Recent Trends in Alternative Regulation

1. P P P E G Pacific Economics Group Research, LLC Recent Trends in Alternative Regulation Dr. Mark Newton Lowry President Pacific Economics Group Research LLC Washington, DC 27 April 2012

2. Introduction • Economics of utility business has changed in recent years • Traditional rate regulation doesn’t always handle new situation well • Several alternative regulation (“Altreg”) remedies are available • This presentation discusses • Changing economics of utility regulation • Popular Altreg reforms

3. Changing Economics of Utility Regulation

4. Economics of Utility Regulation Utilities need rate relief when cost rises faster than revenue Under traditional regulation, base rates only rise in rate cases Between rate cases, revenue rises only w/ service volumes & other billing determinants Most utility revenue comes from volumetric & other usage charges growth Cost - growth Revenue [1] = growth Cost - growth Use >>> Need for rate relief depends on “horse race” between cost & system use 4

5. Economics of Utility Regulation (cont’d) Economic research has shed light on utility cost drivers Growth Cost = growth Input Prices + growth Customers – growth Productivity [2] Thus, growth Cost – growth Revenue = growth Input Prices – growth Productivity – growth Use/Customer [3] >>> Utilities need rate relief if growth in productivity & average use don’t offset input price inflation 5

6. What Has Changed? Growth in cost and system use were balanced in past decades Early postwar period: slow inflation, rapid average use growth 1990-2005: slow inflation declining generation rate base spurs productivity Situation differs today. Although inflation is slow, Distribution utilities have growing rate bases, sizable (e.g. 2.5%) “inflation/productivity gap” Rate base growth of some utilities is accelerating Accelerated system modernization New emissions controls 6

7. 7 >>> Brisk growth in average use offset inflation-productivity gap before 1970 but no longer available Gas distributors often experience declining average use

8. Remedies for Financial Stress Rate cases more frequent than in past Annual rate cases possible for utilities with special financial challenges Problems High regulatory cost (“Groundhog’s Day regulation”) Weakened performance incentives Management has less time to address basic business Traditional rate cases don’t produce enough rate relief >>> Traditional regulation results in frequent rate cases, chronic underearning for utilities with special operating challenges 8

9. Forward Test Years 9

10. Test Year Basics Historical Test Year Test year ends before start of rate case “Known & measurable” changes Uncompensatory when cost growth > billing determinant growth Remedies: Partially forecasted test year Test year ends several months after start of rate case but before start of rate effective year Fully forecasted test year Test year conforms to rate case year or rate effective year 10

11. Test Year Selection by U.S. Jurisdiction Fully-forecasted test years increasingly popular Recently sanctioned in Pennsylvania (HB 1294)

12. Financial Impact of Test Years on Electric Utilities, 2006-2008 S&P Rate FFO/ EBITDA/ Credit of Debt Interest Rating Return Forward Test Year BBB+ 9.2% 21.0 5.1 Historic Test Year BBB 7.9% 18.2 4.2 Sources: Standard & Poor’s Credit Stats: Electric Utilities – US Edison Electric Institute Forward Test Years for US Electric Utilities 12

13. Capex Trackers

14. Targeted Approaches to Regulatory Reform • Many regulators reluctant to pursue comprehensive regulatory reforms • Multi-Year Rate Plan • Fully Forecasted Test Years • Formula Rates • but seek upgrade for traditional regulation • Targeted approaches popular for this reason, “chip away” at imbalance between cost & revenue growth • e.g. Declining average use >>> Revenue decoupling • Rapid cost growth >>> Recover rapidly rising cost • outside rate cases

15. 15 Capex Trackers Capex tracker recover depreciation and return on capex between rate cases Most popular form of Altreg in US

16. Financial Impact of Capex Trackers on Electric Utilities, 2008-2010 S&P Rate FFO/ EBITDA/ Credit of Debt Interest Rating Return Capex Trackers BBB+ 8.7% 6.2 22.1 No Capex Trackers BBB 7.6% 4.2 19.8 Sources: Standard & Poor’s Credit Stats: Electric Utilities – US Testimony of Mark Newton Lowry for PHI Holdings utilities 16

17. Multi-Year Rate Plans 17

18. Basic Idea Rate case moratorium (typically 3-5 years) External “attrition relief mechanism” escalates revenue for changing business conditions Rate caps Revenue caps Many plans have service quality award/penalty mechanisms Advantages: Stronger performance incentives, less frequent rate cases Make sense for energy distributors under normal operating conditions as well as stress periods 18

19. Revenue Cap Design Utility Cost Growth Formula offers revenue cap design framework growth Revenue = Inflation - X + growth Customers Other revenue caps have “stairstep” trajectories e.g. 6% growth in 2013, 5% in 2014, 4% in 2015 Some revenue caps have “hybrid” designs e.g. Stairsteps for capital cost Indexing for O&M expenses 19

20. Precedents for Multi-year Rate Plans 20 Multi-year rate plans the norm for energy distributors in CA, Northeast Growing use in Canada Most popular form of Altreg worldwide

21. Appendix 21

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