Chapter 3 – The Role of the Revenue Requirement

1. Chapter 3 – The Role of the Revenue Requirement • Revenue Requirement • Operating cost • Capital cost • Firm is allowed to make a return on investment called allowed revenues, valued added of the regulated activity, permissible revenues, rate base, regulated revenues, tariff base, total revenues, revenue requirements • Determining revenue requirements • Investments must be prudent • Used and useful • Known and measurable

2. The regulatory compact • Grants monopoly power • Allows firm to make a just and reasonable return on capital • Allows government to regulate firm

3. Factors affecting the revenue requirement • The test year • Used to forecast future costs under normal operations • Vetting costs • Determining what is known and measurable can vary between regulators • Costs • Private vs. social • Original vs. replacement • Short-run vs. long-run

4. Calculating the Revenue Requirements • RR=O&M+A&G+T+D+(WACC*RB) • Operation and maintenance • Administration and general • Depreciation • All taxes • Weighted average cost of capital (represents capital plus rate-of-return and includes income taxes) • O&M+A&G • Deferred vs. accrued • Different rate classes (resid, comm, indust) • Direct vs indirect (joint and common costs)

5. Chapter 5 – Cost Management • Transforming Cost to Price • Firms allowed to make a return on capital expenses • Firms can only make a return of operating expenses • Regulatory accounting requires three sets of books • Statutory books (How are we doing? Were we profitable?) • Tax books (What must we pay?) • Regulatory books (What may we charge?)

6. Steps for Calculating Regulated Prices • Determine the Revenue Requirement • Functionalize Costs depending on the different activities of the utility • Classify Costs (variable, fixed, customer) • Allocate costs to different customer groups • Establish rates and tariffs for the different customers

7. Chapter 6 – Cost Allocation • Functionalization – breaking down into production, transmission, distribution, retailing, and other activities • Classification • Demand (fixed) • Energy (variable) • Customer categories • Allocating costs across the three customer groups (most difficult step) • Residual • Industrial • Commercial

8. Chapter 7 – Rate Setting • Billing determinants (therms, kilowatts of demand, kwh) • Forecasting demand • Forecasting peak demand • Normalizing for weather • Multiple policy goals • Ensure “just and reasonable” rates • Prevent excessive (monopoly) profits • Prevent unreasonable (inequitable) price discrimination among customers and places • Provide regulated firms with “adequate” earnings • Provide service to the most customers possible • Promote “economic development” and employment

9. The Pricing Dilemma P PM PAC DWL AC AC* MC P* D QM Q* QAC Q MR

10. Alternative Design Structures • One-part tariff • Two-part tariff • Multi-block tariffs • Incentive rate structures • Entry-exit tariffs • Interruptible rates • Time-of-use rates • Seasonal rates

11. Two-Part Tariff Pricing P Customers pay marginal cost (P*) for energy, and a fixed charge per customer such that total fixed charges collected equal the shaded area PM AC PAC MC P* D QM Q* QAC Q MR

12. Block Rate Design P Intra-block prices set such that excess cost recovered equals fixed costs P1 P2 AC MC P3 D Q1 Q3 Q2 Q

13. Block Rate Design Increasing Marginal Costs P The first Q1 units are sold at price P1, which is below the firm’s cost. The remaining Q2-Q1 units are sold at price P2=MC above average cost. The two shaded areas are equivalent. Overall revenues for all Q2 units equal AC. P1 P2 AC MC P1 D Q1 QAC Q2 Q

14. Other rate structures • Entry/exit – fixed fees and variable charges • Interruptible rates – uncertainty of service but get a lower rate • Incentive rate – usually paired with economic development, like job creation • Seasonal rate – peak vs. non-peak • Expensive to meter • Seems unfair to customers (i.e. price gouging)

15. Rate Changes • Tariff Levelization • Revenue checks to make sure they are covering costs • Deals with time value of money and multi-year tariffs • Discount to present values future revenues and billing • Embedded and MC methods • Alternative approaches • DCF approach • Model company approach • Benchmarking methods

16. Pricing and Social Policy • One social question is whether multi-part pricing should be increasing or decreasing? • Tariff setting not always about economic efficiency. Sometimes they try to meet some social agenda as well: energy consumption, energy conservation, making sure everyone has enough access.

17. Chapter 8 – Rate and Tariff Adjustment Mechanisms • Rate Adjustments • Pass through mechanisms are meant to encourage efficiency. • Reducing regulatory lag by implementing an automatic price adjustment mechanism, which allow for rate changes without too much of a bureaucratic process • Common for changes in the price of fuels

18. Inflation Adjustments • Most common adjustment mechanism is RPI-X where RPI is the retail price inflation index and X is an efficiency factor that encourages efficiency • This measure reduces price volatility that is common with a producer specific index

19. Other factor adjustments • X Factor – for productivity • K Factor – for capital investment • Q Factor – service quality • Z Factors – factors that affect financial accounting standards, taxes, or environmental or other laws

20. Chapter 9 – Market Power • Because a deregulated industry cannot be re-regulated most electricity transmission operators have a market monitor to ensure competitveness in the market. • FERC oversees mergers & acquisitions to ensure competition

21. Defining Market Power • A firm is able to affect market prices • Other ways to affect market power is through product quality, service, or technological innovation • Market power does create welfare losses, but it’s not all bad because of the nature of energy firms. With high upfront costs and low marginal costs, the firm may need to charge a price greater than MC to recover some of its investments • Market power requires barriers to entry, i.e. costs borne by new market entrants that are not borne by incumbent firms

22. Dominant Firms • When one firm in the market is far larger than all others • The dominant firm has market power and sets price off the residual demand curve (that is, the demand left-over after the “fringe” firms have satisfied their demand)

23. Horizontal and Vertical Market Power • Horizontal • Firm’s ability to influence price in a single market • Market share or market concentration represent horizontal market power • Vertical • Firm with “upstream” market power • Market foreclosure – firms use upstream power to raise prices downstream

24. Other factors • Chapter 10 – uncertainty • Chapter 11 – environmental regulation • Chapter 12 - reliability