6.

Introduction to Rate Making

Calculating ROR
Smyth v Ames
- Established it was unconstitutional to deny PUC reasonable
rate of return and confiscate property without compensation
- Raises the question of how do you calculate a fair rate of
return
Two parts to calculation
- Percentage of return on investment
- How do you value investment that owners have in business to
calculate what percentage should be applied to
Approaches to valuing investment
- 1) How much money did they put in at the start the cost of
investing
- 2) Replacement value of property
o Not what originally paid for, but instead what it is valued
at today
- 3) Market value concept
o Theoretically worked well, but how do you calculate
market value of utility property when all it can be used
is for utilities and that value is based on what the rate is
o Market value depends on ROR so cant use it to
calculate ROR
- 4) Stock price
o Generally rejected
Bluefield (comparable earnings) suggested that we look at returns
in:
- Same time period
- Same geography
- Corresponding risks and uncertainties
o More or less risky than other companies youre looking
at
Hope (the ends result) stated the minimum one must consider is
the original cost/investment by shareholders in utility
- Across all jurisdictions since then, regulators have dealt with
this original cost calculation
Market Street Railway stated that if things other than regulation are
impacting the utilitys ability to generate reasonable rate of return,
then regulators (DO OR DONT) have to keep raising rates
Some individuals are going off the grid with solar power

Would regulators have any constitutional requirements to

raise rates to remaining customers to keep utility earning a
reasonable rate of return

Jersey Central (used and useful) was case in which a lot of money
had already been put into nuclear power plant which was then
cancelled
- Regulator did investigation and came to conclusion that
decisions of manager were all reasonable
- Regulator said theyd let the investors recover capital cost,
but wont allow them to earn anything on the investment
- Utility argued that wasnt fair b/c theyd done everything
reasonable and were entitled to ROR
- Found that the utility was entitled to return
constitutionally
o Utility had alleged it was in financial stress b/c of the
lack of return
Definitions and the Formula
Revenue requirement
- Total amount of money that regulators think is reasonable for
utility to receive for
Cost allocation
Rate design
Most rates based on forecasts so if there are unforeseen
crises, utilities cant recover unless retroactive rates
This is also a method used by utilities to increase their profits
- Forecast price increase for suppliers when they dont have
reasonable belief it will happen in order to make the forecast
costs look higher
Statute in California (CEMA natural disaster lex) now allows rate
recovery in situations where disasters occur when it fulfils the
definition of natural disaster in lex
R = O + i(B D)
- Revenue requirement = operating expenses (what utility
must spend to provide adequate service that isnt invested in
capital assets but is used up as service is provided e.g. in
natural gas the gas that is being delivered to the house is an
expense or meter reading by individual)+ interest
(authorised rate of return) multiplied by (base less
accumulated depreciation)
Rate base = B
Original cost

Reasonableness review
Used-and-useful
AFUDC
- Allowed Funds Used During Construction
CWIP
- Construction Work in Progress
- Able to make a return on projects before they go into service
- Doesnt happen as much these days
Working capital
Averich-Johnson effect
Rate of return = i
Regulator will look at LR debt, preferred stock, shareholder
investment
- 45-50% of financing of entire business being LR debt isnt
unusual
LTD (long-term debt)
Pref. (preferred stock pays fixed dividend that doesnt change over
time just like borrowing money, but subordinate to debt if in
bankruptcy)
CE (common equity - owned by shareholders)
Ratios
- LTD 45%
- Pref 5%
- CE 49%
Cost
- LTD 5.62%
- Pref 7.25%
- CE (decided by regulators) 11.1%
Multiply ratios x cost to get weight
- THEN multiply all the weights to get i
How
-

does regulator decide the ROR of common shareholder?

Risk free bond rate
BETA volatility of earnings
DCF (discounted cash flow) dividend yields, growth of other
stable stock

Expenses = O
Reasonableness
- Reasonable expense to run the company is all that is allowed
- Consider what utility has spent and plans for change
Depreciation wearing out of capital
- Useful lives
- Straight line vs. accelerated
Taxes
Exclusions
- Charitable donations
- Lobbying
- Shareholder-only benefits
- Advertising especially if for corporate image
Forecast vs. recorded ratemaking
Forecasts can lead to utilities either making a lot or a little money
due to the reliance on forecasts

Performance-based ratemaking
Traditional ratemaking lacked incentives for good management
- Should get better at running business after inflation every
year
o Means that rate adjusted for inflation went down
Negative incentives (reducing call centre staff to cut costs) were
discouraged
Gas side
- Gas cost incentive mechanism been in place for past 20 years
- Independent market measure of what price of natural gas is at
the well head
o This is the compared with what utilities actually pay for
the gas
Sales risk (decoupling)
Earning of utilities not affected if sales are higher or lower than
forecast
- Gets rid of fighting over forecasts in rate cases
This is done through an accounting mechanism that looks at
revenues
Rate Design

Customer charge, demand charge, energy charge

Declining vs. inclining block energy charge
Income re-distribution
Time of use
Cost-of-service rate regulation widely accepted method
- Based on firms revenue requirements costs it must recover
to stay in business
- Includes covering fixed and variable costs as well as making
reasonable return for investors
Described as R = B*r + O
- R = revenue requirements
- B = utilitys base rate (capital investment in plant and other
assets)
- r = rate of return regulators allow utility to earn
- O = operating expense (fuel, labour, etc.)
(r) represents a companys cost of capital
Its the opportunity it forgoes by using capital to provide utility
services
- Includes:
o Debt cost of money borrowed on SR and LR basis
o Equity money received by utility in exchange for stock
Split into common and preferred
B/c no fixed commitment to return rate on dividends the cost of
floating stock issue is uncertain
- Based on either
o Market-determined standard focuses on investor
expectations
o Comparable earnings standard earning of capital in
various alternative investments
PUCs attempt to maximise returns
Can:
- 1) Obtain (r) that exceeds actual cost of capital
- 2) Overinvest in capital to produce B and (r) greater than
actual cost of capital used
Smyth v Ames
Facts
- Railroads argued Nebraska statute establishing max rates to
rail service within state violated constitutional prohibition on
taking private property without just compensation

Reasoning
- Case more concerned with rate base b/c discusses Fair value
of property being used
- 4 criteria relevant to fair value
o 1) Original cost of construction
o 2) Amount and market values of utilitys bonds and
stocks
o 3) Present compared with original cost of construction
o 4) Probable earning capacity of property under rates
described
- Later cases rejected this fair value doctrine
Decision
- Corporation may not be requires to use property for benefit of
public without compensation
Bluefield Water Works v Public Service Commission
Facts
- Company contends rate of return is too low
Decision
- Held that public utility entitled to rate permitting it to earn
return equal to return generally made at same time and same
part of country on investments in other undertakings which
are attended by corresponding risks and uncertainties
o Not entitled to profits anticipated in highly profitable
enterprises
- Rate may be reasonable at one time and subsequently
become too high or low
FPC v Hope Natural Gas
Facts
- Validity of Natural Gas Act of 1938 which reduced companys
rates
Reasoning
- Commission not required to use single formula to determine
rates to determine just and reasonable
- Rate cant be invalid if produces meagre return compared to
fair value standard
- Why would latter produce higher rate?
Decision
- Rate not unjust
- Rate must allow company to operate successfully, maintain
financial integrity, attract capital, and compensate investors
for risks

Modern end results test suggests court will focus more on

the output than on monitoring details of calculation of inputs

Decision on residential rate reform

Advanced metering infrastructure (AMI)
Residential rates frozen in compliance with lex due to energy crisis
- Unfair prices for many customers
TOU time of use rates must be flexible enough to address
changes while providing consistency for customers
Rejection of request by investor-owned utilities (IOU) for fixed
monthly charge
- Instead told them to continue tier consolidation, implement
minimum bill, and others
The energy companies in California seek changes in revenue
requirements every three years through general rate cases (GRC)
- Phase 1: sets utilitys revenue requirement (the pie)
o Amount of revenue to be recovered in the rates
- Phase 2: allocation of costs in pie to different customer classes
(dividing up the pie)
Required terms
- Opt-In Rate: A voluntary rate that the customer can choose to
be on. The burden is on the customer to affirmatively choose
the tariff.
- Opt-Out Rate: A voluntary rate the customer can choose to
leave. The burden is on the customer to affirmatively leave
the tariff. A voluntary default tariff can is also an opt-out tariff.
- Mandatory Rate: A rate that the customer cannot opt-out of.
- Default Rate: The rate the customer is automatically put on if
the customer does not affirmatively choose a different tariff.
For residential customers, this is a voluntary (not mandatory)
rate
Miller-Warren Energy Lifeline Act
- Sought to provide Californias residential customers with
necessary amounts of gas and electricity (lifeline quantity) at
fair cost while encouraging energy conservation
- Found:
o (a) Light and heat are basic human rights, and must be
made available to all the people at low cost for basic
minimum quantities.
o (b) Present rate structures for gas and electricity serve
to penalize the individual user of relatively small
quantities, and at the same time encourage
wastefulness by large users.

o (c) In order to encourage conservation of scarce energy

resources and to provide a basic necessary amount of
gas and electricity for residential heating and lighting at
a cost which is fair to small users, the Legislature has
enacted this act
Lifeline programme renamed and revised by 1982 Baseline Act
which set baseline rates at 15-25% less than system average rate
(SAR)
Senate Bill 987 in 1988
- Focused on high winter gas bills not electric bills
AB 1432 enacted in 1992 mandating that Commission retain
appropriate inverted rate structure
AB 1890 in 1996 restructured energy industry in California
- Rates capped slightly above cost-levels in 1996
- Utilities meant to recover stranded costs through innovation
and reduction in costs
- BUT market manipulation and 2001-2001 energy crisis created
gap between costs to produce power for wholesale and retail
rates utilities allowed to charge
In response, Commission required to develop rate design to enable
IOUs to fully recover residential revenue requirements
- 2-tiered structure replaced with 5
Rate tier differentials continued to widen until SB 695 in 2009limited
Tier 1 and Tier 2 rates and consolidated Tier 4 and 5