The Future of Electric Rates in Virginia

1. The Future of Electric Rates in Virginia Steve Ruback Principal The Columbia Group VML Annual Conference Oct. 17, 2006

2. VEPGA Mr. Steve Ruback Ms. Lisa Albee The Columbia Group, Inc. 785 Washington Street Canton, MA 02021 Phone (781) 821-5570 Fax (781) 821-1634 macolumbia@aol.com Mr. Louis Monacell Ms. Cliona Robb Christian & Barton, LLP 909 East Main Street, Suite 1200 Richmond, Virginia 23219 Phone (804) 697-4100 Fax: (804) 697-4112 lmonacell@cblaw.com crobb@cblaw.com • What is VEPGA? • Virginia Energy Purchasing Governmental Association • Successor to VML/VACo Virginia Power Steering Committee • Organized more formally after passage of the Restructuring Act to take advantage of the opportunity to competitively purchase electricity • What is my connection to VEPGA? • The Columbia Group has represented VEPGA and its predecessor for 25 years in negotiating electricity contracts with Virginia Power • Christian & Barton, which has been active in representing large consumers that purchase from Virginia Power for over 30 years, serves as VEPGA’s legal counsel • Contact information:

3. VEPGA White Paperson Electric Utility Deregulation White Paper: Deregulation: Bright Idea or Dim Bulb? (issued August 2006) White Paper for Virginia Local Government Officials on Electric Utility Deregulation: Why Local Governments Need to Be Concerned about Ensuring Fair Pricing for Electricity in Virginia (issued August 2006) For copies of these White Papers, visit the VEPGA website at http://www2.ci.newport-news.va.us/vepga/directors.htm

4. VEPGA White Paperson Electric Utility Deregulation (cont.) • VEPGA is concerned about the impact of electricity deregulation on prices in Virginia based on recent experiences in other states • This concern is not limited to VEPGA. The General Assembly has authorized a subcommittee of the Commission on Electric Utility Restructuring (“CEUR”) to study the provision of electricity service following the expiration of capped rates on December 31, 2010. • The minutes prepared by the staff of the subcommittee following its first meeting on September 28, 2006 noted the following: • “Other states that have deregulated their retail electricity markets have seen sharp increases in rates when transition periods have ended and rates began to reflect the costs of acquiring power in wholesale markets. The current level of wholesale market prices for electricity has generated concerns that electricity rates paid by Virginians may rise sharply upon the expiration of the capped rates period.” • Remarks by representatives of large industrials users quantified these sharp increases for customers switching from capped to market rates: • Delaware customers saw increases in excess of 100% for industrial customers and 59% for residential customers. • Residential Maryland customers of Baltimore Gas & Electric were faced with a 72% increase

5. The future of electric rates in Virginia can be summarized in two words: Rate Shock • “Capped rates” under Electric Restructuring in many instances allow increases in a utility’s costs to be flowed through to consumers • “Capped rates” under Electric Restructuring ensure that decreases in a utility’s costs will NOT be flowed through to consumers • On January 1, 2011, “capped rates” are scheduled to be replaced with market-based rates, which will increase costs even more. • Local governments purchasing from Virginia Power expend about about $280 million for electricity on an annual basis. • If Virginia customers faced the kind of market-based rate increases that Delaware and Maryland customers faced, local governments purchasing from Virginia Power annually would pay $165.2 million more for electricity based on a 59% increase, and would pay $201.6 million more based on a 72% increase.

6. How do capped rates ensure that electric rates in Virginia are not just and reasonable? Since its enactment in 1999, the Restructuring Act has been revised in ways that harm consumers: • In the 2000 session, the General Assembly amended provisions in the Restructuring Act to prohibit negative “wires charges.” • Impact: utilities can recover stranded costs from consumers, but consumers cannot recover stranded benefits • When restructuring causes utilities to lose money because market rates are below their cost, consumers have to make them whole by paying stranded costs • When restructuring causes utilities to reap windfall profits because market rates are well above their costs, consumers receive no benefit. • In the 2000 session, the General Assembly amended the Restructuring Act to require that “default service” (the rates that apply when capped rates end) be based on market rates, not cost of service rates • In the 2004 session, the General Assembly rejected efforts to “suspend” the Restructuring Act and return to traditional cost-of-service regulation. Instead, the General Assembly extended capped rates through the end of 2010.

7. How do capped rates ensure that electric rates in Virginia are not just and reasonable? (cont.) • In the 2004 session, the General Assembly amended the Restructuring Act to permit utilities other than Virginia Power to seek increases in capped rates • No change was made to permit the SCC to initiate a rate case, either on its own initiative or based on the complaint of a customer or a customer’s representative like the Attorney General’s office • This transformed capped rates into “floor” rates because a utility is unlikely to initiate a rate change that would reduce its revenues • As a result, AEP’s customer may pay 3 significant rate increases during 2006: • Fuel factor increase of 0.3¢/kWh effective 1/1/06 • Environmental and reliability costs (“E&R costs”) • Base-related costs increases other than its E&R costs: this sought, on average, a 25% increase in base rates that became effective as interim rates on October 2, 2006. • In the 2006 session, the General Assembly permitted Virginia Power to “unfreeze” its fuel factor and instead pass-through actual fuel costs to its customers. During that same session, legislation that would have required the SCC to consider ALL costs when re-setting Virginia Power’s rates—both cost increases and cost reductions– was rejected.

8. How does replacing capped rates with market-based default rates ensure that electric rates will not be just and reasonable? • Experience of neighboring states • States north of Virginia, such as Maryland, have seen sharp increases when customers moved from capped rates to market-based rates • States south and west of Virginia, such as North Carolina and West Virginia, have retained traditional regulatory structure and experienced moderate increases. • Pricing in wholesale markets vs. cost-of-service pricing • PJM wholesale markets: hourly prices are based on the generating cost associated with the most expensive generating unit whose operation is required to meet demand during that hour • For many hours of the year, the most expensive generator is fueled by natural gas • This means PJM market prices closely track the cost of high-priced natural gas generation, which are often many times greater than coal and nuclear • Cost-of-Service Pricing • In regulated states, pricing is based on the average cost of the generating units, which include base-load coal and nuclear plants built generations ago

9. How does replacing capped rates with market-based default rates ensure that electric rates will not be just and reasonable? (cont.) • Windfall profits at customer’s expense • Utilities’ costs for producing power (based to a large degree on coal and nuclear plants that have depreciated) would be much lower than market prices (based to a considerable extent on natural gas units) • Consumers, who paid for the baseload plants via their utility rates, would be forced to pay market prices • Winners under deregulation • Utilities and their shareholders, who can produce power for 2¢ and sell it for 8¢/kWh • Independent power producers, who own coal plants and can sell the power well above the cost to produce it

10. How does replacing capped rates with market-based default rates ensure that electric rates will not be just and reasonable? (cont.) • Losers under deregulation: • Customers in general, who financed the generating plants and then are forced to pay higher market-based rates • Residential homeowners: there are no real substitutes for electricity. • With high gasoline prices, consumers could car pool or take the bus • There’s no alternative for running a refrigerator, fan, or air conditioner • Commercial and industrial businesses • Their customers • Their employees • Possible layoffs or even relocations outside Virginia • Local governments • Higher taxes or reduced services

11. Is there evidence that deregulation has currently harmed Virginia customers? • Delmarva Power & Light sought a 50% increase in total rates • Utility is primarily located in Maryland & Delaware with a small percentage of its customers in Virginia • Increase was caused by new purchased-power supply contract in which the sole and winning bid was from Delmarva Power & Light’s affiliate • The utility sought a $20 million increase in rates that would have resulted in a 49.5% overall rate increase, with a 43% average increase for residential customers and a 65.3% average increase for large commercial/industrial customers • The SCC approved an increase of $11.5 million, based on a previous order that made the SCC’s approval of the transfer of Delmarva’s generating plants contingent upon customers being protected from harm caused by the transfer of the generating units • The SCC commented “the fact that there was only one bidder—and that bidder was an affiliate of [Delmarva]—raises questions as to whether the resulting price was, in fact, competitive.”

12. Is there any evidence that Virginia utilities will accept cost-of-service rates in the future? • There is evidence that Virginia utilities will accept cost-of-service rates. On May 25, 2006, American Electric Power Service Corporation filed with FERC a 20 year contract for Appalachian Power Company to sell wholesale power to the City of Salem at cost-based rates, effective July 1, 2006 • This contract is not governed by the Restructuring Act because it involves a wholesale sale rather than a retail sale to end-user customers • However, it suggests that pricing at cost-of-service rates is still feasible in Virginia well beyond January 1, 2011.

13. What should local governments be doing? • Virginia’s transition period is not scheduled to end until January 1, 2011 • It’s not too soon to become fully educated on the policy choices for electric deregulation in Virginia • Public officials and citizens in Maryland and Delaware were caught off guard by sharp increases when capped rates were replaced by rates based on market prices • In Maryland, a political blame game ensued, with the General Assembly enacting legislation to fire five members of the Public Service Commission, the Governor vetoing the legislation, the General Assembly overriding the veto, and the whole mess ending up in the Maryland Supreme Court. An issue in Maryland’s statewide elections is who bears responsibility for the rate increase • This should provide a wake-up call for Virginia • Unlike Maryland and Delaware, Virginia still has the option to pull back from the brink because Virginia Power and AEP have not divested themselves of their generating units

14. Poster Child for Finding a Cure for Electricity RestructuringAlcoa Eastalco Smelter in Frederick Maryland

15. Statistical Profile • 630 Total Employees – 520 Local 7886 USWA members • $54mm annual payroll • $115mm supplies, materials, water, gas and other non electricity charges • Estimated 830 spin off jobs in surrounding area • 600,000 metric tons of ore trans shipped through the Baltimore Port every year • Several multi million $ improvements in the mid and late 1990’s for long term sustainability

16. Why Close Eastalco? Cash Cost! Long Term Alum Revenue Trend +86% -3%

17. 2006-2007 PJM Market Forwards

18. 2006-2007 PJM Market Forwards US World