatest Difference)
Utility
33%
27%
Regulator
40%
60%
40%
0%
Framing the regulatory rules of the game for a competitive energy marketplace
Utility
20%
Regulator
54%
26%
40%
40%
20%
Achieving less regulation - not more.
Utility
20%
40%
Regulator
40%
50%
25%
25%
Promoting the efficient use of energy by a utility's customers.
Utility
Regulator
7%
53%
40%
40%
60%
0%
Achieving a reasonable level of rate equity among its customer groups.
Most/More Important
Source: 2005 Navigant Consulting Utility Regulatory Survey
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Important
Least/Less Important
The Utility Rate Design Process: Balance is Essential
» Historical Factors
» Economic Factors
− Cost of service
− Rate perspective
− Value of service
− Rate continuity
» Social and Political Factors
− Competitor prices
− Price differences and discrimination
− Customer reaction and acceptance
− System load equalization
− Public relations aspects
− Availability of gas supply/capacity
− Economic conditions of
− Return and revenue stability
» Regulatory Factors
− Precedent
− Intervenor interests
service territory
− Social obligations to particular
customer groups
− Political attention and involvement
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For Many Utilities, Their Major Business Drivers
Have Prompted the Filing of General Rate Cases…
1. Unstable margins – leading to earnings stress
2. Uncontrollable and unpredictable costs
3. Declining use per customer
4. Challenges to achieving growth
5. A “Back to Basics” business strategy
6. Regulatory lag (process can be slow, costly, inefficient)
7. Aging infrastructure and focus on system reliability
8. Regulatory uncertainty
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Many Innovative Ratemaking Mechanisms are Being
Proposed by Utilities in Rate Cases to Address Their
Specific Business Challenges.
1. Straight Fixed-Variable Rate Design
2. Revenue Decoupling Mechanisms
3. Bad Debt Recovery Mechanisms
4. Infrastructure Replacement Cost Recovery Mechanisms
5. Revenue (Return) Stabilization Mechanisms
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In Addition, the Static Nature of a “Test Year” is Being
Challenged Through Utility Rate Design Initiatives in
These Rate Cases.
Key Assumptions in the Use of a Test Year:
» A test year represents a snapshot in time that attempts to reflect a
level of plant and expenses comprising a utility’s total revenue
requirement – which will be representative of the period the new
rates will be in effect.
» Use of a test year assumes that the utility’s costs in a future period
can be reasonably represented by its historical costs (often with
known and measurable changes) – which means such costs are
assumed to be predictable, stable, and controllable.
» In today’s highly volatile and unpredictable cost and energy usage
environment, are these still realistic assumptions?
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When Does it Make Sense to Utilize an Automatic
Adjustment Mechanism?
An automatic adjustment mechanism should be considered as an
appropriate cost recovery method when they address costs and/or
business factors (e.g., weather, gas usage) that are:
• Uncontrollable by the utility.
• Variable and Unpredictable.
• Material and of a Recurring nature.
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Examples of Automatic Adjustment Mechanisms
»
Purchased gas adjustment (PGAs)
» Weather normalization
»
Revenue decoupling
»
Bad debt/uncollectible expense
»
Environmental costs
» Property taxes
»
Infrastructure cost recovery (capital and O&M)
−
Infrastructure improvement
−
Pipeline integrity (mandated safety programs)
−
Public improvement projects
»
Energy efficiency/DSM costs
»
Stranded restructuring costs
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Why all the interest in the concept of revenue
decoupling for gas utilities?
Customers’
Energy
Consumption
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Utility’s
Earnings
(Revenues)
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Energy Efficiency and Conservation Can Provide
Relief for Customers From High Natural Gas Prices…
There is a renewed focus by utilities on promoting cost-effective energy
efficiency measures to relieve consumer burdens.
» Typical programs include:
 Audit – analysis of conservation opportunities
 Retrofit/replacement (rebates) – weatherization, programmable
thermostats, efficient equipment replacement
 New construction – new buildings and expansions
» These programs make sense for customer, economic, and public
policy reasons, provided that utility financial impacts are
addressed:
 Lost revenue recovery
 Contemporaneous recovery of program costs
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Decoupling Can Align Stakeholders’ Diverse Interests
» A properly designed decoupling mechanism can achieve significant
benefits for the utility and its customers:
1. Mitigates the utility’s disincentives to promote energy efficiency;
2. Removes the relationship between the utility’s sales volume
levels and profits (margin revenues); and
3. Provides increased opportunities to customers to reduce energy
consumption, and to reduce energy bills, created by the various
energy efficiency and conservation initiatives supported by the
utility.
4. Customers’ bills will more accurately reflect the margin recovery
amounts approved by the regulator.
5. Improves the ability of the utility to recover its fixed costs of
providing service.
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Bad Debt Recovery Mechanisms
» An alternative to recovery as a fixed expense in base rates set in a
rate case
» The tracker permits recovery of actual bad debt expense through a
deferral account - periodically is “zeroed out” through the
application of surcharges or credits to base rates.
» Recognizes the uncontrollable/unpredictable nature of such costs
and close correlation with changes in the price of natural gas
» In some states, base rates reflect a “baseline” level of bad debt
expense, with variations from baseline used to adjust rate
» Others permit separate treatment of gas commodity-related bad
debt expense through its Purchased Gas Adjustment (“PGA”)
mechanism
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Infrastructure Replacement Cost Recovery
Mechanisms
» An alternative to recovery as a fixed expense in base rates set in a
rate case, or through deferred accounting treatment.
» Reflects costs mandated under:
(1) the Pipeline Safety Improvement Act (“PSIA”) of 2002;
(2) public improvement projects; or
(3) accelerated pipe replacement programs.
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Revenue (Return) Stabilization Mechanisms
» A form of Performance-Based Ratemaking (“PBR”) – periodic rate
adjustments are made based on a comparison of achieved vs.
approved rate of return, without the need for a full rate case
» Some of the mechanisms are based on an “earnings sharing”
approach – utility and customers share any increase or decrease in
achieved earnings relative to a target earnings level
» Approved in Alabama, Louisiana, Mississippi, South Carolina
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Is the Utility Ratemaking Paradigm Shifting?
YES!
 There is an increased recognition of the uncontrollability, variability,
and unpredictability of a utility’s costs, and its customers’ usage
levels
 An increased awareness that a much more dynamic process is
needed to ensure a utility’s rates will actually recover the regulatorapproved cost of service – the static nature of a “test year” is being
challenged.
 Increased recognition that the majority of a utility’s costs are fixed,
yet they are recovered through the volumetric component of its rate
structure – which creates financial instability.
 A desire to streamline the regulatory process by reducing the
number of general rate cases.
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Paradigm Shifting (continued)
 Innovative ratemaking mechanisms will appear more frequently in
utility rate case filings because they:
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−
Address important financial customer needs;
−
Provide significant benefits to the utility and its customers; and
−
Streamline the rate case process.
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For further information, contact:
Russell A. Feingold | Managing Director
rfeingold@navigantconsulting.com
412.454.4151 direct
412.596.4987 mobile
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