Total Capitalization: $2.1 billion Total Capital Expenditures: $322 million Total Employees: 1,430

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Who We Are Part II Total Assets: $3.2 billion Total Capitalization: $2.

states with relatively stable economies with opportunity for system investment and grid

Introduction to Regulation and Utility Ratemaking Unique opportunity to provide

1 Who We Are Part II Total Assets: $3.2 billion Total Capitalization: $2.1 billion Total Capital Expenditures: $322 million Total Employees: 1,430 Located in states with relatively stable economies with opportunity for system investment and grid expansion Footprint of service territory covers some of the best win regimes in the U.S. Introduction to Regulation and Utility Ratemaking Unique opportunity to provide transmission services in two different power markets (West and Midwest) 1 Customer Vision Project April 3, 2018

Topics Regulation Development of a General Rate Filing Revenue Requirement (Cost of Service) Allocated Cost of Service Rate Design Process of Establishing Rates Montana

2 Topics Regulation Development of a General Rate Filing Revenue Requirement (Cost of Service) Allocated Cost of Service Rate Design Process of Establishing Rates Montana Regulation Rate Filing Process Processing of a Rate Filing Tariffs and Billing The Balancing Act Customer Needs & Obligations Mutual Needs & Obligations Utility Needs & Obligations 2

3 3 Regulation

4 Government Oversight Two broad, fundamental principles justify governmental oversight of the utility sector: A public utility provides essential services for the well being of society the industry is affected with the public interest. The technological and economic features of the industry are also such that a single provider is often able to serve the overall demand at a lower total cost than any combination of smaller entities could. Competition cannot thrive under these conditions; eventually, all firms but one will exit the market or fail. The surviving entities are natural monopolies and, like other monopolies, they have the power to restrict output and set prices at levels higher than are economically justified. Governmental intervention (regulation) is necessary to achieve public benefits that the market fails to achieve on its own. 4

5 The Regulatory Compact It is generally accepted that regulation constitutes an implied agreement between a utility and the government: In return for the utility accepting the obligation to serve within in its exclusive service territory, the government promises to set rates that will allow the utility an opportunity to recover its cost of service. This implied agreement is sometimes referred to as the regulatory compact. The general objective of economic regulation to ensure the provision of safe, adequate, and reliable service at prices that are sufficient, but no more than sufficient, to compensate the regulated firm for the costs (including returns on investment) that it incurs to fulfill its obligation to serve. The legal obligations of regulators and utilities have evolved through a long series of court decisions. 5

6 In The Public Interest Regulation is intended to protect the public interest: Utilities are expected to offer service to anyone who requests it and can pay for it at the regulator s (or government s) approved prices. In this sense, service is universal and homogeneous to various customer classes. Because most utility consumers cannot shop around between multiple providers as a result of the natural utility monopoly, regulation serves the function of ensuring that service is safe and reliable, reasonably priced, and responsive to consumer needs. Finally, given utilities crucial role in the economy and in society s general welfare, various service standards are often imposed as well. 6

7 Determinant of Prices In a competitive market, the prices of goods or services are determined by what the customer or market will bear. In theory, prices will clear at the point where marginal costs equal the value that consumers, in the aggregate, establishes for a good or service. Because public utilities are natural monopolies, a different approach to price-setting is required. Regulators use a cost of service approach to determine a fair price for electric service by which the aggregate costs (including a reasonable return of, and on, investment) for providing service are determined. Prices are then set to recover the aggregate costs apportioned by customer class (eg. residential, commercial, and industrial) 7

8 Development of a General Rate Filing 8

Revenue Requirement (Cost of Service) Revenue Requirement = Expenses + Return on Rate Base RR - is the total Revenue Requirement or the total normalized cost of providing

9 Revenue Requirement (Cost of Service) Revenue Requirement = Expenses + Return on Rate Base RR - is the total Revenue Requirement or the total normalized cost of providing utility service E - is all Expenses allowed by the Commission for ratemaking purposes RB - is the allowed Rate Base, or net valuation of utility property serving utility customers 9

10 Revenue Requirement Revenue Requirement = Expenses + Return on Rate Base r - is the allowed return on Rate Base (as a percentage) r(rb) - is the overall allowed return multiplied by the Rate Base The allowed return is not a guarantee, the Utility is provided an opportunity to earn 10

11 Revenue Requirement Formula Let s look at E E equals Supply Expense: typically includes the cost of the coal, oil, gas, nuclear fuel, etc. used to fuel electric generating plants, plus the entire cost of purchased power and natural gas (NorthWestern s electricity and natural gas supply expenses are recovered separately in trackers) plus Non-Supply Operating Expenses: all O&M, A&G, and other expenses to run the company plus Depreciation Expense: the amount allowed in a given year for recovery of prior capital expenditures (not the return on capital investment) plus Taxes: all property, payroll, income, and other taxes 11

12 Revenue Requirement Formula Let s look at r r is comprised of cost of debt: the interest charged on the company s debt and cost of equity: the return allowed on common stock (based on return on common stock of comparable utilities) NOTE: r, the allowed return on Rate Base is often called the overall Rate of Return and designated ROR; the authorized return on equity is often called the rate of return or ROE. 12

13 Revenue Requirement Formula Let s look at RB RB equals original cost of facilities (assets): the total capital investment in plant and equipment used to provide utility service minus accumulated depreciation: the amount of capital investment already recovered through depreciation expense 13

14 Revenue Requirement Formula Let s look at r(rb) r(rb) equals overall rate of return: the cost of debt (i.e. interest) and the equity (i.e. ROE), in percentage terms (debt and equity comprise the capital structure) times net utility capital investment: financed by both debt and equity 14

15 Revenue Requirement Formula Let s look at an Income Statement RR = E + r(rb) Income Statement Revenue equals» Expenses plus» Income Income Rate Base = Overall Earned Rate of Return on Investment 15

16 Simplified Revenue Requirement Calculation Expenses $100,000,000 Rate Base $1,000,000,000 Allowed Rate of Return 7.50% Allowed Return on Rate Base $75,000,000 Total Revenue Requirement $175,000,000 Rate Computation: Revenue Requirement $175,000,000 Divided by Test Year Sales (kwh) 2,000,000,000 Tariffed Rate $/kwh) $

17 Allocating Utility Cost of Providing Service Electric System: Supply, Transmission, & Distribution 17

18 Allocated Cost of Service Effect: ACOS analysis creates a hypothetical utility by customer class Functional Cost Allocation Revenue Requirement (Cost of Service) Detailed Accounting Costs Energy (Production) Transmission Distribution Customer Customer Class Allocation Energy Demand Customer Energy (Production) Transmission Distribution Customer Residential General Service Industrial Energy (Production) Transmission Distribution Cost Classification Customer Energy Demand Customer 18

19 Rate Design Establishing Rate Structures to Meet Rate Design Goals and Objectives: Understandability and feasibility of application Freedom from controversies about interpretation Yield total revenue requirement Revenue stability year-to-year Rate stability and predictability Fairness of rates in apportionment of total costs among customers Avoidance of undue discrimination in rate relationships Promote efficient use of utility service 19

Rate = Class Revenue Requirement divided by Test Year Billing Statistics Class Revenue Requirement (from Allocated Cost of Service) Billing Statistics/Billing Determinants: Number of Customers

20 Rate = Class Revenue Requirement divided by Test Year Billing Statistics Class Revenue Requirement (from Allocated Cost of Service) Billing Statistics/Billing Determinants: Number of Customers Demand: Kw Electric/MDDQ Gas Energy (Commodity): Kwh Electric/Therm Gas Components/Structures: Customer Charges (Fixed) Demand (Fixed) Charges Energy (Commodity) Charges Other (Special Charges, Refunds) Alternative Rate Structures Averaging Process Rate Design 20

21 Rate Design Customer Billing Impact: Revenue at Proposed Rates minus Revenue at Current Rates Revenue at Current Rates = % Bill Impact Moderate Billing Impact Class revenue moderation Revise class revenue targets Sum to total revenue requirement Design rates to reflect moderated revenue targets 21

22 Process of Establishing Rates 22

23 Montana Regulation Montana Public Service Commission (PSC) Five members elected from five separate districts for four-year terms Legal and Technical Staffs Montana Consumer Counsel (MCC) Supporting Attorneys and Technical Staff 23

24 Rate Filing Process Other Intervening Parties Large Customer Group Qualifying Facilities Natural Resources Defense Council Human Resource Council, District XI Montana Environmental Information Center/Sierra Club 24

25 Rate Filing Process NorthWestern prepares filing according to PSC Rules/Filing Requirements (testimony and exhibits) The MCC and other parties intervene or join proceeding MCC and other parties ask Data Requests MCC and other parties file their own testimony and exhibits 25

26 Rate Filing Process MCC and others respond to data requests NorthWestern files rebuttal testimony and responds to more discovery Hearing is held before the Commission Briefs are filed Commission issues Order Possible reconsideration by any party New tariff rates are established 26

27 Public Service Commission Hearing Noticed Public Hearing Formal Process Court-Like Setting Court Reporter Witness Stand Court Reporter Commission Commission Staff Lawyer Representation NorthWestern Energy Montana Consumer Counsel Main Street Business Assoc. Technical in Nature Low-Income Sr. Citizens Large Industrial Customers Develops Record for Decision Audience Public Testimony 27

Tariffs and Billing Rate Schedules and Tariff Updates Published Tariffs are Public Information Source for Rates and Regulations Governing Utility Service: Table of

28 Tariffs and Billing Rate Schedules and Tariff Updates Published Tariffs are Public Information Source for Rates and Regulations Governing Utility Service: Table of Contents Rate Schedules Service Rules and Regulations Available electronically on NorthWestern Energy website Billing System modified to use new rates to bill customers 28

29 QUESTIONS?

Cost of Service Ratemaking Overview Before the House Economic Matters Committee. January 10, Maryland Public Service Commission

1 Public Service Commission Cost of Service Ratemaking Overview Before the House Economic Matters Committee January 10, 2019 2 Ratemaking Overview: Topics Covered Rate-Making Concepts Legal Standard Key