Tariff Development III: Developing a Rate Design

1. Tariff Development III:Developing a Rate Design Energy Regulatory Partnership Program Abuja, Nigeria July 14-18, 2008 Ikechukwu N. Nwabueze, Ph.D. Director, Regulated Energy Division Michigan Public Service Commission

2. Fair and Just Rates Late 19th Century concern over the growing economic power of certain corporations that were affected with the public interest. Suspect behavior fell into four groups: • Prices were “too high” reflecting monopoly power; • Prices were “too low” (implying predatory pricing, which discouraged economic entry); • Prices that were “too high” for some, but “too low” for others (involving “undue” discrimination and/or subsidies for some markets); • Prices that were “unstable” (making it difficult for producers and consumers to plan ahead). 2 of 79

3. Today’s Pricing Issues • Few issues today are fundamentally different from those at the turn of the century. This is due in part to the early recognition of the fundamental characteristics of a natural monopoly (Farrer 1902): • Capital intensive (having significant fixed costs or scale economies) • Necessity (essential to the community) • Nonstorable (yet subject to fluctuating demands) • Produced in particularly favored locations (yielding rents) • Involve direct connections with customers • The unregulated monopolist has the power to set prices that are not in the public interest. 3 of 79

4. Equity (“fairness”) goals Be just and reasonable (fair to various groups) Be subsidy free No group or service charged less than its incremental cost or more than its stand alone cost (i.e., the utility receives a positive rate of return from each group or service but not a monopolistic profit) Goals of Rate Design 4 of 79

5. Efficiency Goals Give correct signals to consumers and to the utility (i.e., Price = Marginal Cost) Promote efficient use of resources and efficient planning by the utility. Allow for efficient competitive entry Prevent predatory pricing, price squeezes, uneconomic bypass, and cross-subsidization of competitive services by monopoly services. Goals of Rate Design (Continued) 5 of 79

6. Goals of Rate Design (Continued) • Social goals may include: • Promoting universal service • Promoting conservation (e.g., inverted rate structure) or at least discouraging wasteful use of a utility service • Promoting environmental protection • Promoting economic development and full employment • Assisting senior/low income consumers 6 of 79

7. Goals of Rate Design (Continued) • Operational Goals • Be sufficient to allow the utility to collect its legitimate costs (i.e., allowed capital and operating costs) • Be relatively stable from period to period • Avoid rate shock • Promote revenue stability for the utility • Be understandable and administratively feasible • Avoid undue discrimination across rate classes or services • Apportion costs fairly 7 of 79

8. Goals of Rate Design (Continued) Additional Comments • It is often difficult — or impossible — to achieve all these goals at once • Almost all real-world rate designs are compromises • Certain goals may be conflicting • Rates that are efficient may not be considered fair • Efficiency involves maximizing total net economic value • Fairness involves distribution of net economic value among customers and the utility • Rates that promote energy conservation may not be efficient or considered fair 8 of 79

9. Allocation of Revenue Requirements to Various Classes of Service • Group customers into rate classes • Rate classifications should produce homogeneous groups based upon characteristics of each group • Residential • Commercial – Secondary and Primary • Industrial – Secondary and Primary • Retail Open Access – ROA 9 of 79

10. Rate Structures • The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structures. • Evaluate the performance of current structure: • Do rates provide revenue stability? • Do rates provide for recovery of revenue requirements for that class of service? • Are the rates perceived to be fair by the customers? 10 of 79

11. The Traditional Ratemaking Process Revenue Requirement Cost Allocation Rate Design (prices) 11 of 79

12. Steps in Traditional Ratemaking • Three basic steps: • Determination of revenue requirements (cost assessment) for a test year • Allocation of costs to customers based on usage pattern • Rate design to recover costs through rates and charges • Considerable discretion is involved in all three steps. 12 of 79

13. What Stakeholders Want from the Ratemaking Process • Utilities: a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability; protection from ruinous competition. • Customers: Nondiscriminatory service at fair, reasonable, and affordable rates; protection from monopoly abuse (captive customers). • Regulators/Society: Utility services that promote the public interest, including price signals that encourage efficient use of resources and promote other social goals. 13 of 79

14. Ratemaking Process • Cost allocation determines how many dollars to collect from various classes or services • Rate design determines how to collect dollars from various customer groups and services • Like cost allocation, rate design is as much art as science – more “sausage making” 14 of 79

15. Designing Sound Tariff Structures • Pricing principles provide a foundation for rate design and sound tariff structures: • Fairness to both the regulated utility and the ratepayers. • Avoidance of unjust or undue discrimination between rate classes or customers. 15 of 79

16. Design Rates to Provide for Recovery of Revenue Requirements • General Attributes of a Sound Rate Structure: • Effectiveness in yielding total revenue requirements. • Revenue and rate stability and predictability. • Fairness and avoidance of undue discrimination among the different rate classes. • Political and public policy issues e.g. subsidies. • Simplicity, understandability, and public acceptability. • Practicability, metering and billing constraints. 16 of 79

17. Objectives in Setting Rates • Protect the ratepayer’s interest by assuring safe, reliable and reasonably priced services. • Fairly apportioning cost among customers. • Protect the shareholder’s interest by allowing the utility a reasonable opportunity to earn a fair rate of return on its investment. 17 of 79

18. Rate Structure v. Rate Levels • Regulators must approve both the rate structure and rate levels. • The term rate structure refers to how the prices are designed. The rate structure may reflect various attributes. For example: - Numberof rate levels (e.g., declining block or constant rate per kWh) - Customer classes (industrial, commercial, government, residential) - Time of day (peak v. off-peak) - Capacity (kilowatt) • The term rate level refers to the price per unit sold (e.g., 5 cents per kWh or $10.50 per kW). 18 of 79

19. Pricing Attributes Dr. James C. Bonbright in his book “Principles of Public Utility Rates” (1961), which is often quoted by rate design witnesses, provides a list of eight traditional rate-making or pricing attributes: • Simplicity and public acceptability • Freedom from controversy • Revenue sufficiency • Revenue stability • Stability of rates • Fairness in apportionment of total costs • Avoidance of undue rate discrimination • Encouragement of efficiency 19 of 79

20. Simplicity and Public Acceptability • The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties. • Consumers’ information processing costs should be included in the derivation of efficient prices. • Why do consumers prefer flat-rate telephone service? 20 of 79

21. Simplicity and Public Acceptability (Continued) • AT&T’s vice-president, E.J. Hall, conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network, or no connection charge and a usage charge for each call, they were confused by the combination of paying an entry and usage fee: “The claim that [a two-part tariff] is easy for the customer to understand, and would therefore be popular, is not justified by history nor will it stand logical analysis. No compound proposition [i.e., two-part tariff] can be as easily understood as can either one of the simple ones from which it is composed.” • Simple rate structures may conflict with other pricing objectives (e.g., efficiency) 21 of 79

22. Freedom from Controversy • Hard to modify an existing rate structure or rate levels in a manner that is free from controversy. • In order to minimize the level of controversy, regulatory commissions will often phase in the change. • Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates. 22 of 79

23. Revenue Sufficiency • In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost, even where marginal cost was less than average cost and a government subsidy was required to maintain production. • This policy proposal had serious weaknesses. It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost; it ignored the probable effects on the administrative structure; it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs; it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies. • But if prices are not to equal marginal cost, the question of what the structure of rates should be needs to be examined. 23 of 79

24. Revenue Stability • Concern is not so much revenue stability as it is net revenue (revenue – cost). • When comparing alternative rate structures, regulators must examine how rates, customer responses, and production costs interact to yield net revenue stability. 24 of 79

25. Stability of Rates • Stability allows consumers to plan ahead. Alcoa, for example, needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter. • But if costs are changing, and rates are inflexible, there can be shortages or excess supply. • To avoid imposing hardships on particular customers, regulators will tend to prefer a gradual transition to new rates. 25 of 79

26. Fairness in the Apportionment of Costs • Bonbright discussed fairness in terms of apportionment of total costs. When you move away from rate base regulation and towards price caps, the discussion evolves to a debate over the apportionment of costs (e.g., common costs). • Can the winners compensate the losing group when a new rate structure is adopted? If they could, then an economist might contend that the change should be implemented, even if no compensation is paid. 26 of 79

27. Fairness in Ratemaking • An inherent tension exists between equity v. efficiency • Sometimes cost differences are ignored (e.g., old and new customers) • Values and perceptions of equity vary from place to place and evolve over time • Regulation considers whether rates are “just and reasonable” • In practice, rate design can be a mix of art, science, and politics 27 of 79

28. Avoidance of Undue Rate Discrimination • Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B. • Price discrimination is often seen as welfare enhancing. Telephone and airline pricing. • Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market. 28 of 79

29. Encouragement of Efficiency • Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output. • Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs. • Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development. 29 of 79

30. A Feedback Loop Customer Behavior Revenue Requirement Cost Allocation Rate Design (prices) 30 of 79

31. Rate Design • There are a wide variety of rate structures to choose from – flat rates, step rates, declining block rates, demand rates. • Michigan employs a three step structure: • Customer Charge – Fixed monthly charge. • Delivery or Distribution Charge – Energy (and Demand for some Commercial & all Industrial rates) charge on each unit of sale. • Power Supply Charge – Energy charge (and Demand for some Commercial & all Industrial rates) on each unit of sale. • Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304, Nuclear Decommissioning, or expanded security at power plants 31 of 79

32. Unbundling • Michigan uses tariffs broken down by delivery and power supply charges on customers’ bills so that customers can shop for the power supply portion of their service from an alternate energy supplier • Transmission is included in production as it is now billed as component of power supply just as purchased power • Customer costs are recovered along with distribution costs under delivery charges 32 of 79

33. Unbundling (Continued) • Unbundled rates are designed to meet the functionalized power supply and distribution revenue deficiency/sufficiency targets derived in the cost of service study by major rate class or sometimes by rate. • With the restructuring of utility industries, "customer charges" are being unbundled — broken down into smaller components • Metering, billing, line maintenance, and transmission may appear separately on the bill, with transmission as a usage-sensitive charge. 33 of 79

34. A Point to Consider • Utility rates are prices • People respond to prices • Prices provide incentives and signals to producers and consumers • Rate design will affect behavior • Expect a different response to a high customer charge and low usage charge than to a low customer charge and a high usage charge, even if the two are designed to produce equal revenues in the short run (Why?) • Rate design affects behavior, which affects future costs 34 of 79

35. A Point To Consider (Continued) • Illustration: • Rate design 1: customer charge = $5.00, energy charge = 4 cents/kWh • Rate design 2: customer charge = $10.00, energy charge = 2 cents/kWh • The utility expects sales of 250 kWhs or revenues of $15, no matter which rate design is applied • But, assuming a price elasticity of -0.2, one would expect sales to be 20% higher under rate design 2 35 of 79

36. Rate Designs • Marginal cost-based rates • Definition of MC: change in cost due to change in output; represents economic opportunity cost • Favored over fully allocated cost rates by economists 36 of 79

37. Rate Designs (continued) • Multi-part rates • Also called nonlinear prices or two-part tariffs • Include a fixed customer charge plus a usage charge • Relatively high fixed or customer charges and relatively low usage charges • May be efficient but do not promote energy conservation • Shift risks away from the utility 37 of 79

38. Rate Designs (continued) • Peak-load, seasonal, real-time or time-of-day rates • Vary by time of day or season of use • Used for energy services and sometimes for telephone services • Inverted block rates • May promote conservation (Why?) 38 of 79

39. Rate Designs (Continued) • Demand-side management (DSM) rates • Energy efficiency discounts • All-electric rates • Load-control rates • Reliability-based pricing • Interruptible vs. firm power rates 39 of 79

40. Rate Designs (Continued) • In principle, usage charges should recover only usage-sensitive costs • Some fixed charges, however, are typically recovered through usage charges (particularly for residential and other small customers) • Exhibited in declining-block rates for electricity 40 of 79

41. Cost of Service Issues Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings. Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff. An example of this can be seen with the on-going debate of production plant allocation methods. High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for. 41 of 79

42. Block TariffsDecreasing-block rate 42 of 79

43. Increasing-block rate 43 of 79

44. Seasonal rate 44 of 79

45. Examples of Rate Designs Flat Rate per period, no usage charge Uniform: Flat Rate per unit Declining Block Inverted Block $ $ Q Q $ $ Q Q 45 of 79

46. Rate Designs(Continued) Seasonal or Time of Use $ Period2 Period1 Q 46 of 79

47. Illustration of the Hopkinson Demand Rate for Industrial Customers • Bills customers for maximum measured demand (e.g., the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage. • Two-part tariff that has a separate demand and energy rate. • Example: • $9.50 per kW of maximum demand per month • $0.065 per kWh usage in a given billing month • Rates can have declining (inverted) block demand and/or energy charges. • Higher load-factor customers pay a lower average price. 47 of 79

48. Pricing Philosophies • Cost of Service Pricing • Tends, on average, to collect more-or-less equal rates of return from all classes of customers and all services (“rate-of-return parity”) • Each covers its variable costs and an equal relative contribution to common overhead and capital costs. • For example, if a utility’s overall allowed rate of return is 12.5%, it would earn 12.5% from each customer class. 48 of 79

49. Pricing Philosophies (Continued) • Value-of-service pricing • Form of price discrimination • Charging different prices for the same service when no equivalent cost difference exists (e.g., economic development rates) • Charging different customers the same price when a significant cost differential exists (e.g., rural customers charged the same rate as urban customers) 49 of 79

50. Pricing Philosophies (Continued) • Value-of-service pricing - continued • May consider customers willingness to pay, ability to find alternative suppliers, or ability to engage in self supply 50 of 79