Infrastructure and Rate Structure:
Lessening the Shock
Presented to:
2012 NASUCA Annual Meeting
Baltimore, MD
Presented by:
A. Lawrence Kolbe
Philip Q Hanser
Bin Zhou
November 12, 2012
Copyright © 2012 The Brattle Group, Inc.
www.brattle.com
Antitrust/Competition Commercial Damages Environmental Litigation and Regulation Forensic Economics Intellectual Property International Arbitration
International Trade Product Liability Regulatory Finance and Accounting Risk Management Securities Tax Utility Regulatory Policy and Ratemaking Valuation
Electric Power Financial Institutions Natural Gas Petroleum Pharmaceuticals, Medical Devices, and Biotechnology Telecommunications and Media Transportation
Challenges Facing Utilities and Ratepayers
The utility industry’s infrastructure and environmental
compliance investment needs are enormous.
Forecast of Electricity Utility Investments
Base Case:
No Carbon Policy
Upper Case:
with Carbon Policy
Capital Investment in $ Billions (2010 - 2030)
Generation
Transmission
AMI and EE/DR*
Distribution
Total
505
298
85
582
1,470
951
298
192
582
2,023
* Advanced Metering Infrastructure, Energy Efficiency / Demand Response Programs
Source: Brattle Report "Transforming America's Power Industry:
The Investment Challenge 2010-2030," Table 1.
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Slow Growth in Electricity Demand
At the same time, electricity demand (and utility revenues) is
expected to grow slowly:
“U.S. Electricity Use Is Expected To Grow Slowly
… electricity demand growth has slowed progressively by
decade since 1950, from 9% per year in the 1950s to less than
2.5% per year in the 1990s. Electricity demand grows by 0.8%
per year through 2035.” (EIA)
The combination of investment requirements and slowed growth
in electric demand can potentially lead to rate shocks.
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A Unique Moment?
Interest rates are at historic lows as is inflation in short-run.
U.S. Treasury Rates and Inflation Rates in the Last 3 Decades
30.0%
Inflation Rate
10-Year Treasury Rate
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
1980-01
1985-01
1990-01
1995-01
2000-01
2005-01
2010-01
Source: Federal Reserves (Treasury Rates) and Bureau of Labor Statistics (Inflation).
Source: Federal Reserve Bank of Cleveland, “Estimates of
Inflation Expectations.”
These conditions make investing now very attractive.
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Traditional Ratemaking Contributes to Rate Shocks
Standard ratemaking based on depreciated original cost (OC)
leads to front-end loaded rates.
Rate Base and Capital Charges under Standard Ratemaking
($1,000 Asset, 20-Year Straight-line Depreciation, 9% Nominal Cost of Capital)
Remaining Rate Base
Annual Capital Charges
1,200
180
1,000
150
800
120
600
90
400
60
OC
200
OC
30
0
0
1
3
5
7
9
11
13
15
17
19
21
1
5
3
5
7
9
11
13
15
17
19
Alternative Ratemaking Can Reduce This Problem
Rate Base and Capital Charge under Alternative Ratemaking Methodologies
($1,000 Asset, 20-Year Straight-line Depreciation, 9% Nominal and 7% Real Cost of Capital)
Remaining Rate Base
Annual Capital Charges
180
1,200
Levelized Rate
150
1,000
Levelized Rate
120
800
TOC
600
400
TOC
90
60
OC
200
OC
30
0
0
1
3
5
7
9
11
13
15
17
19
21
1
3
5
7
9
11
13
15
17
19
• Trended original cost (TOC): delays inflationary portion of the rate of return;
• Level real rate (shown above): level total recovery in real terms (but rising in nominal);
• Level nominal rate (not shown): level total recovery in nominal terms.
In addition, these rates are more consistent with prices in competitive markets.
6
Levelized Rates Widely Used Outside Electric Utilities
TOC or levelized (real or nominal) rates have been adopted in FERC-regulated
industries:
• TOC first adopted by FERC in the 1980s for oil pipelines, but just for equity;
• Increasingly used in gas pipelines and electric transmission;
• Many technical/implementation details have been resolved in FERC proceedings.
Comparison of Capital Recovery Rate
12.0%
Alliance
Depreciation Rate
10.0%
Kern River
25-year Straight Line
8.0%
6.0%
4.0%
2.0%
0.0%
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Levelized rates are also widely used in independent power purchase contracts and
renewable contracts.
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Impact of Levelized Rates v. Other Mechanisms
Allowing construction work in progress (CWIP) in the rate base offers short-term
funding relief over the construction period, but could still lead to rate shocks:
♦ CWIP in rate base: the return on
investment during construction is
directly recovered in current rates
rather than capitalized and
deferred for future recovery;
♦ Pre-funding of construction costs
serves similar purposes.
Levelized rates can be used in combination with CWIP to further spread the capital
cost recovery over the life of the asset’s service period.
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Investor Risks and Utility Financing Challenges
While alleviating rate shocks, levelized rates and TOC delay
capital recovery.
♦ Investors will want compensation for the increases in risks.
• Regulatory risk aside, investors require higher rates of return for
longer-maturity investments.
♦ Utilities will view these approaches as raising their financing
challenges and regulatory risk.
• Multiple tranches of debt with different maturities may be required to
match the project cash flows.
• Utilities debt/equity ratio may have to be decreased.
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Remedies for Investor Risks / Financing Challenges
Mechanisms to reduce regulatory risks.
♦ Establish regulatory processes and procedures to measure
capital recovery:
• Reinvested Earnings Account (akin to regulatory asset accounts in
accounting).
♦ Legislation may be needed that strengthens the
commitment to long-term recovery of the capital investment.
Credit rating agencies recognize explicitly the regulatory
commitment in evaluating a utility’s credit worthiness.
♦ A positive feedback between regulatory environment and
credit ratings may lower the cost of debt and, ultimately,
rates.
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Conclusions
Huge investments for utility infrastructure and environmental
compliance are needed.
♦ Financing costs are at record lows.
♦ Traditional ratemaking front-end loads investment costs,
aggravating the problem of rate shock.
Levelized and TOC rates can reduce the rate impacts.
♦ Widely adopted in other energy industries.
♦ Increased risk to investors and utilities must be addressed
for these approaches to work.
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Additional Readings
Myers, S.C., A.L. Kolbe, and W.B. Tye, “Regulation and Capital Formation in the Oil
Pipeline Industry,” Transportation Journal, Vol. 23, No. 4 (Summer, 1984), pp.
25-49.
Myers, S.C., A.L. Kolbe, and W.B. Tye, “Inflation and Rate of Return Regulation,”
Research in Transportation Regulation, Vol. 2 (1985), pp. 83-119.
Tye, W.B., and A.L. Kolbe, “Optimal Time Structures for Regulated Industries,”
Transportation Practitioners Journal, Vol.59, No. 2 (Winter, 1992), pp. 176-196.
Graves, F., P.Q. Hanser, and G. Basheda, “Rate Shock Mitigation,” Edison Electric
Institute, June 2007.
Hanser, P.Q., M. Celebi, and B. Zhou, “State Regulatory Hurdles to Utility
Environmental Compliance,” The Electricity Journal, April 2012.
Kolbe, A.L., P.Q. Hanser, and B. Zhou, “Infrastructure and Rate Structure: Lessening
the Shock,” The Brattle Group working paper (forthcoming).
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Speaker
Speaker Bio
Bioand
andContact
ContactInformation
Information
Insert
corporate
headshot
here.
Philip Q Hanser
Principal
Cambridge, MA
Phil@brattle.com
Phone: (617) 864-7900
Fax: (617) 864-1576
Mr. Hanser assists clients in issues ranging from utility industry structure and market power and associated regulatory
questions, to specific operational and strategic issues, such as transmission pricing, generation planning, and tariff
strategies. He also has expertise in fuels procurement, environmental issues, forecasting, marketing and demand-side
management, and other complex management and financial matters.
Over his thirty years in the industry, Mr. Hanser has appeared as an expert witness before the Federal Energy Regulatory
Commission (FERC), many U.S. and Canadian public utility and siting commissions, before arbitration panels, and in
federal and state courts. He served six years on the American Statistical Association’s Advisory Committee to the
Energy Information Administration (EIA).
Prior to joining The Brattle Group, Mr. Hanser held teaching positions at the University of the Pacific, University of
California at Davis, and Columbia University, and served as a guest lecturer at the Massachusetts Institute of
Technology, Stanford University, and the University of Chicago. He is currently a Senior Associate, Mossavar-Rahmani
Center for Business and Government, Harvard Kennedy School. He has also served as the manager of the Demand-Side
Management Program at the Electric Power Research Institute (EPRI). He has been published widely in leading industry
and economic journals.
The views expressed in this presentation are strictly those of the presenter(s) and do not necessarily state or reflect the views of The Brattle Group, Inc.
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