Rethinking Natural Gas Utility Rate Design: A Framework for Change

Rethinking Natural Gas Utility Rate Design: A Framework for Change American Gas Foundation The NARUC Foundation Executive Forum at Ohio State University Russell A. Feingold Managing Director May 22-23, 2006

Today’s Discussion • So, why do we need to “rethink” natural gas rate design? • Natural gas ratemaking fundamentals of the past • How do today’s energy industry challenges provide us with a framework for change? • Is the utility ratemaking paradigm shifting? Navigant Consulting Inc. 2006 All Rights Reserved

Why Do We Need to “Rethink” Natural Gas Rate Design? • Changing industry drivers • Supply/demand balance, price dynamics, customer usage, etc. • Changing stakeholder policy objectives • Societal considerations, competitive position, financial goals • The current rate design may not be working as intended • Unexpected stakeholder impacts • Original rate design objectives not being satisfied Navigant Consulting Inc. 2006 All Rights Reserved

To Add Further Complexity to the Equation, “Rate Design is an Art – Not a Science”… • There is no right or wrong answer in deciding upon the “optimal rate design” • The many stakeholders in the process have diverse, and often, conflicting perspectives, opinions, and objectives • No stakeholder has the ability to precisely “forecast” exactly how a group of customers will respond to a change in rate design • How one defines “due” and “undue” discrimination is in the eye of the beholder • There is a natural tension that exists between the residential consumer and industrial customer (with commercial businesses in the middle) when class revenue and rate levels are established Navigant Consulting Inc. 2006 All Rights Reserved

Gas Utility Rate Design Tends to Evolve Over Time (an Illustrative Example) The Competitive Era (Mid 1990s to Early 2000s) Emergence of Natural Gas (1950s to Early 1970s) The Open-Access Era (Mid 1980s to Early 1990s) Ratemaking Trend Industry Driver(s) Policy Rationale Navigant Consulting Inc. 2006 All Rights Reserved

A Fundamental Consideration Over the Years: Declining or Inverted Block Rate Structure? • The declining block rate structure was the predominant rate form in use during the period of adequate gas supplies (1948 through 1971). • As natural gas supplies tightened, and curtailment of supplies became the norm (mid to late 1970s), rate structures were analyzed with conservation in mind. • The most common rate forms were marginal cost rates, incremental cost rates, flat rates, inverted block rates, or lifeline rates. • Declining or inverted block rates? – depends on how the gas supply situation is perceived by stakeholders, and how strongly they desire to influence customer behaviors (encourage or discourage gas use) through rate design. Navigant Consulting Inc. 2006 All Rights Reserved

To Borrow From a Popular 1950s Song; “What a Difference a Day Makes”… THE “GOOD OLE DAYS” Robust and stable use per customer levels were the norm Wellhead gas prices represented a small percentage of the burner-tip price of gas to utilities’ residential customers Utility rate cases were driven more by rate base increases rather than by expense increases “Normal weather” actually was experienced in some years Customers generally paid their gas bills TODAY Declining use per customer Purchased gas costs represent upwards of 70% of the customer’s gas bill Concern over how the utility will recover its approved revenue requirement through rate design Aging infrastructure and focus on system reliability “Warmer-than-normal” weather conditions are defining new norms Bad debt expenses increasing as gas commodity prices increase Navigant Consulting Inc. 2006 All Rights Reserved

A Changing Ratemaking Perspective in the Energy Industry “Then” “Now” Rate Design Pricing • A static process • Fixed prices • Cost-driven • Revenue predictability • A dynamic process • Flexible prices • Market-driven • Revenue uncertainty Navigant Consulting Inc. 2006 All Rights Reserved

In the “Good Ole Days,” We Worried About Things Like: • “Should 2 or 3 rate blocks be included in the residential rate structure?” • “Should we increase the residential monthly customer charge by $0.50 or $1.00 per month?” • “Should we establish rate classes and rate structures by end-use or by volume?” • “Do we really need to focus on end-user transportation rates because customer choice and the existence of third-party gas marketers are both temporary market conditions?” Navigant Consulting Inc. 2006 All Rights Reserved

And Today, We Worry About Things Like: • How do we promote the efficient use of natural gas through rate design? • How do we develop rates to minimize the utility financial and customer billing impacts of weather variability? • How do we minimize through rate design the impact of declining use per customer on a utility’s financial condition, and on the stability of customers’ bills? • How should varying levels of bad debts be accommodated through rate design? • How do we recover costs associated with aging infrastructure and enhanced system reliability? Risk Volatility Price Uncertainty Navigant Consulting Inc. 2006 All Rights Reserved

In Recent Times, the Wellhead Price of Gas Has Surpassed the Price of Transmission and Distribution Delivery Services Wellhead Price as a Percent of Burner-Tip Price 1967 - 15% 2005 - 59% 2006 - 70%+ Source: U.S. Energy Information Administration (weighted average price levels) Navigant Consulting Inc. 2006 All Rights Reserved

Yet, Both Components Are Equally Important to the Utility and its Customers for Different Reasons • Commodity Cost of Gas – most important to end-use customers because it currently is driving the total price of natural gas and the relative level of their gas bills • It has the greatest impact on the customer’s monthly gas bill • It has the greatest influence on the price signal received by residential customers • Delivery Margin – most important to gas pipeline companies and gas distribution utilities because it directly impacts their current financial performance and ongoing business viability • Utilities do not make money from purchased gas costs incurred to serve their sales customers1 1Unless they operate under a gas cost PBR plan Navigant Consulting Inc. 2006 All Rights Reserved

The “Perfect Storm” is Now Upon Us… • Unpredictable costs and sales levels • Restructured assets • Increased financial stress Energy Market Conditions Regulatory Roles and Actions • Increased volatility • Higher commodity prices • Uncertainty • Changing roles • Tough issues to balance Distribution Utilities End-Use Customer Characteristics • Responses to high prices • Declining gas use • Bill payment problems Navigant Consulting Inc. 2006 All Rights Reserved

Some Threshold Regulatory Considerations • What constitutes a customer’s “efficient use of natural gas?” • How do you define for a gas utility: • “A reasonable opportunity to earn its allowed rate of return?” • “Its normal risks of doing business?” • Which costs and/or business factors for a utility are considered uncontrollable, unpredictable, material, and recurring? - and should they be treated differently for rate design purposes? • What does it mean to achieve a reasonable level of rate equity among a utility’s customer groups? • Should utilities be rewarded for “superior performance?” Navigant Consulting Inc. 2006 All Rights Reserved

However, There is No Clear Consensus Among Utility Executives and Regulators on What is Most Important The Most Important Objectives for a Utility Regulator to Achieve (Greatest Difference) Source: 2005 Navigant Consulting Utility Regulatory Survey Navigant Consulting Inc. 2006 All Rights Reserved

No Clear Consensus … (continued) The Most Important Objectives for a Utility to Achieve (Greatest Difference) Source: 2005 Navigant Consulting Utility Regulatory Survey Navigant Consulting Inc. 2006 All Rights Reserved

The Utility Rate Design Process: Balance is Essential • Historical Factors • Rate perspective • Rate continuity • Social and Political Factors • Customer reaction and acceptance • Public relations aspects • Economic conditions of service territory • Social obligations to particular customer groups • Political attention and involvement • Economic Factors • Cost of service • Value of service • Competitor prices • Price differences and discrimination • System load equalization • Availability of gas supply/capacity • Return and revenue stability • Regulatory Factors • Precedent • Intervenor interests Navigant Consulting Inc. 2006 All Rights Reserved

For Many Utilities, Their Major Business Drivers Have Prompted the Filing of General Rate Cases… • Unstable margins – leading to earnings stress • Uncontrollable and unpredictable costs • Declining use per customer • Challenges to achieving growth • A “Back to Basics” business strategy • Regulatory lag (process can be slow, costly, inefficient) • Aging infrastructure and focus on system reliability • Regulatory uncertainty Navigant Consulting Inc. 2006 All Rights Reserved

Many Innovative Ratemaking Mechanisms are Being Proposed by Utilities in Rate Cases to Address Their Specific Business Challenges. • Straight Fixed-Variable Rate Design • Revenue Decoupling Mechanisms • Bad Debt Recovery Mechanisms • Infrastructure Replacement Cost Recovery Mechanisms • Revenue (Return) Stabilization Mechanisms Navigant Consulting Inc. 2006 All Rights Reserved

In Addition, the Static Nature of a “Test Year” is Being Challenged Through Utility Rate Design Initiatives in These Rate Cases. Key Assumptions in the Use of a Test Year: • A test year represents a snapshot in time that attempts to reflect a level of plant and expenses comprising a utility’s total revenue requirement – which will be representative of the period the new rates will be in effect. • Use of a test year assumes that the utility’s costs in a future period can be reasonably represented by its historical costs (often with known and measurable changes) – which means such costs are assumed to be predictable, stable, and controllable. • In today’s highly volatile and unpredictable cost and energy usage environment, are these still realistic assumptions? Navigant Consulting Inc. 2006 All Rights Reserved

When Does it Make Sense to Utilize an Automatic Adjustment Mechanism? An automatic adjustment mechanism should be considered as an appropriate cost recovery method when they address costs and/or business factors (e.g., weather, gas usage) that are: • Uncontrollable by the utility. • Variable and Unpredictable. • Material and of a Recurring nature. Navigant Consulting Inc. 2006 All Rights Reserved

Examples of Automatic Adjustment Mechanisms • Purchased gas adjustment (PGAs) • Weather normalization • Revenue decoupling • Bad debt/uncollectible expense • Environmental costs • Property taxes • Infrastructure cost recovery (capital and O&M) • Infrastructure improvement • Pipeline integrity (mandated safety programs) • Public improvement projects • Energy efficiency/DSM costs • Stranded restructuring costs Navigant Consulting Inc. 2006 All Rights Reserved

Energy Efficiency and Conservation Can Provide Relief for Customers From High Natural Gas Prices… There is a renewed focus by utilities on promoting cost-effective energy efficiency measures to relieve consumer burdens. • Typical programs include: • Audit – analysis of conservation opportunities • Retrofit/replacement (rebates) – weatherization, programmable thermostats, efficient equipment replacement • New construction – new buildings and expansions • These programs make sense for customer, economic, and public policy reasons, provided that utility financial impacts are addressed: • Lost revenue recovery • Contemporaneous recovery of program costs Navigant Consulting Inc. 2006 All Rights Reserved

Decoupling Can Align Stakeholders’ Diverse Interests • A properly designed decoupling mechanism can achieve significant benefits for the utility and its customers: • Mitigates the utility’s disincentives to promote energy efficiency; • Removes the relationship between the utility’s sales volume levels and profits (margin revenues); and • Provides increased opportunities to customers to reduce energy consumption, and to reduce energy bills, created by the various energy efficiency and conservation initiatives supported by the utility. • Customers’ bills will more accurately reflect the margin recovery amounts approved by the regulator. • Improves the ability of the utility to recover its fixed costs of providing service. Navigant Consulting Inc. 2006 All Rights Reserved

Bad Debt Recovery Mechanisms • An alternative to recovery as a fixed expense in base rates set in a rate case • The tracker permits recovery of actual bad debt expense through a deferral account - periodically is “zeroed out” through the application of surcharges or credits to base rates. • Recognizes the uncontrollable/unpredictable nature of such costs and close correlation with changes in the price of natural gas • In some states, base rates reflect a “baseline” level of bad debt expense, with variations from baseline used to adjust rate • Others permit separate treatment of gas commodity-related bad debt expense through its Purchased Gas Adjustment (“PGA”) mechanism Navigant Consulting Inc. 2006 All Rights Reserved

Infrastructure Replacement Cost Recovery Mechanisms • An alternative to recovery as a fixed expense in base rates set in a rate case, or through deferred accounting treatment. • Reflects costs mandated under: (1) the Pipeline Safety Improvement Act (“PSIA”) of 2002; (2) public improvement projects; or (3) accelerated pipe replacement programs. Navigant Consulting Inc. 2006 All Rights Reserved

Revenue (Return) Stabilization Mechanisms • A form of Performance-Based Ratemaking (“PBR”) – periodic rate adjustments are made based on a comparison of achieved vs. approved rate of return, without the need for a full rate case • Some of the mechanisms are based on an “earnings sharing” approach – utility and customers share any increase or decrease in achieved earnings relative to a target earnings level • Approved in Alabama, Louisiana, Mississippi, South Carolina Navigant Consulting Inc. 2006 All Rights Reserved

Is the Utility Ratemaking Paradigm Shifting? YES! • There is an increased recognition of the uncontrollability, variability, and unpredictability of a utility’s costs, and its customers’ usage levels • An increased awareness that a much more dynamic process is needed to ensure a utility’s rates will actually recover the regulator-approved cost of service – the static nature of a “test year” is being challenged. • Increased recognition that the majority of a utility’s costs are fixed, yet they are recovered through the volumetric component of its rate structure – which creates financial instability. • A desire to streamline the regulatory process by reducing the number of general rate cases. Navigant Consulting Inc. 2006 All Rights Reserved

Paradigm Shifting (continued) • Innovative ratemaking mechanisms will appear more frequently in utility rate case filings because they: • Address important financial customer needs; • Provide significant benefits to the utility and its customers; and • Streamline the rate case process. Navigant Consulting Inc. 2006 All Rights Reserved

Rethinking Natural Gas Utility Rate Design: A Framework for Change