Cost of Service and Rate Design Workshop

1. Cost of Service and Rate Design Workshop Sherman Elliott Manager, State Regulatory Affairs, Midwest ISO, Inc. July 14-15, 2005 Midwest Independent Transmission System Operator, Inc. 701 City Center Drive Carmel, Indiana 46032 217.522.6674 217.522.6676 (f) selliott@midwestiso.org

2. Workplan • Introductions • Presenter • Overview of the approach • Introduction to ratemaking • Revenue requirements • Cost of capital • Cost of Service • Concepts • Embedded cost study • Marginal cost study • Group Discussion • Role playing (Utility, consumer advocate, industrial advocate) • Cost of service alternative scenarios

3. Workplan • Next Morning’s Session • Interclass Revenue Allocation • Review of Cost Concepts • Marginal • Embedded • Turning Costs into Rates using different Scenarios • Use results of cost studies to price services • Discuss rate effects of alternative scenarios • Rate shock and Equity concerns • Rationale for deviating from cost causation

4. Introduction to Ratemaking (6 Slides)

5. The Regulatory Equation (1) • Revenue Requirement = OC + r(V-D) + T + d + OSS • OC = Operating Costs • T = Taxes • d = Annual depreciation expense • r = Rate of return • V = Value of physical and financial capital • D = Accumulated depreciation • r(V-D) is called the “return portion” and V-D is called “rate base” • OSS = Off System Sales

6. Setting the Period of Examination (2) • Test Year - Any 12 month period used for evaluating the revenues, operating expenses, depreciation, taxes, and rate base for purposes of setting rates. • Current (or historical) Test Year – A 12 month period which reflects the actual results of current operations could be adjusted for known and measurable changes. • Future or Forecasted Test Year - A future 12 month period which reflect the anticipated results of normal operations.

7. Adjustments (3) • Pro-Forma Adjustments – known and measurable changes • Non-recurring expenses • One-time basis, irregular intervals • Amortized over the time period between rate cases

8. Determining Rate Base (V-D) (4) • How to determine rate base? • Net original cost (i.e., book) rate base (net means V-D) • Fair market value • Reproduction cost - the cost of duplicating the existing plant and equipment at current prices • Replacement cost - the cost of duplicating the old plant with the modern technology version

9. When to Measure Rate Base? (5) • End of period rate base - Value of the rate base at the end of the test year. This concept typically is used in conjunction with a current or historical test year. • Average (normalized) rate base - Average rate base throughout the test (i.e., typical) year. This concept typically is used in conjunction with a future or projected test year.

10. Major Items in Rate Base (6) • Plant in Service • Construction Work in Progress (CWIP) • AFUDC • Materials and Supplies • Cash Working Capital • Prepayments • Typical Deductions: • Accumulated Depreciation • Deferred Taxes • Contributions in Aid of Construction

11. Cost of Service (21 Slides)

12. Introduction to Cost of Service (1) • Cost of service studies (COSS) are used to: • Attribute costs to different customer classes • Determine how costs will be recovered from customers within classes • Calculate costs of different services • Separate costs between jurisdictions • Determine revenue requirement between competitive and monopoly services • General types of cost studies • Embedded (Test year accounting costs) • Marginal (Change in costs related to change in output)

13. Steps in COSS (2) • Obtain test year utility revenue requirement (generally an accounting/finance function e.g., USOA) • Other revenues (e.g., off-system sales, Hub sales, etc.) • Jurisdictional revenues/costs • Determine customer classes • Allocation of costs to cost-causers

14. Customer Class Determination (3) • Attempt to group customers together that have common cost characteristics, for example, • Size (volume and capacity) • Type of customer and meter (residential, commercial, industrial, electricity generation) • Type of usage (space heat, non-space heat etc.) • Type of load (firm, interruptible) • Load factor (average usage relative to peak usage) • Competitive alternatives (related to opportunity cost)

15. Embedded Cost Studies (ECOSS) (4) • Functionalize (production, distribution, transmission etc.). • For gas and electric utilities, functionalization is generally an accounting exercise (i.e., use USOA). • Exception: Electric transmission may need additional analysis (e.g., FERC seven factor test). • Classification (demand-related, volume-related, customer-related, etc.). • Allocation. • Direct assignment. • Allocator (demand, energy, customers, etc.).

16. Functionalization (5) • Electric and Gas utilities • Generation or gas production • Distribution (low voltage lines, low pressure mains) • Transmission (high voltage lines, high pressure mains) • Customer Service (costs associated with hooking up customers, meters, service drops, etc.) • General plant and administrative and general expenses (management costs, costs of buildings and offices, etc.)

17. Functionalization-Example Electric Utility (6) Plant in Service Accounts Expense Accounts

18. Classification of Costs (7) • Costs are assumed to be related to demand, energy, customer or revenues. • Capacity costs (e.g., gas mains, generation plant, etc.) do not change as output changes, but do change as the capacity of the system changes. These are fixed costs that are generally classified as demand-related (i.e., related to kW or therm capacity). • Energy-related costs change with output (e.g., fuel). These are classified as energy-related or volumetric (i.e., related to kwh or therm throughput). • Customer-related costs (e.g., meters, services) change with the number of customers added to the system. • Revenue-related costs (e.g., revenue taxes) are related to the revenue received by the company.

19. Classification of Costs-Examples-Gas (8)

20. Classification-Examples (9) • Generation Plant • Is generation plant entirely related to providing capacity? • Gas mains or electric distribution • Are these costs solely demand-related or is there also a customer cost component (or are they solely customer-related)?

21. The Logic of Classification: Gas Distribution Mains (10) • What are gas distribution mains used for? • Meeting peak demand? • Historic and future planning parameters • Mains are sized to meet the highest peak demand on the peak day • Meeting average demand? • What evidence exists concerning the reason for investment (e.g., maintenance and replacement of existing mains) • Hooking up customers? • How does investment cost change with number of customers?

22. Classification Example: Gas Mains (11) • Zero-intercept method • Statistical procedure that relates main costs and size with number of customers • Minimum distribution system • Engineering method that determines the cost of a system of a certain size and allocates classifies those costs as customer related

23. Zero-intercept method (12) • Some level of main costs are required to serve new customers • This level can be deduced from regressing unit costs of various size of mains on the sizes of mains • This suggests a level of main costs that is necessary just to expand system (i.e., just to hook up customers some level of main investment is needed)

24. Zero-intercept method (13)

25. Scatter plot-Cost of Steel Mains (14)

26. Regression Results (Steel Mains) (15)

27. Minimum Distribution Method (16) • Applies actual engineering costs of a minimum size system to determine what costs are related to customers • Question becomes what is the appropriate size of main to use to estimate the minimum size?

28. MDS-Example (17) + + = $9,078,448 Total Cost of 2” MDS • The difference between the 2” main costs and the above 2” main costs is the demand related costs (i.e. the costs in excess of a minimum distribution system) • 77% (9m/11m) are customer-related, the remaining costs (23%) are demand related

29. Allocation to customer classes of Demand-Related Costs (18) • Peak responsibility methods • Allocates capacity based on peak hour or some average of the peak hours • Customers who consume off-peak will not be allocated these costs • Peak and average methods • Uses average and peak volumes weighted by the load factor • Recognizes that some investment is for not peak day needs

30. Demand Allocation (19)

31. Demand Allocation: Recognizing Energy (20) • If part of the production plant is classified as energy-related (e.g., 25%), then energy portion would be allocated based on an energy allocator. • If portions of capacity are not re-classified as energy, the energy function may still be recognized through the allocation process.

32. Average and Excess (21) Average demand is Energy/8760 Load factor is Average demand/ CP

33. Marginal Cost (35 Slides)

34. Introduction to Marginal Cost Pricing (1) • Overview of micro-economics • Cost curves • Revenue curves • Profit maximization • Why marginal costs? • Application of marginal cost to the electric industry? • Marginal Generation Costs • Marginal Distribution Costs • Marginal Transmission Costs

35. Overview of Microeconomics (2) • Total Cost is defined as follows: • Total Cost = Fixed Costs of Production + Variable Cost of Production • Fixed Costs are those costs that do not change with changes in output • Variable Costs are those costs that do change with changes in output

36. Total Costs in the Electric Sector (3) • The total cost of the production of electricity is related to the capital costs of the delivery and production system and the costs of operating and maintaining the system. • Sunk Costs are those costs that cannot be avoided and could not be recovered if the firm exits the business. For example, a power plant that is built for serving a particular load center may have little value outside of providing service to those customers.

37. Total Cost (4) C F q Cost(q) = Fixed Costs + Variable Cost(q) • The Total Cost Function can be re-written as a function of quantity, where q is the quantity of goods produced Graphically, total cost looks like this:

38. Average Cost (5) • Average Total Cost is the is the average cost of production at any point in the production functions. It is defined mathematically as follows: Cost/q = Average Total Cost = Fixed Costs/q +Variable Costs/q =Average Fixed Costs + Average Variable Costs Where Average Fixed Costs = Fixed Costs/q Average Variable Costs = Variable Costs/q

39. Average Cost-Graphically (6) Decreasing Average Cost COST Diseconomies of scale Minimum Efficient Scale Increasing Average Cost F qmin quantity Economies of scale

40. Marginal Cost (7) • Marginal Cost is change in the total cost as a result of the change in the output. Mathematically, it is defined as follows: dC(q)/dq = C’(q) = Marginal Costs

41. Total Revenue (8) • Total Revenue is defined as the total revenues received for the production and sales a specific quantity of a commodity. Mathematically it is defined as follows: R(q) = P(q) * q Where: q is the level of output p is the price Marginal revenue is the change in revenue as output changes

42. Profit Maximization (9) • Running assumption is that firms select quantities to maximize profits. • Profit is defined as the difference between Revenues and Total Cost and is defined mathematically below: Profit = R(q) - C(q) • Mathematically, this function is maximized when R’(q) = C’(q)

43. Graphically, what does this say? (10) Total Cost Marginal Revenue at q* Cost Total Revenue Maximum Difference Between Revenue and Cost Marginal Cost at q* q* Quantity

44. Economically, what does this say? (11) Cost Marginal Cost Marginal Revenue q1 q2 q* Quantity MC < MR MC > MR

45. Why use marginal cost? (12) • Competitive markets price based on marginal cost • Efficiency in production • Efficiency in consumption • Maximizes social welfare • More accurately follows utility planning and investment decisions • Creates a level playing field for unbundling

46. Competitive Firm (13) Price/ Cost Quantity MC ATC P=MR=D=MC Economic Profit =0, i.e., TR=TC Price is set at marginal cost Maximize Social Welfare q*

47. Social Welfare Maximization (Under Competition) (14) Consumer Surplus Price/ Cost Producer Surplus Quantity Supply P* Demand Q*

48. Monopoly Output (15) Price/ Cost PM Economic Profit Total Revenue Total Cost QM Quantity Economic Profit >0, i.e., TR>TC Marginal Cost Price > Marginal Cost Output is reduced relative to competitive output ATC Marginal Revenue Demand

49. Social Welfare Under Monopoly (16) Consumer Surplus Transferred to Producer Price/ Cost PM Lost Consumer Surplus Lost Producer Surplus (gained back from transfer) Quantity QM Supply P* Demand Q*

50. Use of Marginal Cost in Price Setting (17) • Short-run marginal cost would not include capital • Utilities are capital intensive • How to solve dilemma? • Use of long-run marginal costs for rate making • Long-run simply means that all inputs are variable and therefore the fixed costs of capital are variable • Translate capital investment into annual cost using the carrying charge or fixed rate charge calculation.