STATE OF VERMONT PUBLIC SERVICE BOARD

Transcription

1 STATE OF VERMONT PUBLIC SERVICE BOARD Docket No Tariff filing of Vermont Gas Systems, Inc. requesting: (1) a 14.8% rate increase in its firm rate, effective April 19, 2001; and (2) approval of a Rate Stabilization Plan ) ) ) ) ) ) ) Public Hearing at South Burlington, Vermont May 29, 2001 Technical Hearings at Montpelier, Vermont July 31, August 1 and 2, 2001 September 10, 11, and 24, 2001 Order entered: 11/9/2001 PRESENT: APPEARANCES: Michael H. Dworkin, Chairman David C. Coen, Board Member John D. Burke, Board Member Sarah Hofmann, Esq. June E. Tierney, Esq. for Vermont Department of Public Service John H. Marshall, Esq. Downs Rachlin & Martin PLLC for Vermont Gas Systems, Inc. OPINION AND ORDER

2 Docket No Page 2

3 Docket No Page 3 I. Introduction...3 II. Cost of Service...4 A. General...4 B. Natural Gas Costs...5 C. Personnel Costs...13 D. Health Care and Other Employee Benefit Expenses...15 E. Liability Insurance Deductible...17 F. Liability Insurance Premium...18 G. Lobbying Costs and Corporate Donations...19 H. Expenses Related To Maintaining Mains...20 I. Inventory Adjustment Expense...21 J. Interruptible Revenues...22 III. Rate Base...23 IV. Cost of Capital...24 V. Rate Stabilization Plan...26 VI. Asset Management Agreements, i.e., Outsourcing...38 VII. Integrated Resource Plan and Demand-Side Management Programs...39 VIII. Service Quality Plan...42 IX. Conclusion...45 X. Order...46 Appendix: Procedural History...47

4 Docket No Page 4 I. INTRODUCTION This Docket is the fourth rate case filed in the last two years by Vermont Gas Systems, Inc. ("VGS"), the state's only natural gas local distribution company. In Docket 6370, filed February 18, 2000, VGS requested a 7.6 percent increase in firm rates, proposed to take effect on and after November 1, The Vermont Department of Public Service ("Department" or "DPS") supported the request and stipulated accordingly. This increase was approved on September 21, In Docket 6413, filed July 13, 2000, VGS requested a 15.6 percent increase in firm rates, proposed to take effect on and after November 1, 2000 (cumulative 24.4 percent). The Department supported VGS's request, with one slight modification, and an increase of 15.4 percent was approved on March 28, In Docket 6444, filed September 22, 2000, with the Department's support, VGS requested an 11.2 percent increase in firm rates (cumulative 38.2 percent). By Order of June 6, 2001, the Public Service Board ("Board") granted VGS's request. In reviewing and granting these rate increase requests, the Board has relied upon a combination of approaches to accommodate VGS's needs. In all three dockets, we accepted VGS and Department stipulations. In Docket 6413, we allowed for temporary rates to go into effect pursuant to a subsequent full investigation. In Docket 6444 (where the Board found there to be extraordinary circumstances), it also approved an accounting order that established a deferral account. In this Order, the Board considers a request by VGS to increase its firm retail rate by 14.8 percent, to take effect April 19, 2001, and to be implemented on a service-rendered basis on October 1, The proposed rate change represents an increase in VGS's revenue requirement of approximately $8.2 million annually. VGS has also requested that the Board approve VGS's proposed "Rate Stabilization Plan" which includes provisions for (a) Gas Costs Risk Management, (b) a "Rate Stabilization Account," and (c) Regulatory Reporting. In addition, in this Order we review VGS's Integrated Resource Plan filed on November 1, 2001, and a stipulation entered into by VGS and the Department regarding a Service Quality Plan for VGS. 1. Tariff Filing No

5 Docket No Page 5 In our decision today, we decline to approve the rate increase requested by VGS, and, instead, require a rate decrease of 3.4 percent. This decrease represents a $1.891 million decrease in VGS's revenue requirement for firm gas, and sets VGS's adjusted test year cost of service at $ million. We have also decided to not approve VGS's Rate Stabilization Plan. We also decline VGS's request for approval of a Rate Stabilization Account because, for reasons more fully explained below, we believe that such an account is neither in keeping with Vermont law nor with sound and long-standing regulatory policy. Criteria for Decision Vermont law requires this Board to set rates that are "just and reasonable." This end is typically achieved by using cost-of-service rate-making methodology, although the relevant statutes neither expressly require nor prohibit any specific methodology. To arrive at an appropriate cost of service for the prospective rate year, actual expenses are taken from the latest 12-month period, i.e., the test year, and adjusted for known and measurable changes. The Board takes into consideration the predictive value of proposed adjustments when weighing their merit. II. COST OF SERVICE A. General Issues and Positions VGS's March 5, 2001, tariff filing requests a 14.8 percent increase in the Company's firm rates, effective April 19, The 14.8 percent increase equates to $8,167,679 above the previous annual revenue level, and was calculated by VGS based on high natural gas costs early this year. Due to a subsequent decline in commodity gas costs, VGS proposed a 0.2 percent rate decrease in its prefiled rebuttal testimony, for a revenue reduction of $110, In its prefiled rebuttal testimony, the Department recommended a 4.88 percent rate decrease. Taking into account subsequent cost of service modifications, at the time of the filing of its Initial Brief, the Department recommended at least a 4.54 percent rate decrease, equivalent 2. Schedule 1 of VGS's Reply Brief incorporates additional reductions in commodity gas costs resulting in a 1.8 percent revenue reduction, equivalent to a $984,873 decrease in firm revenues.

6 Docket No Page 6 to $2,507,817. This rate decrease calculation excluded the effects of two additional adjustments the Department later made and included in its October 5, 2001, Reply Brief. Incorporating these adjustments, the largest of which was made to reflect lower spot market prices for natural gas, in its Reply Brief the Department requested an 8.41 percent rate reduction. Findings 1. Vermont Gas Systems, Inc., is the only company in Vermont engaged in the distribution of natural gas. The Company serves approximately 34,000 customers in the northwestern part of Vermont. Gilbert pf. at For the twelve-month period ended September 30, 2000, VGS recorded firm gas sales of $37.1 million and interruptible gas sales of $13.3 million. Morgan reb. pf., sched. LKM The test year is the twelve-month fiscal year ended September 30, The adjusted test year is the twelve-month period from October 2, 2001, through September 30, VGS exh. 1, Attachment B. B. Natural Gas Costs Issues and Positions The largest component of VGS's cost of service is attributable to the purchase of natural gas. VGS has four types of natural gas costs at issue in this proceedings, those related to: (1) unhedged commodity costs; (2) basis differential; (3) storage; and (4) carrying costs. In the discussion below, each is considered in turn. The first two categories unhedged commodity costs and basis differential are best understood together. VGS purchases all of its natural gas through contracts with Canadian suppliers. The commodity price that VGS contracts for with these suppliers is based on a futures index, the New York Mercantile Exchange ("NYMEX") index. The contracts for future delivery of the gas commodity are traded on the NYMEX and their price reflects delivery of the commodity to Henry Hub in Louisiana. VGS, however, takes actual delivery of gas from its Canadian suppliers in western Canada, i.e., at a location other than Henry Hub. Consequently, there is a need to reflect the difference in cost between the NYMEX delivery point in Louisiana

7 Docket No Page 7 and the actual delivery points in western Canada. This is known as the "basis differential." The NYMEX futures contracts, therefore, represent one part of the commodity costs. The basis differential represents the remaining part, i.e., the difference between the NYMEX cost of the hedged amount and the cost of actual delivery of the commodity. Generally speaking, the two issues here are (1) whether the NYMEX index provides an appropriate proxy for VGS's adjusted test year unhedged commodity costs; and (2) the exact number that the Board ought to adopt to represent the basis differential. In addition to the costs associated with unhedged commodity and the basis differential, VGS's natural gas costs include storage costs and carrying costs. In order to avoid paying premium rates for commodity during high demand winter months, VGS purchases gas during offpeak months which it puts into storage. VGS bears costs to purchase and store gas in the offseason; however, those costs are justified if the commodity procurement costs during off peak storage season are sufficiently lower than commodity costs during peak season when VGS draws on its stored supply. The issue here is exactly what costs should be treated as storage costs. The final category of VGS's supply costs is related to carrying costs associated with the purchase of gas the cost of which VGS deferred pursuant to an Accounting Order issued by the Board in October At issue here is whether carrying costs on the deferral account balance are appropriately included in VGS's cost of service. In its prefiled testimony, VGS asked us to base rates upon expected natural gas costs of $ million, while the Department calculated test year natural gas costs of $ million. Thus, there was an initial $ million difference between VGS's and the Department's natural gas expense calculations. A significant drop in the commodity price of natural gas has occurred since the time of VGS's initial filing on March 5, As a result of this drop in gas prices and VGS's lock-in of additional gas supplies, the initial difference between the parties' natural gas 3. See Findings below. 4. Foley pf. 7/31/01 at 2.

8 Docket No Page 8 expense calculations of $ million, has been reduced by the close of the evidentiary record to $1.193 million. 5 In particular, the Department proposes four adjustments to VGS's natural gas costs. The Department asks that we recalculate the: (i) price for remaining gas purchases for the rate year; 6 (ii) basis differential; 7 (iii) storage gas inventory values, including costs related to VGS's hedging of storage costs; and (iv) carrying costs associated with a deferral account authorized by the Board in an accounting order on October 30, Findings 4. The cost of the natural gas VGS purchases for its customers represents over 60 percent of its total costs. Gilbert pf. at VGS's original filing calculated rate year natural gas costs of $ million. This figure was subsequently revised downward to $ million during the course of these proceedings. Simollardes reb. pf. VGS revenue sched. 1, 10/4/ Using updated spot-market forecasts and basis differential figures, the Department calculated total natural gas costs of $ million. Morgan pf. DPS-sched. LKM-10, 10/5/01. (1) Unhedged Commodity Prices 7. Through a combination of purchasing hedging instruments and storage inventories, the price for 77 percent of the Company's adjusted test year's projected firm sales was locked in and incorporated in the test year expense totals. Tr. 9/10/01 at 44 (Simollardes). 5. There are additional adjustments recommended by the Department in its Reply Brief that widen the difference between the parties' estimate of natural gas expense calculations to $3,006, Specifically with regard to the test year expense used to estimate the cost of the remaining 23 percent of projected firm sales in the rate year, the Department advocates using the Goldman Sachs spot market forecast, or an average of the Goldman Sachs forecast and the DRI-WEFA forecast. (DRI-WEFA, a unit of Global Insight Company, provides economic and financial data, market analysis and forecasting and consulting services.) VGS is basing its cost of service amount for the unhedged portion of firm sales on the NYMEX 12-month strip. 7. In addition, in oral testimony and in its Initial Brief, the Department contends that an expected change in the basis differential from $0.16 Mmbtu to $0.50 Mmbtu will lower VGS's production costs by nearly $600,000. This adjustment was not included in the Department's recommendation of a 4.54 percent rate reduction, as set forth in its Initial Brief.

9 Docket No Page 9 8. Market price levels cannot be forecast with complete reliability. Tr. 8/2/01 at 22 (Foley). 9. The NYMEX futures market is an indicator of the wholesale-market price for natural gas. Scholten pf. at As of 9/21/01, VGS could have locked in the cost of the remaining 23 percent of firm gas needs at the NYMEX strip price of $2.91. Tr. 9/24/01 at 9 (Steinhurst). 11. The Goldman Sachs projection for winter strip gas costs in September was between $2.00 Mmbtu and $2.50 Mmbtu. Id. 12. Neither the Goldman Sachs forecast nor the DRI-WEFA forecast are commodities that VGS could purchase. The NYMEX strip is a purchasable instrument through which VGS could meet most of its firm service needs. Simollardes reb. pf. at 11; tr. 8/2/01 at (Foley). (2) Basis Differential 13. VGS's supply contract with TransCanada Energy ("TCE") is a NYMEX-based contract, but since VGS purchases the gas at Empress, Alberta, a two-part basis differential is established to reflect the locational differentials between Henry Hub, where NYMEX is based, and Empress, where VGS takes delivery of its gas. One part of the basis differential is reestablished annually; the second part fluctuates monthly. Tr. 9/10/01 at 94 (Simollardes); Board. exh VGS used a full basis differential of $0.16 in its adjusted test year cost of service. Tr. 9/10/01 at 94 (Simollardes); tr. 9/11/01 at 155 (Foley). 15. The full differential is likely to be in the range of $0.435 $0.355 Mmbtu. Board exh The basis differential from Henry Hub to Alberta Energy Company, Ltd. ("AECO") for the gas year beginning November 1, 2001, is fixed at $0.465 Mmbtu. Id. 17. The second part of the differential, from AECO to Empress, will fluctuate monthly and be the greater of $0.05 Cdn/mcf, (equivalent to $0.03 Mmbtu), or market, up to full Nova tolls, plus $0.10 Cdn/mcf. Id. 18. The market AECO to Empress differential is currently at or below $0.05 Cdn/Mcf, this results in a full Henry Hub/Empress differential of $0.435 Mmbtu. Bd. exh 3.

10 Docket No Page The change in the differential from $0.16 Mmbtu to almost $0.50 Mmbtu would reduce VGS's production cost by almost $0.5 million to nearly $600,000. Tr. 9/11/01 at 155 (Foley). (3) Storage Inventory Valuation 20. VGS injects gas into storage during shoulder and off-peak months, and withdraws it during the winter period to meet its firm load needs. Foley pf. 7/31/01 at Gas withdrawn from storage for use by VGS's customers is priced at the weighted average cost of gas in storage inventory. VGS exh. 1 at Using the same strategy it employed in the year 2000, in April 2001, VGS executed a combination of two separate financial instruments, a process known as a "collar", to fix ceiling and floor prices on a commodity whose prices would otherwise float. Tr. 7/31/01 (Scholten); tr. 9/10/01 at 102 (Simollardes). 23. In April 2001, VGS also executed a series of commitments, i.e. "locks", for approximately 35 percent of its storage volumes to permanently capture a decline in price below the ceiling established through the collar position it had established. Tr. 9/10/01 at 102 (Simollardes). 24. VGS conducted these transactions to make sure that some amount of the storage volumes were going to be captured at a lower price level than would have been reflected in the proceeding at the time it filed this docket. Tr. 9/10/01 at 103 (Simollardes). 25. VGS included in its storage cost its option costs for gas in storage. Simollardes reb. pf. at 6 7; tr. 9/11/01 at 155 (Foley). 26. Secondary transactions such as the locks executed by VGS during the summer of 2001, were attempts at further insurance, creating a benefit if prices had come back down, and tempering the weighted cost of gas. Tr. 8/1/01 at 178 (Leash). (4) Deferral Account Carrying Costs 27. In its Accounting Order dated October 30, 2000, the Board authorized VGS to record in FERC Uniform System of Accounts No. 186 certain excess gas costs used to serve its customers. Morgan reb. pf. at 5.

11 Docket No Page Pursuant to the October 30, 2000 Accounting Order, the final deferral balance is $3.513 million. Of this amount, VGS labels $81,216 as carrying costs. Simollardes pf. 8/13/01 at VGS proposes to amortize this deferral account over three years. The total amount of carrying costs VGS includes in the adjusted test year cost of service is $34,495. DPS Morgan reb. 3, Schedule 2i. 30. There is no requirement that costs recorded in Account 186 accrue carrying costs. Id. 31. The October 30, 2000, Accounting Order is specific about what costs can be recorded in the deferral account. Tr. 8/1/01 at 9 (Simollardes). 32. The Accounting Order does not specifically authorize the recovery of a return on deferred gas costs recorded in the deferral account. Morgan pf. 6/15/01 at 5; tr. 8/1/01 at 9 (Simollardes); DPS exh Account No. 186 is a miscellaneous deferred debit account, and can be viewed as an account that is used to record costs that do not fall in any specific category of assets. Morgan reb. pf. at 5. Resolution (1) Natural Gas Costs In establishing an appropriate cost of service level for VGS's unhedged natural gas costs, the question to be determined is whether VGS should base its estimate of these costs on forecasts of spot market prices or on the NYMEX 12-month strip. The Department recommends using forecasts of the spot price, and proposes a reduction in VGS's gas costs of $275,199, a figure it derives from averaging the Goldman Sachs Henry Hub NYMEX price outlook as of July 26, 2001, and the July 2001 DRI-WEFA natural gas price outlook. The DPS asserts that both forecasts are known and measurable, reputable, reasonable, likely to occur, and are in accordance with past experience in forecasting spot prices. 8 VGS, on the other hand, urges the Board to use the NYMEX strip as the basis for deriving the cost of service level for VGS's unhedged natural gas. For the reasons that follow, we adopt VGS's recommendation. 8. Tr. 8/2/01 at 16 (Foley); VGS agrees that these forecasting firms are reputable. Simollardes reb. pf. at 7.

12 Docket No Page 12 First, there is substantial evidence in the record to indicate that market price levels cannot be reliably forecasted. In fact, as the Department's witness testified, "all forecasts state that past performance are [sic] not an indication of future performance, and you got to take that into account especially with people who are forecasting commodities...." 9 The Department did not undertake an analysis of the accuracy of any Goldman Sachs energy forecasts made prior to this past summer. 10 Given changes in natural gas price forecasts during the pendency of this case, we are not swayed by the claim that an average of two forecasts of future spot market natural gas prices has a high likelihood of occurring. Consequently, we are unconvinced of the probability of the Department's forecast being in effect in the adjusted test year." 11 Second, we conclude that the NYMEX strip provides a more credible proxy for future market prices than do the projections that the Department is advocating. We reach this conclusion because the NYMEX strip is a purchasable commodity. Neither the Goldman Sachs, nor the DRI-WEFA forecasts are. When VGS executes a position using the NYMEX strip, VGS locks the NYMEX quoted price for a series of months. 12 Thus, unlike the Goldman Sachs or DRI-WEFA forecasts, the NYMEX strip is a market product whose price is set by actual buyers and sellers. We, therefore, conclude that the figure for VGS's unhedged natural gas costs should be based upon the NYMEX futures strip as VGS has recommended, and that it should be included in its cost of service. (2) Basis Differential In order to establish a reasonable figure for VGS's basis differential, we asked both parties for comment on updated basis differential figures submitted by VGS in its Reply Brief. 13 Evidence indicates that the full basis differential for the natural gas year beginning November 1, 2001, could range between $0.435Mmbtu and $0.355Mmbtu. There is overlap in the recalculated 9. Tr. 8/2/01 at 24 (Foley). 10. Id. 11. In re Green Mountain Power Corp., 162 Vt. 378, 381 (1994). 12. Tr. 8/2/01 at 10, 14 (Foley). 13. VGS Reply Brief at 22, n.13. The Board received comments from VGS on October 30, 2001, and from the Department on the following day, October 31, VGS and the Department's comments have been added to the evidentiary record in this docket, respectively, as Board exhs. 2, 3.

13 Docket No Page 13 figures provided by both parties at $0.435Mmbtu. Neither party has objected to the inclusion of this updated information. On the basis of this information, therefore, we believe the reasonable basis differential to use to calculate VGS's rate year cost of service is $0.435Mmbtu. We are thus reducing the allowable cost of natural gas by $0.5 million to adjust for the change in the full basis differential. (3) Storage Inventory VGS estimates its storage-inventory value at $8.07 million. The Department's estimate is $7.169 million, the difference is due to the Department's exclusion of costs associated with the impact of secondary hedges made by VGS during VGS argues that these costs should be included because they were efforts to protect the Company and customers from volatility of storage costs. The Department disagrees and argues that the costs should be excluded because only the Company stood to benefit from the hedging positions it took. 15 Using the same strategy it employed in the year 2000, in April 2001, VGS executed a combination of two separate financial instruments, a process known as a "collar," which fixes ceiling and floor prices on a commodity whose prices would otherwise float. VGS executed a series of locks for approximately 35 percent of its storage volumes to permanently capture a decline in price below the ceiling established through the collar position. The secondary hedge positions taken by the Company turned out to be costly. However, since the goal of the hedges was to protect the Company and its customers from volatility of storage costs, a strategy used effectively the prior year, we view the cost and impact of this particular hedging effort as appropriate to be included in the Company's adjusted cost of natural gas. In the short run, VGS benefits from success in these efforts; however, customers also benefit from successful efforts that stabilize rates and avoid tariff increases. We, therefore, do not accept the Department's disallowance proposal. The costs of the secondary hedges made by VGS during 2001 for the limited percentage of storage volumes are, therefore, included as part of its storage inventory value. 14. Foley pf., exh. DPS-SAF-07, exh. VGS-EMS-Reb. 15. Simollardes reb. pf. at 6.

14 Docket No Page 14 (4) Carrying Costs The parties disagree as to whether VGS should be allowed to recover $34,495 of carrying costs on the balance of the deferral account established by the Board on October 30, The Accounting Order of October 30, 2000, establishing the deferral account was specific as to what costs could be deferred, and the Order does not specifically mention carrying costs. Consequently, we are denying VGS's recovery of carrying costs on the deferral account. This disallowance results in a reduction of $34,495 in VGS's proposed cost of service. (5) Overall Conclusion on Appropriate Natural Gas Costs In summation, we find that a reduction of $556,495 to VGS's proposed cost of service for natural gas costs to be appropriate. Accordingly, we are allowing in rates total gas costs of $ million. C. Personnel Costs Issues and Positions At issue here is the appropriate treatment of expenses related to vacancies during the test year. In calculating personnel costs, VGS has adjusted actual test year personnel expenses to remove the effects of vacancies which were subsequently filled before the end of the test year. The Department contests this adjustment, and has proposed a reduction of $197,525 in payroll and related expenses relating to positions that were vacant for all or part of the historic test year. 16 The Department contends that a certain level of vacancy is normal, and that no company can be expected to operate at a full complement of employees. Findings 34. VGS's cost of service adjusted wage expense (not capitalized) of $5,160,193 is based on full staffing levels. The Company increased actual test year labor expense by $161,900 to account for positions that were vacant or new during the historic test year. The specific vacancies were a 16. Morgan pf. 6/15/01 at 8 9.

15 Docket No Page 15 DSM auditor, a service department manager, the director of human resources and two service technician positions. Tr. 9/10/01 at (Simollardes). 35. The Department believes personnel costs related to the DSM vacancy should be included in the cost of service. Morgan pf. 6/15/01 at The amount of time required to fill a vacancy varies with the level and skill set required. Tr. 9/10/01 at (Simollardes). 37. All the vacant positions during the historic test year were filled as of the end of the historic test year, resulting in an average number of employees in the adjusted test year of 109.6, compared to the that the Company proposed in its rates, and the average of the 12- month period ended September Id. at 65; DPS exh VGS has made adjustments to its historic test year labor expenses for union wage increases, per VGS's union contract, and for wage/salary increases for non-union employees. Morgan pf. 6/15/01 at During the course of this proceeding, Donald Gilbert was promoted to Chief Executive Officer, replacing John Kimbell who retired. Mr. Gilbert's new salary is $44,851 less than Mr. Kimbell's, which was included in the original cost of service submitted by VGS. Both parties subsequently agreed to the removal of $44,851 in labor expense resulting from the change in chief executive officers. Mr. Gilbert's prior position as Vice President has been eliminated, but the exact savings from this change have not been quantified. Tr. 9/11/01 at 68 (Gilbert). Resolution In other cases where employee vacancies were an issue, the Board ruled that payroll expense should be based on the number of full-time employees at the end of the test year and through the most recent month for which information was available. 17 VGS's cost of service followed that methodology. We find it consistent with past policy and reasonable on its own merits. In particular, we do not accept the implied premise in the Department's testimony that a well-managed firm would budget its employee costs at less than its current staffing level, barring a 17. Dockets 5841/5859, Order of 6/16/97 at 46.

16 Docket No Page 16 planned downsizing. We thus find the Company's position to be appropriate, and are not reducing VGS's cost of service payroll expense by $197,525 as requested by the DPS. D. Health Care and Other Employee Benefit Expenses Issues and Positions VGS is proposing adjusted test year cost of service health care benefit expenses of $635,735, based on the Company's estimates of rate year health care costs. This figure is 0.4 percent above actual test year health claims. In its recommendation to reduce test year health care expense by $166,460, the Department used an average of health care claims, adjusted for stop-loss insurance premiums and COBRA receipts, to reflect a normalized level of health care costs. The Department also adjusted payroll taxes and other employee benefit items to align with its suggested reduction in personnel costs. Findings 40. VGS is self-insured with respect to employee health insurance. Morgan pf. at The test year health care expense amount is an accrual to a reserve from which claims are paid for actual health care expenses. Id. 42. The Company proposed an adjusted test year health insurance expense of $635,735 which is a 0.4 percent increase over actual fiscal year 2000 claims and stop-loss insurance premiums. Simollardes reb. pf. at The current trend in health care claims results in adjusted test year medical expenses in excess of $700,000. Id. 44. The adjusted test year health insurance cost of service figure used by VGS is based on the Company's then-current estimates of health insurance costs for calendar year Morgan reb. pf. at 3; tr. 9/10/01 at (Simollardes). 45. The Company later received alternative insurance quotes for medical coverage which were higher than the number used in the cost of service. Tr. 9/10/01 at 67 and 80 (Simollardes); DPS exh. 3; VGS exh. reb. 4.

17 Docket No Page The Department recommends a $166,460 reduction in health insurance costs. It derives its figure by taking a three-year average of health care claims from the years 1998 to 2000, adding the test year stop-loss insurance premiums, and deducting COBRA payments received by the Company. Morgan pf. 6/15/01 at The Department's proposed adjustment to health care benefit expense results in health care benefit expense below VGS's actual test year costs. DPS exh. 3 at Medical insurance costs have been rising, on average, 23 percent over the past three years, and there is no evidence that health care costs will decline. Simollardes reb. pf. at Despite fluctuations from year to year, there is an upward trend in VGS's health care costs. Tr. 8/1/01 at 13 (Simollardes). 50. For rate-setting purposes, the level of expense in an account during the test year is considered to be the reasonable ongoing level of expense unless there are circumstances, known and measurable, to indicate otherwise. Morgan pf. 6/15/01 at 10. Resolution VGS is proposing adjusted test year health care benefit expenses of $635,735, based on the Company's estimates of health care costs at that time. Expense data for the first ten months of fiscal year 2001 (which ended September 30, 2001), shows that VGS's health care claims were $499,807, or $650,000 when annualized, including administrative and stop-loss fees. 18 In its recommendation of a $212,018 reduction in the health care benefit expense, the Department employed a three-year average and attempted to normalize what seemed to be an unusually high level of test year claims. However, given VGS's experience of a 23 percent average annual increase in the cost of health care benefits over the past three years, and the current environment of continued escalating medical insurance costs, we find the Department's position simply unrealistic. We are persuaded that VGS's adjusted test year cost of service for medical claims is likely to be at a level at least equal to that actually incurred in Accordingly, we find that the Company's adjusted test year expense of $635,735 for health care benefits should be included in rates. 18. VGS Brief 9/27/01 at 57.

18 Docket No Page 18 E. Liability Insurance Deductible Issues and Positions In calculating the appropriate level of liability insurance deductible expense to be included in the adjusted test year cost of service, the parties disagree on whether it is appropriate to use a three-year average of the level of reserves, as VGS has done, or an average of actual claims, as proposed by the Department. The difference in their positions is $48,350. Findings 51. The Company annually accrues an amount to a reserve account to fund the deductible on its liability insurance; the amount of the accrual reserve depends on pending liability claims and the balance in the reserve account. The accrual is charged to O&M expense. This has the effect of not charging claims which were paid from the reserve to O&M; instead these claims are deducted from reserves. Morgan pf. 6/15/01 at 9; Morgan pf. 9/6/01 at 5; Simollardes reb. pf. at VGS's past practice was to reverse the amount reserved, if no claims were pending. Simollardes reb. pf. at The Company is proposing an adjusted test year liability insurance deductible expense of $183,762, which is the three-year average of actual amounts reserved. Id. at The deductible expense is variable. Because of the variability of these costs, an average is appropriate for rate-making. Id. at Using a three-year average of actual claims and expenses charged against the reserve, excluding the affects of the Pine Street Barge Canal liability, results in adjusted test year expenses of $135,412. Morgan suppl. pf. 9/6/01 at 5. Resolution Logically, the difference between a three-year average of claims and the reserves set aside to meet those claims will be de minimis over time. To avoid overstatement during the period for which this Order is setting rates, the Department's recommendation to use a three-year average of actual expenses is appropriate. We are thus adopting its recommendation for a $48,350 reduction in liability insurance deductible cost of service expense.

19 Docket No Page 19 F. Liability Insurance Premium Issues and Positions In calculating the appropriate level of liability insurance premiums in the adjusted test year cost of service, VGS based its cost of service liability insurance premium figure on a three-year average. The Department's recommendation is to use historic test year figures. The Department thus recommends a $94,440 reduction of VGS's proposed expenses. 19 Findings 56. VGS over-amortized liability insurance premium expense in 1998 and 1999, leading the Company to under-amortize this expense item in the test year. Simollardes reb. pf. at 26 27; tr. 9/10/01 at 80 (Simollardes). 57. To smooth out the variability in this expense, VGS proposes an adjusted test year expense of $258,371, based on a three-year average. Id. 58. In VGS's last three rate cases, the Company used the historic test year figures for liability insurance premiums rather than a three-year average. 20 See Schedule 7.b to VGS Cost of Service in Dockets 6444, 6413, and Resolution Given VGS's previous filing practice, and the fact that VGS had use of the funds it overamortized during the two years prior to the test year, we find merit in the Department's recommendation. We, therefore, reduce the cost of service expense line for liability insurance premiums by $94,440. The Board recognizes that the events of September 11, 2001, may effect future insurance liability premiums, but the record does not support including such possible changes in the Company's cost of service. 19. Morgan pf. at The DPS requested in its Initial Brief dated September 27, 2001, that the Board take judicial notice of Schedule 7b of VGS's filed cost of service in Dockets 6444, 6413, and VGS did not object, and so the DPS's request is granted, and the Board takes official notice of the above referenced schedules pursuant to 3 V.S.A. 810 (4).

20 Docket No Page 20 G. Lobbying Costs and Corporate Donations Issues and Positions VGS has included an aggregate $80,285 in its adjusted test year cost of service for lobbying expenses and charitable donations. The Department objects that under traditional ratemaking, lobbying expenses and charitable donations should not be included in the cost of service. Findings 59. VGS's test year cost of service includes $31,462 in lobbying expenses which were included in its Outside Services account. Morgan pf. at VGS included $48,823 in charitable donations in its cost of service in the test year. Morgan pf. 6/15/01 at Donations are not a cost of providing natural gas service. Id. Resolution The Board has ruled several times on this issue, at least once in regard to VGS. 21 We thought we had been abundantly clear: no matter how laudable, corporate donations are not necessary for the provision of utility service to Vermont. Lobbying costs are similarly discretionary. Accordingly, it is inappropriate to include them in rates, and the Board disallows $80,285 from VGS's cost of service for these items. We note that the costs of this proceeding, an issue about which VGS has expressed concern, have been unnecessarily increased by VGS's own decision to seek unprecedented recoveries in this area. H. Expenses Related To Maintaining Mains Issues and Positions At issue here is whether actual test year expenses relating to maintenance of gas mains is a better indicator of adjusted test year expense, or whether a three-year average of expenses related 21. In Dockets 4874/4875, for example, we wrote: "The issue of both charitable and lobbying expenses has been repeatedly litigated before this Board, and the Board has consistently maintained a policy of not including either in the cost of service." Dockets 4874/4875, Order of 10/5/84 at 51. See also Docket 5516, Order of 2/14/92 (Tariff Filing of Vermont Gas Systems).

21 Docket No Page 21 to the upkeep of mains results in a more normalized figure. The Department utilizes the threeyear average, which would result in a $49,108 reduction in the adjusted test year's cost of service. Findings 62. During the test year, the Company incurred a $106,026 expense related to maintenance of mains. This expense reflects rights of way clearing that did not occur during the prior two-year period, and thus was unusually high. Morgan pf. 6/15/01 at The Department recommends a downward adjustment of $49,108 in rate year mains' maintenance to bring cost of service expense down to a normalized level. The Department uses a three-year average of these costs, and derives a figure of $56,918. Id.; DPS exh. Morgan 1. Resolution VGS's test year expense for maintenance of mains reflected rights of way clearing that did not occur in the prior two-year period. The Department argued that since the amount was unusually high, the test year expense should be normalized to reflect a normalized level of expenses. The Department thus used a 3-year average of the costs. Since VGS provided no evidence suggesting that maintenance expenses for mains would be high in back-to-back years, we find that the three-year average of $56,918 provides a reasonable estimate of adjusted test year expense. We consequently adopt the Department's adjustment that yields a $49,108 reduction to O&M expenses. In its attempt to justify these expense figures, VGS argues that it had inadvertently removed $65,000 from its filed cost of service for an expired lease, rather than merely removing the lease's actual $28,959 costs. It also indicated that several other cost increases were also not reflected in its original cost of service filing. VGS, consequently, asserts that the overall operating expense level that it did use in its adjusted test year is "understated", and that its cost of service as presented is thus reasonable. 22 We reject this argument. Understating overall operating expense levels does not justify particular cost components. 22. Simollardes reb. pf. at 29.

22 Docket No Page 22 I. Inventory Adjustment Expense Issues and Positions VGS's test year inventory adjustment costs total $50,808. VGS derived this figure by combining three separate charge-off categories: inventory obsolescence, inventory reconciliation costs, and an amount for future inventory write-offs. The Company also justified its cost of service inventory expense as being part of a "reasonable" overall operating expense total. The Department's position is that only one of the three expense categories that VGS included in its adjusted test year cost of service is recurring. The Department thus recommends that the other two expense categories should be excluded from the adjusted test year cost of service total. Further, the Department recommends using a three-year average to calculate inventory obsolescence. The Department's recommendations would reduce VGS's adjusted test year expenses by $44,092. Findings 64. VGS has included in its test year cost of service three inventory expense items: $20,148 to recognize inventory obsolescence; $15,660 in order to reconcile the inventory balance; and $15,000 in future inventory obsolescence costs. Morgan pf. 6/15/01 at The DPS is recommending a $44,092 reduction in test year inventory expenses based on a three-year amortization of the actual inventory charge of $20,148 incurred in the test year. Id.; DPS exh. Morgan As of September 30, 2000, VGS carried $437,180 worth of plant materials and supplies on its balance sheet. VGS Annual Report The test year write off of inventories for obsolescence equates to 4.6 percent of plant material, operating supplies, and merchandise carried on VGS's balance sheet at the beginning of the test year; the $15,660 adjustment to reconcile the inventory balance represents another 3.6 percent. The Department's recommendation to take a three-year average of actual test year write offs equates to 1.5 percent of these accounts. VGS Annual Report 2000 at 110; Morgan pf. 6/15/01 at 11.

23 Docket No Page At the time of the adjusted test year, the $15,000 future inventory obsolescence writeoff did not represent a known and measurable loss. Morgan pf. 6/15/01 at 12. Resolution In its rebuttal testimony, the Company justified its cost of service inventory expense as being part of a "reasonable" overall operating expense total. As we noted in our earlier discussion, at Section H above, regarding expenses related to maintaining mains, we are unpersuaded by the logic of this argument. VGS's test year costs for inventory adjustments totaling $50,808 contain three charge-off categories, only one of which appears to be recurring, and thus to have predictive value. In contrast, the other two inventory expense items appear to be more one-time in nature, are not part of "normal" operations, and thus have limited predictive value. For this reason, we find the Department's argument for using a three-year average for inventory adjustment expense convincing. The resulting proposed charge-off expense of $6,716, equivalent to 1.5 percent of combined plant materials and supplies, appears realistic. We are thus adopting the Department's recommendation, and are reducing VGS's allowed cost of service expense for inventory adjustments by $44,092. J. Interruptible Revenues Issues and Positions VGS and the Department agree that interruptible revenues should be based on VGS's projection of interruptible sales and the interruptible special contract rates. Special contract rates vary with gas costs. Since the parties disagree on the appropriate methodology of accounting for natural gas procurement costs, there is also a difference in their calculation of interruptible revenues. VGS uses the NYMEX strip to derive its estimate of interruptible revenues; the Department used an estimate of spot prices.

24 Docket No Page 24 Findings 69. Interruptible revenues vary with gas costs and should be calculated consistently with gascost assumptions. Simollardes reb. pf. at 14 (COS); tr. 8/1/01 at 96 (Morgan). 70. Use of the NYMEX strip will result in interruptible revenues of $7.837 million. Simollardes reb. pf. at 14 (COS). Resolution In our earlier discussion on natural gas costs, we concluded that it is appropriate for VGS to use the NYMEX strip price as a basis for calculating the cost of its unhedged firm gas purchase expense. We consequently agree with the Company's position that interruptible revenues should also be based on the NYMEX strip. Therefore, we do not accept the Department's recommendation of a $40,857 adjustment to interruptible revenues. III. RATE BASE Issues and Positions VGS proposes a gross rate base of $52,021,465. The DPS recommends a rate base of $ million. The $899,000 differential between the parties stems from three contested amounts: a $671,000 difference for storage inventory value; $86,000 for unamortized deferral account balances; and $141,579 for working capital. Earlier disagreements over the level of accumulated depreciation were resolved during the course of this proceeding. As discussed at Section I, the parties disagree as to the inclusion of costs of certain hedges in storage inventory values. Similarly, as explained in Section B(4), the calculation of the appropriate deferral account balance requires a determination of whether to include carrying costs. Both parties agree that working capital should be based on 12.5 percent of operating expenses. However, the Department's calculation of working capital excludes payroll taxes from operating expenses.

25 Docket No Page 25 Findings 71. The appropriate gas storage inventory value included in the rate base is $3.517 million incorporating gas storage costs included in the cost of service, and a starting storage value of $8.07 million. Simollardes reb. pf. exh. VGS-EMS-Reb The appropriate deferral account balance included in the Company's rate base is $2.881 million, and does not include carrying costs from the deferral account balance. Morgan pf., sched. LKM-2; Simollardes reb. pf. exh. VGS-EMS-Reb. 3, sched It is appropriate to deduct payroll taxes from working capital. Morgan pf. at Both parties agree that the adjusted test year should include depreciation expense of $3.537 million, and a rate base accumulated depreciation figure of $ million. Morgan pf., scheds. LKM 1 and 2; VGS exh.1, sched. 1; Simollardes reb. pf. exh. VGS-EMS-Reb 3, sched. 12. Resolution Incorporating the changes made to working capital and the cost of the deferral account, a rate base of $ million is appropriate. IV. COST OF CAPITAL Issues and Positions The parties are in agreement over the appropriate adjusted test year cost of capital and VGS's test year capital structure. Findings 75. VGS's current capital structure is comprised of percent long-term debt, percent short-term debt, and percent common equity. VGS Exh. 1, sched. 11; Morgan pf., sched. LKM The high percent of common equity is a result of VGS maintaining a lower dividend payout ratio (dividends to net income) than other utilities: the average dividend-payout ratio between July 1999 through July 2001 for natural gas utilities was 68.2 percent, and 69.4 percent

26 Docket No Page 26 for electric utilities. During the same period, the Company paid out only 25 percent of earnings in dividends. The 10-year average dividend payout ratio for VGS was 37 percent. Exh. DPS: VGS (Submitted in response to Board question.) 77. The low dividend payout ratio is justified by the Company's high level of capital spending. It amounts, in essence, to a policy of reinvesting potential dividends in the growth of the Company; with resulting benefits for both investors and customers. Tr. 7/31/01 at 73 74, 79 80, 150 (Gilbert). 78. The Company is proposing a 9.65 percent return on rate base, comprised of its actual annual cost of long-term debt of 7.62 percent, a 6 percent cost of short-term borrowings, and an percent return on equity. The Department is not challenging these proposed returns. Tr. 8/1/01 at 61 (Gilbert); Morgan pf. at sched. LKM-21. Resolution There are three steps to establishing the cost of capital in a rate proceeding. First, we must determine an appropriate capital structure. Second, we determine the costs and rates of each component in the capital structure. Finally, we compute the overall cost of capital from the component rates, after adjusting for the proportional contribution of each. The parties have agreed that the overall cost of capital for VGS is 9.65 percent, based on a capital structure comprised of percent long-term debt, percent short-term debt, and percent common equity. The Company's capital structure reflects the cumulative effects of a change in policy at VGS to retain a greater portion of its earnings to internally fund its significant capital investments in Vermont, which will thus increase common equity. We agree that the resulting and relatively high proportion of common equity is appropriate for VGS at this time. Incorporating the rate base adjustments made above, the cost of service should include $5.009 million associated with the cost of financing the rate base.

27 Docket No Page 27 V. RATE STABILIZATION PLAN Issues and Positions Wholesale natural gas prices have become more volatile in recent months. In order to make its gas costs more predictable, VGS has proposed a change in the manner in which it currently procures gas. Instead of relying upon its present supply arrangements, VGS proposes to set the price of its gas purchases through the use of price hedging techniques. In order to do this, VGS has proposed a Rate Stabilization Plan ("RSP") that would include the implementation of what VGS refers to as a "Systematic Hedging Program" and also a Rate Stabilization Account ("Deferral Account") designed to periodically adjust its gas costs and recoveries. It has asked for Board approval of the RSP. VGS maintains that the RSP is a reasonable strategy, given the high volatility in the wholesale market, and that ratepayers would benefit from knowing what prices are going to be. The Department disagrees. It maintains that, regardless of whether VGS hedges or not, the Board should not pre-approve the Company's actions because it is the role of company management to develop and implement such strategies for itself without regulatory priorapproval. The Department also argues that the Deferral Account, for various reasons, would be illegal under Vermont law. Findings (1) General 79. In its March 5, 2001, filing, VGS requested Board approval of a three-part Rate Stabilization Plan, under which: (a) the Company would periodically hedge the price of approximately one-quarter of its firm-market gas volumes by purchasing, ahead of time, a corresponding 12-month strip; A "strip" refers to the simultaneous purchase or sale of future positions in consecutive months. The Company originally proposed to take positions on a quarterly basis. Later it modified the hedging proposal by proposing to move its quarterly systematic hedging forward by six months, i.e., to execute hedges earlier. The (continued...)