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ECONOMIC FUNDAMENTALS Geoff Marke, Chief Economist Missouri Office of the Public Counsel Utility Revenue Requirement

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Page 1: Rate Design: Inclining Block Ratesipu.msu.edu/wp-content/uploads/2019/08/Economic... · • Historic + Normalized + Annualized + Pro‐Forma Test Year ‐see previous and pro‐forma

ECONOMIC FUNDAMENTALS

Geoff Marke, Chief EconomistMissouri Office of the Public Counsel

Utility Revenue Requirement

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About your speaker

Geoff Marke, Chief Economist, Missouri Office of the Public Counsel (“OPC”)• Consumer Advocate Office for ratepayers in:

– Vertically Integrated Electric, Natural Gas, Water and Sewer cases before the Missouri Public Service Commission

• Obligatory Disclaimer: – The comments and work product are my own

and do not necessarily reflect any position of the Missouri OPC.

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ON CONSUMER ADVOCATES

“What have the Roman’s ever done for us?”

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Course Objectives• Audience should:

– Become more comfortable with the fundamental economic underpinnings of utility regulation

– Obtain a basic understanding of the component parts of a utility’s revenue requirement and the various ways it is calculated and processed, both under a traditional rate case and through alternative mechanisms

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MARKETS & NATURAL MONOPOLIES

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Competitive Markets

• Many buyers and sellers

• Easy entry and exit

• Transparent information

• Absence of price control

• Creative Destruction*

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Walmart CEO Doug McMillon

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Mortality Rate?

• “It doesn’t matter if you’re selling bananas, airplanes, or whatever—the mortality rate is the same. Though the number, of course, varies from firm to firm, the team estimated that the typical company lasts about ten yearsbefore it’s bought out, merges, or gets liquidated.”

How long do firms live? Finding patterns of company mortality in market data, Daepp, MIG, et al (2015)

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How are utilities different?

• Natural Monopoly

• Essential Services

• Captive customers

• Regulated

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• For utilities, the state supplies the regulatory risk in the absence of market risk—it’s a proxy for the market

• Utilities that operate under rate-of-return regulation have low business risk because of the strength of the regulatory compact.

• Utilities operating under the compact are not supposed to be shielded from all economic or business risks nor denied the rewards that come with effective risk management

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Regulatory Compact• Investors provide capital

to maintain or expand the utility system

• Regulators allow utilities to recover their prudent costs and the opportunity earn a reasonable return

• Utilities provide safe and reliable services, exclusive franchise (monopoly) and captive customer base

• Ratepayers get the assets dedicated to them for their useful life

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• The “central, continuing responsibility of legislatures and regulatory commissions” is “finding the best possible mix of inevitably imperfect regulation and inevitably imperfect competition.”

Economist, Alfred Kahn

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Law of the Conservation of Evil

• “The total amount of evil in any system remains constant. Hence, any diminution in one direction - for instance, a reduction in poverty or unemployment -is accompanied by an increase in another, e.g., crime or air pollution. ”

Economist, Charles Issawi

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Utility Mortality Rate?

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THEORY & PERSPECTIVES

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Theoretical Perspective(s)• To correct “market failure” in order to serve

the “public interest” and provide “just and reasonable” rates

• Public Interest Theory: Regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices.

• Public Choice Theory: Regulation is supplied in response to the demands of interest groups struggling among themselves to maximize the incomes of their members.

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• Positive statementsare objective statements that can be tested, amended or rejected by referring to the available evidence.

• Normative Statementsexpresses a value judgment about whether a situation is desirable or undesirable. It looks at the world as it "should" be.

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Fox-Hedgehog Metaphor

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Balanced Regulatory Thinking

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The Feedback Loop

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How do utilities make money?

Sell product Build assets

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RATE CASE: PROCESS, RULES & TOOLS FOR ASSESSING THE REVENUE REQUIREMENT

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Rate Case Process

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General Rate Case Process

• Essentially concerns two parts:

• Revenue Requirement (How big of a pie?) – Uniform System of Accounts (“USOA”)

• Rate Design (How to slice it up the pieces?)– NARUC Cost Allocation

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Process Continued…

• New rates are generally implemented on a going-forward basis (not retroactive ratemaking)

• Interim rates? – Depends on Jurisdiction

• Is the net operating income inadequate?– Rate increase

• Is the net operating income too high?– Rate decrease* (Complaint Case)

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FERC Uniform System of Accounts (“USOA”)

• Accounting standards used to provide uniformity and consistency in reporting financial information.

• Accuracy, reliability, comparability

• Clear, concise, consistent, detailed financial and operations information

• Verifiable and auditable by a third party

• Understood by lenders, investors, taxpayers, and others

• Utilities need accounts specifically crafted for the purpose of ratemaking (as opposed to taxation or SEC reporting)

• Ratebase consists primarily of the utility’s investment in plant facilities

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Test Year & Regulatory Lag

• “It’s like déjà vu all over again.”Yogi Berra

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Rate Case Test Year

• Snapshot of time to measure the revenue requirement. A baseline

• 12 months

• Designed to ensure rates are based on the costs expected during the period rates are in effect.

• Matching revenues to required costs: Matching Principle

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3 Flavors of Test Years

• Historical: recent 12 months, focus on utility accounting records

• Future (Forecast): forecasted 12 months of costs, focus on utility budget

• Hybrid: both

• Each represents different assumptions about the costs and revenues in future rates.

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Adjustments to Test Year• Need to adjust for known and measurable conditions

expected during the period the rates are in effect

• Normalization – adjust test year data for abnormal conditions (e.g., weather)

• Annualization – extend over the period, or eliminate from the period, events that had partial effects and are either recurring or have terminated (e.g., new labor contract)

• Pro-Forma – what might happen – update to revenue requirement cost categories based on known and measurable changes—during the rate case procedure.

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• Historical Test Year ‐ a 12‐month period in which actual costs are known (based on per book amounts) and contained in the utility’s accounting records.

• Normalized + Historic Test Year ‐ see above but records are normalized for weather or other non‐recurring expenses.

• Historic + Normalized + Annualized Test Year ‐ see above and other costs are annualized for changes in costs that occurred in the historic period that result in higher or lower costs when applied over a full 12‐month period.

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• Historic + Normalized + Annualized + Pro‐Forma Test Year ‐ see previous and pro‐forma adjustments for changes that have occurred after the end of the test year.

• Hybrid Test Year ‐ a 12‐month period of which a part is actual and part is forecast that may or may not be subject to a full true‐up during the rate case process.

• Forecasted Test Year ‐ a 12‐month period that is fully forecasted at the time the utility’s ratecase is filed. In some forecast test years the forecast may be for the actual Rate Year period, whereas in other cases the forecast is at least partially known and measurable before the Rate Year occurs.

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Matching Principle• A fundamental concept of accrual basis

accounting, which provides that in measuring net income for an accounting period, the costs incurred in that period should be matched against the revenue generated in the same period.

• Such matching creates consistency in income statements and balance sheets by preventing distortions of financial statements which present an unfair representation of the financial position of the business.

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Regulatory Lag

• In its simplest form, regulatory lag is the time between the incurrence of a cost by the utility and when those costs are recovered in rates.

• As a result, the amount of regulatory lag that a utility experiences is impacted by how the test year is defined in the utility’s rate case and the timing of regulatory decisions in those rate cases.

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Illustrative Example

More on this later

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GENERAL RATE CASE PROCESS:REVENUE REQUIREMENT

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General Rate Case Process:Revenue Requirement

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What is the revenue requirement?

• The utility’s revenue requirement represents the total amount of money a utility must collect from customers to pay all costs including a reasonable return on investment

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Jurisdictional Costs and Revenues

• Need to identify the revenues and costs specifically related to the jurisdiction and service for which are setting rates. For example, the utility may:

• Operate in more than one state;

• Have both wholesale (FERC) and retail (state) operations;

• Provide more than one service (gas & electric); and

• Have non-regulated operations

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Revenue Requirement Formula

• RR = (RB)R + OC + T + D • RR is the revenue requirement, the total amount of

money a regulator allows a utility to collect from customers.

• OC is operating costs• T is taxes, state and federal • D is the utility's depreciation expense • RB is rate base, the gross investment – accumulated

deprecation • R is the rate of return a utility is allowed to earn on its

rate base

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Revenue Requirement Formula

• RR = (RB)R OC + T + D

[Rate Base x Rate of Return]

+ operating expense

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Investor Example

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Rule of Thumb

• Rates are set based on what will be reflective of the utility’s financial operations in the future

• Adjustments generally not more that one year out of the test year

• Known, measurable, quantifiable or contracted

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“OC”Operating Costs

• Not capital investments

• Wages, supplies, maintenance, fuel (fuel clause?), must be recouped if the utility is to stay operational.

• Operating costs are most often the largest component of the revenue requirement, and the easiest to determine.

– 1.) which items should be allowed for expense– 2.) what is the value of those items (utility

management judgement)

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Above or Below the Line?• Lobbying?

• Advertisements?

• Rate case expense?

• Customer surveys?

• Charitable Contributions?

• Homeowner Insurance revenue?

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“D”Depreciation Expense

• “The Return of”

• Accounts for “using up” of capital assets used to provide utility service through wear & tear

• May be thought of as compensation to capital investors for use of capital assets.

• Depreciation expense is designed to be recovered incrementally over the assets service life.

• Only charge customers for assets that are used to provide them service. Today’s customers should pay for today’s plant (not tomorrow’s or yesterday’s)

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Depreciation: How quickly to recover?

• Too much– Higher rates, increased cash flow and a

reduction in the utility’s return on investment as rate base is smaller.

• Too little– Lower rates, decreased cash flow, greater return

on the utility’s investment as rate base is bigger

• In theory – pretty straightforward• In practice – a moving target • Use of “mortality curves” to make

reasonable projections

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“T”Taxes

• Revenue requirement needs to be adjusted for taxes expected to be due

• Include federal, state and local income taxes, and taxes on property, payroll, franchise, excise and sales.

• Example: Missouri Wind• Property Tax: generation asset • Payment in lieu of taxes (“PILOT”): booked

as “taxes other than income”

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“RB”Rate Base

(gross investment – accumulated depreciation)

• “It’s all about the bass.”Meghan Trainor

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“RB”Rate Base (+ Gross Investments)

• Gross Investments include:– Plant in Service: land, infrastructure used to provide

service in test year – most important rate-base item

– Plant for future use: property acquired for future use

– Construction Work in Progress (CWIP): Depends on jurisdiction (“used and useful, "see also “AFUDC”)

– Cash Working Capital: Cash Working Capital is the amount of cash necessary for a utility to pay the day-to-day expenses incurred to provide utility services to its customers. Cash from customers (reduction in rate base) or shareholders (increase in rate base).

– Prepayments: also working capital: payments made in advance to the period they apply—prepaid rents, insurance…

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CWIP vs AFUDC

• Construction Work In Progress– usually not in because “used and useful”

• Allowance for Funds Used During Construction– Deferral accounting – regulatory asset – Represents accrued financing charges

associated with CWIP, but is not included in rate base yet.

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CWIP vs AFUDC

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“RB” Rate Base

(-accumulated deprecation and deferred taxes)

• Accumulated Deprecation – The total amount of plant’s costs allocated to deprecation

expense since the asset has been in service. – Net salvage, proceeds from the retirement of an asset less

costs of removal

• Accumulated Deferred Income Taxes (“ADIT”) – Taxes deferred as a result of revenues and expenses being

recognized in different periods for book and tax purposes

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What’s the difference between Depreciation Expense and Accumulated Depreciation?

• Depreciation Expense: value of the capital “used up” during test year – Increases the revenue requirement

• Accumulated Depreciation: value of the capital “used up” in prior years– Decreases the revenue requirement – A reduction in rate base (gross investment –

accumulated depreciation)

• RR = (RB)R OC + T + D

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Rate Base for:

• Vertically Integrated Electric Utilities:– Generation, transmission, distribution

• Deregulated Electric Utilities: – Minus generation

• Gas Utilities:– Pipes and mains, meters, (gas storage?)

• Water Utilities: – Pipes and mains, water treatment plants, meters,

hydrants

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But wait there’s more

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What aboutRegulatory Assets/Liabilities?

• Deferral Accounting for the Uniform System Of Accounts (“USOA”)

• Regulator authorizes the deferral, to a future period, of a given expense that would normally be recorded on the Company’s income statement during the present period.

• Accounting standards = prospect of recovery is probable (likely) but not guaranteed.

• Extraordinary, Material, Unusual and Unique and Non-Recurring

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Possible Examples of Regulatory Assets/Liabilities

• Environmental Costs• Decommissioning Costs• Extraordinary Repair and Maintenance

Costs• Y2K• Income Tax • Other…

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• Regulatory assets are not necessarily general physical plant assets which is an example of why taking the value of the company’s net plant as a proxy for rate base can be wrong.

• Operating capital, storm damage, conservation programs, other “regulatory assets” all go into rate base

• The un-amortized portion earns the rate of return.

• Utilities typically prefer long amortization and deprecation periods—because they borrow money at low rates and invest in high return capital projects

• See also Averch Johnson effect: excessive capital accumulation under rate of return regulation (aka, gold plating)

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“R”Rate of Return

• Represents the amount allowed to be earned, expressed as a percentage of the utility’s rate base

• The result of a weighted-average cost of capital calculation (WACC); includes the cost of debt and cost of equity.

• Debt: Capital borrowed from investors and upon which interest is owned.

– Can be gleaned by reviewing the stated cost rates for each particular debt issue. Contractual necessity – not controversial

• Equity: capital obtained by selling shares of ownership of the Company; instead of interest, shareholders may receive dividends and (upon sale of stock) capital gains.

– No stated return for common equity. – controversial, because its costs cannot be measured definitively.

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• The applicable rule of law prohibits a rate of return that provides earnings that are inadequate and therefore confiscatory, and it assures an opportunity to earn a fair return.

• However, utilities are not assured that a fair return will be realized

• If revenues received actually produce a satisfactory net operating income to meet the cost of debt and provide a fair return on equity capital, then the regulatory process worked!

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Supreme Court on Rate of Return

• The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money necessary for the proper discharge of its public duties.

– Bluefield water Works & Improvement Company Vs. Public Service Commission of West Virginia, 262 U.S. 67 L.ed. 1182-3, 1923

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Cost of Capital & Capital Structure

• “Hey, must be the money.”Nelly

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So, why is Capital Structure important?

• Cap Structure used to calculate WACC

• Although Commission allowed ROE gets most of the attention, equity ratios can have as large an impact on revenue requirement.

• Cost of capital consistent with investment grade

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Cost of Capital and Capital Structure

• Utilities use various sources of funding to finance rate base:– Short term debt– Long term debt– Common equity

• Common stock issuances• Retained earnings

– Hybrid securities such as preferred stock– Capital structure is the proportion of each

source of funding used to support the utility’s rate base

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Debt Vs Equity• First, debt and equity investors face different risks

• Debt is generally cheaper (compared to the common equity in the same company) and less risky, because it ranks higher than equity in the event of a bankruptcy

• Interest is paid prior to dividend payments

• Interest expense is tax deductible (dividend payments are not)

• Generally interest expense on debt is fixed (exception might be non-investment grade utilities)

• Company’s total risk profile will determine its cost of debt and equity capital. Measuring risks:

– Fixed income investments – bond ratings– Equity Investments – Beta

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If debt is less expensive than equity, why use equity to finance

rate base?• Proportion of debt is limited

• Utility’s financial risk will increase (can’t support all debt)

• Leads to increase financial risk where the utility could not issue further debt

• Provides financing flexibility needed for capital intensive projects

• Need equity to maintain credit ratings

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Return On Equity (“ROE”)

• Should be primarily based on the return the utility would have to pay shareholders to incentivize them to purchase stock; (i.e., capital attraction)

• Three factors to consider:– 1.) the rate shareholders could at least maintain if

they put their money elsewhere (opportunity cost)

– 2.) the relative financial risk of the utility’s stock (e.g., as indicated by debt/equity ratio)

– 3.) The leniency of the commission in other matters (low rate base valuation can be off-set by higher rate of return).

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So… Return on Equity• Parties can agree to disagree … and they do.

2019 Results

• Electric 9.73 to 9.57 ROE• Gas 9.55 ROE

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Does rate of return regulation operate efficiently?

• Remember Regulatory lag?

– The time between a change in utility costs or revenues (+ or -) and a change in authorized rates through a rate case

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• It is designed to reward utilities for efficient management of costs between rate cases, because the utility can keep the higher earnings for a time

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Regulatory Lag

• Freezing rate for the period of the lag imposes penalties for inefficiency, excessive conservativism, and wrong guesses, and offers rewards for their opposites; companies can for a time keep the higher profits they reap from a superior performance and have to suffer the losses from a poor one.

Economist, Alfred Kahn

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Works really well when

• There is more certainty in: – Demand of service – Costs – Technology

• So, is regulatory lag effective as conditions change?

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Are utilities revenue requirements growing?

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CapEx Highlights• Tax code changes

• Upgrades to everything… see also “smart”

• 2018 energy utility capex totaled $115.4 billion – all time high and 8% above 2017

• American Water = 55% of the sector’s capex, experienced a year-over-year growth of 10.6%

• Natural Gas – ongoing expansion (new customers) and replacement (safety)

• 2019 Renewable forecast = $19 billion

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Energy utility actual & estimated capital expenditures (CapEx) ($B)

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CapEx by Business Category 2019-2021E

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CapEx to Depreciation & Amortization

• When utility capital expenditures outpace depreciation, the general implication is the utility is growing its rate base.

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Have customers seen a lot of rate cases and rate increases

recently?

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Utility authorized base rate increases and rate case count

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What is driving the decline?

• Increased use of single-issue rate mechanisms

• Increase in customer surcharges and costs outside of a rate case—above and beyond base rates

• Surcharges were historically rare – fuel adjustment clauses

• Does this result in a shift in risk profile?

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Examples of Surcharges

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Single-Issue Ratemaking

• Mechanisms for specific costs and investments arguably go against the ideal that regulators should look at the utility holistically for its financial needs.

• Can reduce regulatory lag

• Usually on an expedited basis, true-up(s)

• Prudency Reviews

• Opportunity Costs

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% of Adjustment Clauses

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Alternative Regulation

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“Alternative” Regulatory Plans

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• Formula-based rates: • Rates adjusted automatically if the company earns a

return that is outside of an authorized range.

• May allow for automatic rate adjustments based upon changes in an inflation measure such as the Consumer Price Index or Gross Domestic Product Price Index, less a productivity offset.

• Rate freeze/cap plans/multi-year plans: • Moratoriums from authorizing base rate adjustments

prior to a predetermined date. • Plans may not specify any earnings restrictions, and any

achieved cost savings may be retained by the company. • Plans may include multi-year rate plans, which allow a

utility to implement a predetermined annual rate change over the course of the plan.

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“Can Regulation and Competition Coexist?”

• “Early in the course of the public debate in California over the proposal of its PUC to open the market to competition . . . Dedicated environmentalists began to express views ranging from ambivalence to opposition:

• “Wait a minute!” they interject; I’m all in favor of competition, but competition isn’t an end to itself. Who’s going to promote the electric car?”

• Whenever I hear someone start out that way, I reach for my wallet, to make sure it’s still there…

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• It may of course be politically easier to accomplish those worthy social purposes by regulators making the utility companies undertake the good works while passing the costs onto ratepayers.

• It is also, however, profoundly anti-democratic and potentially inefficient—that is to say, injurious to consumers.

• Economic welfare is not a goal to be lightly dismissed, as is all too often by well-educated, well-to-do interveners in regulatory proceedings.

Economist, Alfred Kahn

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Value Added Services?

• EV Charging infrastructure? • Rooftop Solar? • Green Tariffs? • Community Solar? • Smart Home Platform? • Home Security? • Insurance policies?

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Questions?

Geoff MarkeMissouri Office of the Public Counsel

[email protected](573) 751-5563