“TEEING OFF” OUR DISCUSSION ON RETHINKING NATURAL GAS UTILITY RATE DESIGN

1. “TEEING OFF” OUR DISCUSSION ON RETHINKING NATURAL GAS UTILITY RATE DESIGN Ken Costello Senior Institute Economist AGF/NARUC sponsored Executive Forum at Ohio State University Columbus, Ohio May 23, 2006 The National Regulatory Research Institute

2. Three Key Features of the Forum • “Rethinking” • “Rate Design” • “Natural Gas” May 23, 2006

3. The Meaning of Rate Design • The third and last stage of ratemaking • Involves determining how a utility will recover its revenues in line with (1) a pre-determined revenue requirement and (2) cost allocation to different classes of customers and services • Specifies how utility services are priced • Four examples – SFV, declining block rate structure, inverted rates, seasonal rates May 23, 2006

4. Why Rate Design Is Important • Helps to achieve important regulatory/social objectives, which prominently include the financial viability of utilities and the efficient use of natural gas • Rate design is imperative for promoting economic efficiency (for example, in providing correct incentives for consumer behavior) • As many economists would say, if you price a commodity or service solely on the basis of marginal-cost principles, many of the problems would go away; but few others, including regulators, would agree May 23, 2006

5. Why Rate Design Is Important -- continued • Serious consequences from poor rate design – major ones include • “Wasteful” consumption • Excessive/deficient utility earnings • Uneconomic bypass • Inequity • Undue price discrimination May 23, 2006

6. Why Rate Design Is Important -- continued • This is recognized by both utilities and regulators, although they may disagree not only over • What is good and bad rate design, but also • The gravity of adverse outcomes May 23, 2006

7. Two-Part Tariffs: The Foundation for Rate Design • Basic Structure: TBi = F + pqi, • Where the total bill for customer i (TBi)equals the sum of the customer charge (F) and the volumetric charge (p) times the amount of gas consumed (qi) • Non-linear in the sense that average expenditure per unit consumed (TBi/qi) falls as qiincreases • Can do much better from an efficiency perspective with two-part tariffs than with second-best Ramsey linear pricing May 23, 2006

8. Two-Part Tariffs-- continued • Basic Structure: TBi = F + pqi-- continued • Ideally, from an economic-efficiency perspective • At the margin customers would pay a usage price equal to marginal cost, with the difference between revenues generated from usage charges and the utility’s total costs covered with a fixed fee (e.g., customer charge) that acts as a lump sum tax • As long as the fixed fee is less than consumer surplus net of usage expenditures, consumers will pay the fixed fee and consume at the efficient level May 23, 2006

9. Two-Part Tariffs-- continued • Basic Structure: TBi = F + pqi– continued • Non-linear pricing has been used in the pricing of electricity, gas and telephone service since early in the 20th century • Early proponents of non-linear pricing such as Samuel Insull saw this pricing method as a way to expand demand and lower average costs while meeting a break-even constraint • In advancing various social objectives, this rate design has evolved over time to where typically a gas utility recovers much of its fixed costs in the volumetric charge May 23, 2006

10. Examples of Rate Designs: Conflicts in Objectives Flat Rate per period, no usage charge Uniform: Flat Rate per unit Declining Block Inverted Block $ $ Q Q $ $ Q Q

11. Examples of Rate Designs -- continued Seasonal or Time of Use $ Period2 Period1 Q

12. Regulatory Objectives and the Role of Rate Design • Changing major regulatory objectives -- priorities change over time, as well as the specification of objectives • Rate design from different perspectives – a conflict among stakeholders • Tasks for regulators • Listing and prioritizing of rate-design principles • Integrating rate-design principles with regulatory objectives May 23, 2006

13. Rate-Design Objectives: The Usual List May 23, 2006

14. Why This Forum and the Recent Interest in Natural Gas Utility Rate Design? HIGH GAS PRICES, HIGH GAS PRICES, HIGH GAS PRICES ALONG WITH VOLATILE GAS PRICES! May 23, 2006

15. Consequences of High Gas Prices

16. Recent Rate Design Proposals and Issues

17. Why This Forum?-- continued • This forum is timely • A dialogue on rate design issues is critical to reach consensus and for utilities, regulators and other stakeholders to become better informed • Delaying the implementation of new rate designs can inflict a high cost on society • Prevailing rate designs may result in undesirable outcomes from a public-interest perspective (e.g., outcomes inconsistent with regulatory or public policy objectives) May 23, 2006

18. Things to Keep in Mind • Over time, rate design in the utility sector has evolved to accommodate market, technological and regulatory/governmental changes • We have seen this in not only in the public utility industries but in other industries as well • Historically, regulators have responded to changed conditions by entertaining and accepting new rate designs when compatible with prevailing objectives May 23, 2006

19. Things to Keep in Mind -- continued • Conditions in the natural gas industry have changed significantly over the past several years, warranting a review of prevailing rate designs • Specifically, these changed conditions have shifted priorities of regulatory objectives • To repeat from earlier, the status quo in rate design may carry high costs for utilities, consumers and society as a whole May 23, 2006

20. Things to Keep in Mind -- continued • Regulation has many objectives, with some conflicting, and priorities (ranking of objectives) changing over time • Rate design in practice reflects a compromise of the multiple objectives such as economic efficiency and equity • The “balancing act” of regulation or “sausage making” in applying both basic principles and judgment May 23, 2006

21. Things to Keep in Mind -- continued • We should assume that regulatory objectives differ from utilities’ objectives • Both in terms of what gets on the list and where on the list each objective ranks (e.g., utility financial viability, promotion of energy efficiency, risk allocation to consumers and the utility) • If this were not so, regulation would have no reason to exist, as the “invisible hand” of the marketplace would guide a utility’s actions toward the public good May 23, 2006

22. Things to Keep in Mind -- continued • The reasons for regulators reluctant to change rate design • Inertia • Uncertainty over the outcome • Disinformation/deficient information • Changed rate design should accommodate the new realities and conditions in the natural gas industry May 23, 2006