REVENUE REQUIREMENT CGA Regulatory Course. Michelle Carman FortisBC Energy Inc.

Transcription

1 REVENUE REQUIREMENT 2016 CGA Regulatory Course Michelle Carman FortisBC Energy Inc. 1

2 Introduction Presentation Objectives Part 1: Explain and demonstrate the calculation of revenue requirement for the cost of service form of regulation Part 2: Explain Regulatory Approval of Capital Expenditures 2

3 Revenue Requirement Part 1 Revenue Requirement Explain and demonstrate the calculation of Revenue Requirement for the Cost of Service Form of Regulation 3

4 Revenue Requirement Part 1 : Presentation Overview Introduction Generally Accepted Regulatory Principles Rate Base Cost of Capital Cost of Gas Sold Operating, Maintenance and Administration Expense Depreciation and Amortization Expense Revenue Forecast Income Tax Regulator s Decision 4

5 Part 1: Introduction Natural Gas Industry Schematic Gas Wells Producing Basin Transmission Lines Gas Processing Plant LNG Compressor Stations Large Volume Customer Meter/ Regulator Underground Storage City Gate (Meters / Regs) Distribution Mains Residential Customer Commercial Customer 5

6 Part 1: Introduction Customer-Related Activities Customer Account Management Meter Management Billing Financial Reporting Payments Collections Accounts Receivable Bad debt Collection Agencies 6

7 Part 1: Introduction Integrated Energy Utility Areas of Focus 7

8 Part 1: Introduction Regulatory Compact Bargain between regulator and regulated utility Private property put to use in the public interest Government will protect the interests of both the consumer and the utility Utility has both rights and responsibilities Shareholder /Owner Regulator Customer Utility

9 Part 1: Introduction Revenue Requirement Revenue Requirement: The revenue that a regulated utility needs to earn in a test year in order to provide adequate service to its customers and a fair return for its shareholders. 9

10 Part 1: Introduction COST OF SERVICE / RATE OF RETURN REGULATION Forecast of Revenues at Existing Rates Residential, Commercial, Industrial (sales and transportation) + Other Revenue = Revenue Forecast Forecast of Expenses for the year Cost of gas + OM&A + property taxes + Depreciation / Amortization + Income taxes + rate base return (interest, ROE) = Revenue Requirement If Revenue Requirement < Revenue Forecast Utility applies for Rate Decrease If Revenue Requirement > Revenue Forecast Utility applies for Rate Increase 10

11 Part 1: Introduction Cost or Value Who determines the price? The provider - Cost based Price determined by the cost incurred by the provider of the product or a service and not by the price the purchasers are willing to pay. The purchaser - Value based (market value) Price based on what purchasers are willing to pay. Purchasers make decisions by comparing prices of similar products or services offered by other competing providers. In a perfectly competitive market, the cost-based price of the most efficient producer will set the market price. Less efficient producers must meet this price to stay in business; an incentive to be efficient. 11

12 Part 1: Introduction Top Down vs. Bottom up Competitive Business Regulated Gas Utility Revenue - Cost of Goods Sold - Operating expenses - Depreciation - Interest - Taxes = Net income = Revenue Requirement + Cost of Gas + OM&A + Depreciation + Interest + Taxes Net income (ROE) 12

13 Part 1: Introduction Rate Case Evidence Test Year budget forecast for future year Bridge Year or Base Year budget estimate for current year Historical Year financial results for the last completed year 13

14 Part 1: Introduction Common Terms Rate Base Earned Return Cost of Service Revenue Requirement Test Year Construction & purchase of assets Return & interest on investments in assets Return of and other costs of owning & operating assets and delivering energy Revenue needed to recover cost of service, including earned return Year for which rates are being reviewed 14

15 Part 1: Introduction Revenue Requirement Formula RR = revenue requirement r = return on rate base RB = rate base = (OC - AD) RR = G + OMA + D + T + r(rb) OC = original cost of assets when placed in service AD = accumulated depreciation on assets since placed in service G= cost of gas sold OMA = operating, maintenance and administration expense D = depreciation and amortization expense T = income tax expense r(rb) = return on rate base or cost of capital G + OMA + D + T is sometimes referred to as cost of service while others refer to revenue requirement as cost of service 15

16 Part 1: Introduction Typical Corporate Structure Parent Energy Company Unregulated Subsidiary Gas Company Subsidiary Energy Services Company Gas Distribution Division Regulated Utility Gas Storage Division Regulated Utility Commodity Marketing Division Unregulated Retail Services Division Unregulated Gas Transmission Division Regulated Utility Non-utility Business Division Unregulated 16

17 Part 1: Introduction Regulated Gas Utility Example Gas Distribution Division, Gas Storage Division and Gas Transmission Division Regulated monopoly utility business Notional entity, need not be a legal entity For regulated rate setting purposes only All under one regulator Regular rate cases 17

18 Generally Accepted Regulatory Principles (GARP) 18

19 Part 1: Generally Accepted Regulatory Principles 1923 Bluefield Waterworks Decision A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money for the proper discharge of its duties. 19

20 Part 1: Generally Accepted Regulatory Principles GARP Generally Accepted Regulatory Principles Rates based on reasonable costs prudently incurred in providing necessary service to ratepayers Annual rates are based on annual costs All costs including taxes are on a utility stand-alone basis Utility evidence is presented from ratepayer perspective Fairness to ratepayers and shareholders 20

21 Part 1: Generally Accepted Regulatory Principles CIAC, AFUDC and IDC CIAC: Contribution-in-aid-of-Construction Funds contributed by a customer toward a capital project AFUDC: Allowance for Funds Used During Construction a charge permitted by the regulator to cover the financing of a utility capital project while under construction AFUDC is based on approved cost of capital (i.e. it has debt and equity components) AFUDC added to the project capital cost on completion. IDC: Interest During Construction Like AFUDC only based on debt interest costs only 21

22 Part 1: Generally Accepted Regulatory Principles GARP and GAAP Balance Sheet G A A P G A R P Left Side Assets Net of accumulated depreciation at a point in time, may include interest but excluding CIAC or Equity Financing Costs Rate Base Annual average net of accumulated depreciation, excluding CIAC, but including AFUDC or Interest Right Side Liabilities & Owners Equity At a point in time Capital Structure Annual average 22

23 Revenue Requirement Example FortisBC Energy Inc Test Year 23

24 Revenue Requirement Example Test Year Rate Base FortisBC Energy Inc. (FEI)

25 Revenue Requirement Example Test Year Capital Structure and Return FEI

26 Revenue Requirement Example Test Year Revenue Requirement FEI

27 Revenue Requirement Example Factors leading to 2015 Revenue Deficiency Formula (0.796) Forecast (1.179) 2.03% Delivery Rate Impact Demand Forecast Other Revenue O&M Depreciation & Amortization Financing and Return on Equity Taxes 2015 Deficiency 27

28 Revenue Requirement Example Revenue Requirement and Rate Increase Summary ($millions) RR = G + OMA + D + T + r(rb) RR = ( ) RR = 1,431.5 Revenue at Existing Rates (+ Other Revenue) = 1,416.0 Revenue Deficiency or Rate Increase = 15.4 Revenue Requirement or Revenue at Proposed Rates = $1,

29 Rate Base the value of the property which [the utility] employs for the convenience of the public 29

30 Part 1: Rate Base Rate Base Components and Categories Rate Base Components Property, Plant and Equipment (forecast average, net of CIAC, net of accumulated depreciation- net gas plant in service) Allowance for Working Capital & Other (forecast for the Test Year) $ Millions Account Categories $3,520.4 Storage Plant Transmission Plant Distribution Plant General Plant Gas-in-storage Materials & Supplies Inventory Security Deposits Cash Working Capital Deferred Charges (Regulatory Assets & Liabilities) 20.3 Energy Cost Variance Accounts DSM incentives Non-Controllable Cost Variances Application Costs Accounting Related Total Rate Base (total average Test Year assets providing service to ratepayers) $3,656.4 To Cost of Service Revenue Requirement 30

31 Rate Base: Storage Plant Liquefied Natural Gas Facility 31

32 Rate Base: Transmission Plant Southern Crossing Pipeline Compressor Station 32

33 Rate Base: Distribution Plant Service Line Tie-in to Main Meter Installation 33

34 Rate Base: General Plant Operations Centre / Office Building 34

35 Part 1: Rate Base Rate Base Calculation Principles Rate base - the net value of utility s assets used in providing service to customers Average Original Cost AFUDC/IDC Accumulated Depreciation Contributions In Aid or Contributed Capital Net Gas Plant In Service Revenue Requirement 35

36 Part 1: Rate Base Calculation of Rate Base Average Simple Annual Average (opening balance + closing balance)/2 Average of Monthly Averages ((month1 avg) + (month2 avg) + + (month 12 avg))/12 The formula can be restated as follows: (Jan.1)/24 + (Jan.31+Feb.28+ Nov.30)/12 + (Dec.31)/24 13-Month Average (Jan.1 + Jan.31 + Feb Nov.30 + Dec.31)/13 36

37 Part 1: Rate Base Regulatory Treatment of Work-in-Progress Work-in-progress ( WIP ) is not in rate base (if AFUDC or IDC is charged) AFUDC or IDC is added to asset cost Allowed to charge AFUDC or IDC to recover capital project financing costs AFUDC or IDC is recovered through depreciation expense charged in rates over the life of the asset 37

38 2015 Revenue Requirements Formula Based Capital Expenditures $180.0 $ Formula Growth Capex Different Growth Factors 2015 Formula Other Capex Total 2015 $90,131 $140.0 $120.0 $100.0 $80.0 $60.0 $40.0 $20.0 $- $(20.0) 2014 Base Inflation Customer Growth Non-Formula 38

39 Part 1: Rate Base Original Cost- Capital Budget vs. Rate Base Additions Line 2015 No. Particulars Forecast (1) (2) Formula Driven 1 CAPITAL EXPENDITURES 2 3 Growth Capital Expenditures $ 28,480 4 Sustaiment and Other Capital Expenditures 117,213 5 Forecast Capital Expenditures 10,611 6 CIAC 6,448 7 Total Regular Capital Expenditures $ 162, Special Projects - CPCN's Huntingdon Station 7, Tilbury Expansion 156, Total CPCN's $ 164, TOTAL CAPITAL EXPENDITURES $ 326, Revenue Requirement 39

40 Part 1: Rate Base Original Cost + AFUDC- Capital Budget vs. Rate Base Additions Line 2015 No. Particulars Forecast (1) (2) From O&M 18 RECONCILIATION OF CAPITAL EXPENDITURES TO PLANT ADDITIONS Regular Capital 21 Regular Capital Expenditures $ 162, Add - Opening WIP 64, Less - Closing WIP (60,516) 24 Subtotal 167, Add - AFUDC 1, Add - Overhead Capitalized 32, TOTAL REGULAR CAPITAL ADDITIONS TO GAS PLANT IN SERVICE $ 201, Special Projects - CPCN's 31 CPCN Expenditures $ 164, Add - Opening WIP 150, Less - Closing WIP (329,488) 34 Subtotal (14,694) 35 Add - AFUDC 14, TOTAL CPCN ADDITIONS $ TOTAL PLANT ADDITIONS $ 201, Revenue Requirement Rate Base 40

41 Part 1: Rate Base Test Year Rate Base Rate Base Components Property, Plant and Equipment (forecast average, net of CIAC, net of accumulated depreciation- net gas plant in service) Allowance for Working Capital & Other (forecast for the Test Year) $ Millions Account Categories $3,520.4 Storage Plant Transmission Plant Distribution Plant General Plant Gas-in-storage Materials & Supplies Inventory Security Deposits Cash Working Capital Deferred Charges (Regulatory Assets & Liabilities) Total Rate Base (total average Test Year assets providing service to ratepayers) 20.3 Energy Cost Variance Accounts DSM incentives Non-Controllable Cost Variances Application Costs Accounting Related $3,656.4 Revenue Requirement 41

42 Part 1: Rate Base Working Capital Calculation Accounts for the net financing costs associated with day to day operations Determined on an annual average basis Different from financial statements, which is at a point in time (Current Assets Current Liabilities) Cash working capital Allowance for timing of cash inflows & outflows Lead Lag Study (most common) Varies amongst utilities Other Working Capital Primarily gas in storage Determined using forecast balances of gas in storage and forecast forward prices Revenue Requirement 42

43 Part 1: Rate Base Working Capital Allowance Lead Lag Study Revenue Requirement 2015 Line Existing 2014 Revised No. Particulars Rates Rates (1) (3) (4) 1 Cash Working Capital 2 Cash Required for 3 Operating Expenses $ 11,727 $ 12, Less - Funds Available: 7 8 Reserve for Bad Debts (7,927) (7,927) 9 10 Withholdings From Employees (5,292) (5,292) Subtotal (1,492) (1,122) Other Working Capital Items 15 Construction Advances (13) (13) 16 Transmission Line Pack Gas 2,251 2, Gas in Storage 77,811 77, Inventory - Materials & Supplies 1,567 1, Refundable Contributions (298) (298) Subtotal 81,318 81, Total $ 79,826 $ 80, Month Average 43

44 Part 1: Rate Base Test Year Rate Base Rate Base Components Property, Plant and Equipment (forecast average, net of CIAC, net of accumulated depreciation- net gas plant in service) Allowance for Working Capital & Other (forecast for the Test Year) $ Millions Account Categories $3,520.4 Storage Plant Transmission Plant Distribution Plant General Plant Gas-in-storage Materials & Supplies Inventory Security Deposits Cash Working Capital Deferred Charges (Regulatory Assets & Liabilities) Total Rate Base (total average Test Year assets providing service to ratepayers) 20.3 Energy Cost Variance Accounts DSM incentives Non-Controllable Cost Variances Application Costs Accounting Related $3,656.4 Revenue Requirement 44

45 Part 1: Rate Base Deferred Charges (Regulatory Assets & Liabilities) Common examples of deferral accounts are in the following areas: Cost of Gas Purchased Gas Variance Account or PGVA Taxes - Income or property tax changes not anticipated in the test year Interest rates Demand Side Management incentive grants Extraordinary losses caused by disasters and other unusual circumstances Rate base treatment of deferral accounts varies by jurisdiction Revenue Requirement 45

46 Part 1: Rate Base Deferred Charges (Regulatory Assets & Liabilities), $ Millions Accounts categorized as follows in FEI: $150.0 Margin Related $100.0 Variance accounts for Energy & Use Rates Energy Policy $50.0 $73.3 Margin Related EEC/DSM incentives NGT programs Non-Controllable $ Millions $- $26.8 Energy Policy Non-Controllable Application Costs Other Residual Cost variances and unanticipated events (tax changes, etc.) Application Costs $(50.0) $(73.3) Other $(6.7) Accounting related, special projects $(100.0) 2015 Forecast 46 Revenue Requirement

47 Part 1: Rate Base Summary,$ Millions $24.1 $20.3 $80.2 $35.6 $3,496.3 Opening Net Plant Changes in Net Plant Deferred Charges Working Capital Other

48 Cost of Capital a return equal to that generally being made at the same time on investments in other business undertakings which are attended by corresponding risks and uncertainties. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility to maintain and support its credit and enable it to raise the money for the proper discharge of its duties. 48

49 Part 1: Cost of Capital Test Year Cost of Capital and Return on Rate Base 49

50 Part 1: Cost of Capital Components of Capital Structure Long Term Debt Amounts are averages of existing and forecast amounts Net of un-amortized finance charges and profit/loss on redemption Existing debt and preference capital at actual rates New debt and preference capital at forecast rates from economic forecast Short Term Debt Short term debt amount is the amount required to balance rate base actual and forecast amounts of short term debt are not used Rate is obtained from the economic forecast of rates on a monthly basis for the test year Common Equity The amount is usually deemed by the regulator based on the risk of the utility s business actual common equity is not used The utility requests approval of a return on equity ( ROE ) for the test year based on evidence of economists In some jurisdictions a formula is used to determine the allowed ROE

51 Part 1: Cost of Capital Return on Equity Models Model Equity Risk Premium Explanation ERP + risk-free rate ERP=historical equity cost vs. long term bond yield risk free rate=long term government bond yield Comparable Earnings Compared to ROE of comparable non-utility companies over one business cycle (approximately 10 years) Discounted Cash Flow Current dividend yield + present value of future dividend growth Overall Recommendation Economists apply different weighting factors to each model 51

52 Part 1: Cost of Capital Formula Based Return on Equity Model Benchmark ROE set at 8.75% If Long Canada Bond is > 3.80% reset ROE Benchmark ROE + 50% of change in Long Canada Bond forecast + 50% of change in A rated Utility bond spread 52

53 Part 1: Revenue Requirement Revenue Requirement Equation ($millions) RR = G + OMA + D + T + r(rb) RR = G + OMA + D + T + (7.0% x $3,656.4) RR = G + OMA + D + T

54 Cost Of Gas Sold 54

55 Part 1: Cost of Gas Commodity-related costs receive different treatment from the cost of service of delivery-related cost components Natural gas pricing is market-based. Commodity options available customer can select marketer or default utility options. Commodity rate changes handled on a flow-through basis Two commodity-related cost streams for FortisBC- commodity and midstream Deferral accounts common to capture commodity cost variances 55

56 Part 1: Revenue Requirement Sample Customer Bill

57 Part 1: Revenue Requirement Revenue Requirement Equation ($millions) RR = G + OMA + D + T + r(rb) RR = OMA + D + T

58 Operating, Maintenance and Administration Expense under efficient and economical management 58

59 Part 1: Operating, Maintenance and Administration Expense OM&A Categories OM&A Plant Operating and Maintenance Customer Care and Marketing Administration Account Categories Storage Plant O&M Transmission O&M Distribution O&M General Plant O&M Meter reading Customer Billing & Administration Call centre Bad debt & Credit Management Program marketing, e.g. DSM H.O., Finance & General Administration Legal Insurance Employee Benefits 59

60 Part 1: OM&A Expense Two main views of OM&A expenses Activity-based view What are the activities carried out in a particular department or business unit (e.g. leak surveys, odorant costs, meter reading, billing, responding to service requests and customer enquiries, etc.) Resource view What resources are employed in delivering OM&A activities (e.g. labour & benefits, materials, vehicle expenses, etc.) 60

61 2015 Revenue Requirements Formula Based O&M Expense ($000) Line Description $ millions Base O&M $ x (1 + Net Inflation) 0.203% 3 x (1 + Growth Factor) 0.614% Formula O&M $ Forecast O&M Total Gross O&M Capitalized Overhead (12%) (32.5) 8 Biomethane O&M transferred (0.6) 9 10 Net O&M $ X Factor To Capital Additions 61

62 Part 1: OM&A Expense Property Taxes Property Taxes Taxing authority granted to various municipal, provincial and other public bodies by statute and regulation. Property taxes are generally based on assessed property values and mill rates but in some cases there are revenue-based taxes Utility property tax rates tend to be among the highest 62

63 Part 1: OM&A Expense Affiliate Transactions Concerns Assets or services Purchased or obtained by the utility from parent company or affiliates Sold or transferred by the utility to the parent company or affiliates Concerns Regarding Affiliate Transactions Transfer of utility earnings, which could have been used to reduce rates, to unregulated affiliate or parent company Purchases by utility from affiliate at more than utility s avoided cost or above market value Sales by utility to affiliate below book value of assets, or below cost of production, or below market value Two arguments No harm to ratepayers test : transaction must not increase rates Benefit to ratepayers test : transaction must decrease rates or yield other benefits 63

64 Part 1: Revenue Requirement Revenue Requirement Equation ($millions) RR = G + OMA + D + T + r(rb) RR = ( ) + D + T

65 Depreciation and Amortization Expense the value of the property which [the utility] employs for the convenience of the public 65

66 Part 1: Depreciation and Amortization Expense Test Year Depreciation and Amortization Expense Depreciation & Amortization Expense $millions Storage Plant $ 7.4 Transmission Plant 30.5 Distribution Plant 87.3 General Plant 39.1 Total Depreciation Expense Amortization of CIAC (8.9) Amortization of Deferred Charges 36.8 Total $ Example Revenue Requirement 66

67 Part 1: Depreciation and Amortization Expense General Concepts Pooled Assets Depreciation Rate Based on Useful Life of Pool Rates determined by Third Party Study Revenue Requirement Code of Accounts as Determined by Regulator Varying Amortization Periods for Deferred Charges 67

68 Part 1: Depreciation and Amortization Expense Distribution Plant Depreciation Expense Gross Plant Balance Depreciation Rate Depreciation Expense $ millions % $ millions Land % 0.0 Services 1, % 24.2 Mains 1, % 20.5 Meters % 17.5 Other Total

69 Part 1: Depreciation and Amortization Expense General Calculation of Depreciation Expense Adjusted for Timing Opening Gas Plant Balance Gas Plant Additions Gas Plant Retirements Depreciation Rate Depreciation Expense Revenue Requirement 69

70 Part 1: Depreciation and Amortization Expense Net Mains Cost in Rate Base Opening Balance Additions Retirements Retirement Costs Closing Balance $millions $millions $millions $millions $millions Gross Plant 1, (1.4) 1,339.3 Accumulated Depreciation (416.6) *(20.5) 1.4 (435.7) Net Plant ** * Accumulated depreciation additions are the annual deprecation expense **Note that ordinary retirements do not change rate base 70

71 Part 1: Depreciation and Amortization Expense Asset Retirement Ordinary Retirements Plant is retired near the end of its economic life No change in rate base Depreciation expense is reduced Extraordinary Retirements Plant is retired prematurely due to external events beyond management control Rate base is reduced by the net book value of the retired plant Depreciation expense is reduced Loss on retirement (net book value + disposal cost salvage value) is recovered from ratepayers in the year incurred (or can be amortized over several years to mitigate rate impacts) 71

72 Part 1: Revenue Requirement Revenue Requirement Equation ($millions) RR = G + OMA + D + T + r(rb) RR = ( ) T

73 Revenue Forecast under efficient and economical management 73

74 Part 1: Revenue Forecast Use per Customer Rates FEI Normalized Residential Use Per Customer FEI Normalized Residential Demand Use rate forecast x number of customers (per rate schedule) to get forecast demand Decline in use per customer creates rate challenges as the addition of new customers is currently not great enough to offset 74

75 Part 1: Revenue Forecast Forecast Volumes and Margin Notes: 1 Rate Schedule 1 2 Rate Schedules 2, 3, 23 3 Rate Schedules 4, 5, 6, 6P, 16, 46, 7, 22, 25, 27, Burrard Thermal, Joint Venture, BC Hydro/Island Cogeneration Project 75

76 Part 1: Revenue Forecast Regulation of Other Revenue What is other revenue? Other revenue is generally utility revenue which is not rate regulated, I.e. its rates are not set by an order of the regulator Utility assets and employees are used to generate other revenue Examples: NGV programs; appliance sales, rentals and service; agent billing and collection service, transactional services How is it regulated? Utility may need to demonstrate that the rate of return (ROR) on utility assets used for other revenue is equal to or greater than the allowed base allowed by the regulator If ROR is less than the allowed, then the regulator may impute revenue to this business to bring it up to the allowed ROR Imputed revenue is a notional increase in other revenue which is not earned by the utility and reduces the allowed rate increase 76

77 Income Tax 77

78 Part 1: Income Tax Utility Tax Calculation Principles Income tax is calculated on utility stand-alone basis, as if the regulated utility was a separate taxable corporation Regulators require that taxes be calculated on flowthrough basis - current customers benefit from maximum current tax deductions. Results in un-recorded deferred taxes to recover from future customers Issue of inter-generational cross-subsidies - current customers are benefiting from CCA tax deductions that should belong to future customers 78

79 Part 1: Income Tax Utility Income Before Interest and Income Tax $millions $millions Total Revenue at Existing Rates $1,416.0 Less Expenses: Cost of Gas Sold OM&A Expense Property Tax 61.5 Depreciation and Amortization Expense Total Expenses 1,124.9 Income before Interest & Income Tax $

80 Part 1: Income Tax Taxable Income Amount $millions Income before Interest and Income Tax $291.1 Deduct: Interest Expense (132.9) Add Non-deductible Items: Depreciation / Amortization Expense Other Non-deductible Items 35.5 Subtract Deductible Items: Capital Cost Allowance (tax depreciation) (154.8) Capitalized Deductible Items (overhead costs) (10.8) Grossed-up Part VI.1 Tax (re: Preferred Shares) Other Deductible Items (41.6) Taxable Income $

81 Part 1: Income Tax Income Tax on Forecast Revenue at Existing Rates Combined Federal / Provincial $millions Taxable Income $178.7 Income Tax Rate 26.0% Income Tax on Revenues at Existing Rates $

82 Part 1: Income Tax Test Year Income Tax on Revenues at Proposed Rates $millions Cost of Capital r(rb) $256.1 Expenses before Income Tax G+OMA+D 1,124.9 $millions Income Tax at Existing Rates Subtotal 1,427.5 Less Revenue at Existing Rates 1,416.0 Net Revenue Deficiency 11.5 Gross Revenue Deficiency Net deficiency/ (1-marginal tax rate) = 11.5/ (1-0.26) 15.4 Income Tax on Gross Revenue Deficiency (15.4 x 0.26) 4.0 Test Year Income Tax at Proposed Rates

83 Revenue Requirement Example Revenue Requirement and Rate Increase Summary ($millions) RR = G + OMA + D + T + r(rb) RR = ( ) RR = 1,431.5 Revenue at Existing Rates (+ Other Revenue) = 1,416.0 Revenue Deficiency or Rate Increase = 15.4 Revenue Requirement or Revenue at Proposed Rates = $1,

84 Part 1: Revenue Requirement Recovery of Revenue Requirement from Ratepayers Revenue Requirement increase is allocated to customer classes Rates are designed to recover all of the Revenue Requirement in the test year based on forecast volumes Revenue/year = number customers x volume/customer/year x revenue/volume Rate = Revenue requirement / unit volume More on cost allocation and rate design in later sessions 84

85 The Decision 85

86 Part 1: The Decision Regulator Balances Interests For Customers Utility service at fair and reasonable rates without undue discrimination or preference For the Utility Recover costs of providing service including a fair and reasonable return on the property employed in providing utility service.

87 Part 1: The Decision Regulator Balances Interests Revenue Requirements Rate Design Shareholders Existing Customers Capital Projects Society at Large Future Customers Cost Allocation 87

88 Part 1: The Decision Regulator Adjusts Revenue Requirement Potential Areas of Adjustment Does not approve certain capital expenditures Effect is reduced rate base, r(rb), depreciation expense, taxes Decides that the revenue forecast is understated Decides that other revenue business should be at the allowed rate of return Decides that OM&A cost forecast is overstated Increases sales volumes and revenue forecast (with corresponding cost of gas) revenue deficiency decreases imputes additional revenue and decreases revenue deficiency reduces OM&A costs and revenue deficiency Reduces ROE or debt interest rates ROE change affects r(rb) and taxes, interest change affects r(rb) 88

89 Part 1: The Decision Adjustments to Revenue Requirement FEI $ Million % Rate Change Proposed Rate Change % Adjustments: Update forecast inflation & interest rates to current information 0.4 Increase to forecast Residential Customer use rate (6.0) Decrease to forecast NGT O&M (0.4) Revision to CIAC amortization* (2.2) Update to actual opening plant & deferral balances (1.4) Adjustments related to Amalgamation Decision (0.6) Total Adjustments (10.2) Revised Rate Change % *oversight identified by FEI in preparing compliance filing 89

90 Part 1: Cost of Service Regulation - Review & Summary Regulatory Process Annual or regular rate hearings where the company is able to adjust rates on an annual basis in response to changes in costs Adequate evidence on each revenue requirement item to justify recovery in rates Forward test year - the company generally only spends what the regulator approves Company is at risk for forecast accuracy of revenue requirement components which are generally under management control Costs not under management control or otherwise subject to deferral are deferred and amortized in approved manner Variance accounts collect variances from forecast costs Deferral accounts collect un-budgeted costs 90

91 Part 1: Cost of Service Regulation - Review & Summary Regulatory Process Decision Arguments Evidentiary Record Closed Oral Public Hearing Pre-Hearing or Procedural Conference Discovery Process Workshop Procedural Conference Notification Intervention Procedural Order Application Duration can be 3 months to over 1 year

92 Part 1: Cost of Service Regulation - Review & Summary Advantages of Cost of Service Regulation Ability to recover the cost of providing service to existing customers Ability to recover the cost of adding new customers Ability to minimize risk by the adjustment of forecasts, generally on an regular basis Ability of utility shareholders to receive a stable ROE over a long period of time 92

93 Part 1: Cost of Service Regulation - Review & Summary Disadvantages of Cost of Service Regulation Long and expensive hearings to determine if the utility s cost forecasts are reasonable. Suspicion that the utility is overstating costs and understating revenues in its forecasts. Little incentive for the utility to cut costs since future savings are passed on to customers. Prone to micro-management of the utility by the regulator Limited flexibility to respond to changing market conditions. It is difficult for utility investors to earn a greater than allowed ROE even for superior performance. PBR may be a solution to some of these problems. 93

94 Approval of Capital Expenditures Part 2 Regulatory Approval of Capital Expenditures An Overview 94

95 Part 2: Approval of Capital Expenditures Capital Expenditure Justification Present value (PV) of future revenues is greater than the PV of all costs (capital expenditure, O&M, taxes, etc.) PV of future savings (capital or O&M) or avoided costs is greater than the PV of all costs. The capital expenditure is necessary to deal with a safety hazard or system reliability concerns. The capital expenditure is necessary to replace an obsolete asset which is necessary but no longer serves its purpose. Signed contracts from customers or shippers requiring new facilities to be constructed. 95

96 Part 2: Approval of Capital Expenditures Cost Estimates of Capital Expenditures Engineering estimates based on similar recent projects Courtesy bids from contractors Quotes from vendors, preferably more than one In addition to the direct capital costs the estimate includes: Environmental costs Contingency costs Overhead costs Regulatory approval costs 96

97 Part 2: Approval of Capital Expenditures Economic Feasibility Project life Length of contract with customer Set by regulator in a previous decision Life of assets, such as gas mains = 40 years Discount factor After tax weighted average cost of capital Net Present Value ( NPV ) NPV = Present Value ( PV ) of Operating Cash Flow + PV of CCA Tax Shield - PV of Capital Expenditure Profitability Index ( PI ) PI = (PV of Operating Cash Flow + PV of CCA Tax shield) / (PV of Capital Expenditures) 97

98 Part 2: Approval of Capital Expenditures Decision by the Regulator The regulator balances the interests of shareholders, current customers, prospective customers, and the society at large. Generally a capital project will increase rates in the near term with current customers bearing the burden of the higher rates initially to the benefit of future customers. Later in the project life this may reverse with the cross-subsidy from the new customers to current customers. The regulator determines what level of intergenerational cross-subsidy is not undue. If the level of cross-subsidy is found to be undue, the regulator may not approve the project or may approve it but require that new customers pay a contribution-in-aid-of-construction. The regulator may have obligations to review any environmental impacts of the project and how they can be mitigated. The regulator may have obligations to determine if there are any landowner compensation or First Nations issues and if they have been adequately dealt with. 98

99 Part 2: Approval of Capital Expenditures Addition to Rate Base on Completion of Capital Project Are actual costs different than forecast? Unforeseen events, weather Explanation of variances Poor cost estimates Is the original justification still valid? Re-do economic justification based on actual costs Potential disallowance of costs if the regulator is unconvinced Not all costs can be added to rate base. 99

100 Revenue Requirement and Performance Based Regulation Bibliography Bonbright, James C.; Danielsen, Albert L.; Kamerschen, David R.; Principles of Public Utility Rates, Second Edition; Public Utility Reports, Inc, Arlington, Virginia, 1988 Phillips, Charles F. Jr.; The Regulation of Public Utilities Theory and Practice; Public Utilities Reports; Arlington, Virginia, 1993 American Gas Association: Gas Rate Fundamentals, Fourth Edition; AGA, Arlington, Virginia, 1987 Mansell, Robert L.; Church, Jeffrey R.; Traditional and Incentive Regulation - Applications to Natural Gas Pipelines in Canada; The Van Horne Institute for International Transportation and Regulatory Affairs; Calgary, Alberta, 1995 Morin, Roger A., Regulatory Finance Utilities Cost of Capital; Public Utilities Reports; Arlington, Virginia, 1994 Schmidt, Michael R.; Performance-Based Ratemaking: Theory and Practice; Pubic Utilities Reports; Vienna, Virginia, 2000 Lowry, Mark Newton, Kaufmann, Lawrence: Performance Based Regulation of Utilities; 23 Energy L. J. 399 (2002) 100