GAZIFÈRE INC. PROPOSAL FOR COMPREHENSIVE PERFORMANCE BASED REGULATION PREPARED BY: RICHARD J. CAMPBELL

Transcription

1 GAZIFÈRE INC. PROPOSAL FOR COMPREHENSIVE PERFORMANCE BASED REGULATION PREPARED BY: RICHARD J. CAMPBELL MAY, 00 Original: GI- Document Page de Requête -00

2 CONTENTS Page INTRODUCTION OBJECTIVES DESCRIPTION OF MECHANISM Total Factor Productivity and the CPI-X Approach Revenue Adjustment Formula Reference Year Growth Inflation d: Inflation Discount Coefficient R: Cost of Capital Adjustment Y Factors Z: Exogenous Factors Earnings Sharing Formula Service Quality Indices 0 TERM AND RENEWAL OFF-RAMP REVIEW FOR MAJOR EVENTS ONE TIME ADJUSTMENT FOR THE YEAR 00

3 GAZIFÈRE INC. PROPOSAL FOR COMPREHENSIVE PERFORMANCE BASED REGULATION INTRODUCTION 0 In its decision D-000-, rendered with respect to Gazifère's 000 Rate Case, the Régie asked Gazifère to propose a consultation process for the renewal of its incentive mechanism and that it include consideration of a more comprehensive performance based regulation ( CPBR ) plan (including capital investments). In phase I of the 00 Rate Case, Gazifère proposed a consultation process that the Régie approved in its decision D-00-. Consequently, Gazifère met with the stakeholders on occasions to discuss the elements of a CPBR proposal and take note of their comments. 0 0 Gazifère proposes a rate setting mechanism which is lighter handed than annual cost of service reviews and one that serves both ratepayer and shareholder interests. The mechanism is a comprehensive revenue cap, for a -year period, and determines the annual distribution revenue requirement to be recovered in rates by means of a formula. The proposal is similar to the O&M targeted plan but is extended to the total revenue requirement. OBJECTIVES Gazifère is a small natural gas distributor with,000 customers and annual distribution costs of under $0 million, yet it is subject to the same regulatory process as much larger energy distributors operating in Québec. The regulatory process requires considerable resources and generates disproportionately high costs for a small utility. This rate-setting method proposed is designed to lighten the regulatory process, give the distributor an incentive to improve performance, while serving customer interests and providing sufficient regulatory oversight. The Company believes that the simple adjustment mechanism proposed is easy to understand, easy to apply and will result in stable and predictable rates for the term of the plan. DESCRIPTION OF THE MECHANISM The proposed mechanism indexes distribution revenues to reflect system growth and inflation. A productivity challenge is provided by means of a discount of the rate of inflation and this provides an annual benefit to ratepayers. The proposal provides additional benefits to ratepayers by including an earnings sharing mechanism, an earnings cap and minimum service quality requirements. Original: GI- Document Page de Requête -00

4 Before presenting the details of the revenue adjustment formula, the section below reviews the results of a total factor productivity study conducted for Gazifère and considers how it might be applied in a CPI-X form of revenue adjustment. Total Factor Productivity and the CPI-X Approach 0 A common type of rate or revenue adjustment mechanism is in the form of CPI- X, where CPI represents the consumer price index or some other index of the rate of inflation, and X is a factor representing expected productivity improvement. In order to determine an appropriate X factor, a common first step is to understand the historic productivity experience of the utility. For this purpose, Gazifère engaged a consultant to conduct an analysis of the utility s total factor productivity. The consultant s report is filed as GI-, document. 0 Recent reviews of PBR regimes demonstrate that a consensus has not developed among regulators on the application of Total Factor Productivity studies to PBR formula and the application of TFP analysis in energy distribution PBR plans is far from consistent. A consensus has not emerged, for instance, on which indicator of output (the number of customers or sales) is most appropriate, on which estimate of capital inputs (accounting capital or physical capital) is most appropriate and on the length of the historic series that is most appropriate. A frequent consequence is that protracted X factor debates take extensive time and resources in regulatory proceedings as consultant reports are tabled, examined and argued. In order to highlight the problem, the consultant s report, GI-, document, may be used to support significantly different conclusions, dependent on the assumptions and the data series chosen. For instance, looking at Table of the report, the productivity experience of Gazifère can be cited as:.% if the average of the last 0 years is used, the number of customers is the output, and accounting capital is an input. 0.% if the average of the last years is used, the number of customers is the output, and physical capital is an input. See for example Lowry and Kaufman, Performance-Based Regulation of Utilities, Energy Law Journal, Volume, No., 00, The Energy Bar Association, Tulsa, Oklahoma., and Michael R. Schmidt, Performance-Based Ratemaking: Theory and Practice, Public Utility Reports, Vienna, Virginia, 000.

5 -.% if the average of the last years is used, actual volumes is the output, and accounting capital is an input. -.% if the average of the last years is used, normalized volumes is the output, and physical capital is an input. 0 Which of these numbers is reasonable? Opinions often turn on the point of view of the advocate. Utilities find reasons to support low productivity data, and therefore a low X factor. At least one major Canadian natural gas utility has advanced evidence supporting negative productivity and consequently a negative X factor. (Gazifère could well make the same submissions in view of the very significant negative productivity trend demonstrated when volumes are used as the measure of output in the productivity analysis.) Customer representatives, on the other hand, find reasons to support high productivity data, resulting in a higher X factor. Obviously, the choice of the X factor has a significant impact on the reasonableness and sustainability of a PBR plan. At the forecast rate of inflation of.% for 00 referenced in this application, substituting the citations above in a CPI X formula yields potential revenue adjustment factors that range between -0.% and +.% 0 Gazifère provides the study of total factor productivity in GI-, document for the information of the Régie and stakeholders. If an adjustment formula in the form of CPI-X were to be used, Gazifère would propose that the productivity index that is most appropriate includes labour, materials and physical capital as inputs and the number of customers as the output. Looking at Table of GI-, document, the average annual productivity for this reference is reported as follows: % 00-0.% 00-.% 0 This series of averages, and the indices on which the averages are based, demonstrate that actual annual productivity gains at Gazifère are in decline. In light of this trend, Gazifère submits that the most recent experience, that of the last five years is the most appropriate predictor of the productivity gains that are attainable by the utility over the next years. This suggests that an X factor of 0.% is appropriate.

6 Nevertheless, this application does not propose an adjustment mechanism in the form of CPI-X. Given the adversarial and very subjective nature of the total factor productivity and X factor debates, Gazifère proposes to provide an annual benefit to ratepayers by means of a discount factor against the rate of inflation. This approach is simple and easy for customers to understand. From the perspective of regulatory review, a complex debate about inputs, outputs, data time series, and the assumptions associated with total factor productivity is reduced to a single question: by what portion of the forecast rate of inflation should total revenues be adjusted? 0 Revenue Adjustment Formula The proposed formula adjusts the annual distribution revenue requirement, expressed on a per customer basis, by a portion of the forecast rate of inflation, and provides for adjustments for cost of capital, for certain pass throughs, for exogenous factors, if they occur, and earnings sharing. That is: RRt RR = ( )*( + d ( CPI )* C + R + Y + Z + ES t C t Q t 0 0 Where; RR C d CPI R Y Z ES = revenue requirement = average number of customers = is a discount coefficient which serves as a productivity challenge = forecast rate of inflation using the Quebec Consumer Price Index = cost of capital adjustment = pass throughs = exogenous factors = earnings sharing adjustment The revenue requirement for the test year is equal to the revenue requirement of the previous year divided by the average number of customers in the previous year, multiplied by a portion of the forecast rate of inflation for the test year, multiplied by the forecast average number of customers for the test year, plus adjustments for the cost of capital, pass throughs, exogenous factors and earnings sharing. Reference Year The mechanism is based on the revenue requirements of the 00 rate case, determined according to the cost of service in the context of the application R--00, excluding the cost of gas and the deferral accounts (DSM, LRAM

7 and regulatory expenses). The cost of gas will be settled through the quarterly rate adjustment mechanism. 0 Growth The costs of a distribution utility are very closely aligned with the number of customers it serves. Each new customer represents new capital costs associated with attachment to the system (mains, lines, metres) and new operations and maintenance costs associated with customer care, meter reading, billing and collection. It is appropriate therefore that a revenue adjustment mechanism recognize the increase in the number of customers. In the proposed formula, growth is recognized by expressing the revenue requirement on a per customer basis. It is also proposed that the number of customers used will be the average number of customers for the rate year. Inflation The inflation index used in the formula is the Quebec Consumer Price Index (QCPI). The QCPI may not exactly reflect the index of the distributor s inputs, but the choice is appropriate for several reasons: () objective forecasts are published; () customers are familiar with the index; and finally, () of the inflation indices considered, it most closely correlates to the utility cost experience. 0 Gazifère proposes to survey the forecasts available from the seven sources referenced in the table below on the first business day of the month in which the formula is applied for rate setting purposes. We expect this to be in the month of August of each year. The forecast used in the formula will be the average (mean) of the seven forecasts in the survey. The Quebec CPI average forecast for 00, as at May, 00, is.% and is shown in the table below. Québec CPI/Average Inflation Forecast (% Change) As of May 00 Forecaster Forecast Date 00F 00F Bank of Montreal March-0.. Royal Bank of Canada March Conference Board of Canada Spring 00.. Desjardins April-0.. Toronto Dominion Bank October-0. na CIBC World Markets February-0.. BMO Nesbitt Burns 00 Q.0.0 Average.. In order to avoid the accumulation of projection errors, the previous year s distribution revenue requirements will be updated to reflect the rate of inflation

8 according to the latest projections. The revenue requirements thus calculated will be used to determine the current year s distribution revenue requirements. This operation (true-up) was also used in Gazifère s former mechanism. d: Inflation Discount Coefficient 0 Gazifère proposes that the discount coefficient be established at 0.. At this level, the revenue requirement per customer will be adjusted by % of the forecast rate of inflation while Gazifère will be required to manage its business in an environment where many of its costs will reflect the full impact of inflation and more. Customers benefit since the utility must seek productivity improvements rather than passing on the full impact of inflation in rates. Why set the discount at 0.? Essentially the decision about the level of the productivity challenge comes down to a judgment about what seems to be appropriate given all the elements of the plan. For instance, in PBR plans where there is no provision for earnings sharing, the productivity challenge is the primary annual benefit for ratepayers and may be set at a higher level than a similar plan which also shares earnings with customers. 0 In the discussion of the CPI - X approach on pages - of this exhibit, it is proposed that if the Régie were to adopt that approach, then an X factor of 0. would be appropriate given the total factor productivity evidence. What discount factor relates to this level of productivity challenge? At the average forecast rate of inflation of.% for 00, that formula yields CPI - X =.-0. =.. This value is achieved in the d(cpi) approach when d = 0., that is, 0.*(.) =.. The rationale for the choice of 0. is that it approximates the CPI - X result, when inflation is forecast at.% and X = R: Cost of Capital Adjustment The detailed cost of capital adjustment is provided in GI-0, document.. The adjustment is proposed in order to more accurately reflect the annual cost of capital throughout the CPBR plan. The adjustment recognizes that the main drivers of the cost of capital, that is, the allowed rate of return on equity and market rates of interest are beyond the control of utility management. Over earning at year end will be calculated using the allowed rate of return on equity derived from the approved ROE formula and reflected in the distribution revenue requirement calculation through this adjustment.

9 0 0 0 Y Factors The following items are calculated outside of the adjustment formula: - Upstream expenses: gas supply, transportation and balancing (These costs will be settled through the quarterly rate adjustment mechanism) - Deferral accounts (regulatory expenses, energy efficiency program expenses, LRAM, PBR, EnVision) (These costs will be added to the result of the formula at cost of service.) - Cost of service impact of major investment projects over $0,000 approved separately by the Régie. (Gazifère will calculate the impact of the major investment project on the cost of service in the first year and add it to the result of the formula. In the second year, it will be an integral part of the distribution revenue requirements that will serve as the base to which the indexing will be applied.) - Impact of the weather normalization account (Gazifère will calculate the impact on cost of service of the variation of the weather normalization account included in rate base.) Z: Exogenous Factors Z factors are completely beyond the distributor s control, and are defined as follows: - Impact of regulatory decisions and orders, for example, a change in amortization rates - Impact of changes in accounting requirements These factors may or may not occur within the plan. Should they occur, the cost consequences will be recorded in a deferral account and will be added to the revenue requirement at the next annual determination of rates when the balance of the deferral account exceeds $00,000. Earnings Sharing Formula Gazifère proposes an earnings sharing formula. The proposal is not symmetrical; no sharing is proposed on the downside. That is, the risk of actual earnings falling below allowed ROE, is entirely that of the shareholder. Gazifère proposes a sharing of over earnings, in three bands, as follows. Earnings above the allowed ROE would be fully retained by the utility for the first 00 basis points. After the first 00 basis points, earnings will be shared 0/0 with

10 ratepayers for the next 0 basis points. Finally, any earnings exceeding the allowed ROE plus 0 basis points will be fully credited to ratepayers. For example, if allowed ROE is 0%: Allowed ROE 0.0% First 00 bpts 0.0% to.0% fully retained by utility Next 0 bpts.0% to.% shared 0/0 Beyond 0 bpts.% fully credited to ratepayers 0 In the event that earnings are at a level to be shared with ratepayers, the amount would be applied to reduce the revenue requirement on the next application of the formula. For example, corporate earnings for 00 will be determined in the first quarter of 00 and the earnings to be credited to ratepayers, if any, would be applied to reduce the revenue requirement for 00. This earnings sharing proposal provides three distinct benefits: (i) the 00 basis points dead band provides an effective incentive for the utility to manage costs and seek efficiencies; (ii) the 0 basis points 0/0 sharing band continues to provide incentive to the utility while providing an opportunity for ratepayers to further share in efficiency gains (in addition to the annual benefit of the productivity challenge); and, 0 (iii) the final band, where all earnings are credited to ratepayers provides a safeguard for the regulator and ratepayers against so called over earning by the utility. The mechanism works to provide an effective cap on actual earnings of the utility, within the plan of the allowed ROE plus basis points. Service Quality Indices Gazifère has been operating for a number of years under an incentive system that requires certain service quality indices to be met. The meeting of service quality 0

11 indices guarantees to customers that any savings realized by the distributor are not realized at their expense. Gazifère is keeping the same service quality indices: - Preventive maintenance - Emergency response - Meter reading - Response to telephone calls The sharing mechanism remains the same and works as follows: 0 () Gazifère s overall performance must be at least 0% for it to be able to apply the earning sharing formula. () If overall performance is between 0% and 0%, Gazifère can keep a percentage determined using the following formula: actual overall performance X earning sharing formula. () If overall performance is below 0%, customers share 00% of the overearning. The following table shows the service quality indices and the corresponding performance thresholds. Quality Indices Performance Thresholds Preventive maintenance Adherence to preventive maintenance program Emergency response time Response within a maximum period of minutes Frequency of meter reading Percentage of meters read according to the policy () Call response time Response to telephone calls within a period of 0 seconds Overall index (arithmetic average) 0 () Except for industrial meters that are read every month, Gazifère s policy is to read meters every months ( times per year).

12 TERM AND RENEWAL The proposed mechanism will be applied over an initial -year period (00 to 00). As soon as possible in the fourth year (00), once years of results are available, the mechanism will be evaluated with a view to its renewal. The Company will file a Report which will review the operation of the plan and indicate if it wishes to extend or renew the term of the plan. 0 OFF-RAMP REVIEW FOR MAJOR EVENTS An off-ramp is provided for when conditions are such that continued use of the mechanism produces results that threaten the financial viability of the company. If conditions warrant, the Company will make application to the Régie explaining the circumstances and request an opportunity to make a cost of service application. 0 ONE-TIME ADJUSTMENT FOR THE YEAR 00 Since 00 is a special year, Gazifère will add to the result of the formula the exceptional expenses that are not part of the distribution revenue requirements approved in the 00 rate application. These expenses are: rent increase (Gazifère moved in December 00), dispatch / (operational change), moving expenses, EnVision costs, and the increase in amortization due to the fact there are no more contributions (account ) to be amortized in 00. In year (00), these expenses will be an integral part of the distribution revenue requirements that will serve as the base to which the indexing will be applied; the one-time moving cost will, however, be excluded.