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Cost Effectiveness and Rate Making. GRIDSCHOOL 2010 MARCH 8-12, 2010 RICHMOND, VIRGINIA INSTITUTE OF PUBLIC UTILITIES ARGONNE NATIONAL LABORATORY Rick Hornby Synapse Energy Economics rhornby@synapse-energy.com 617 661 3248 Do not cite or distribute without permission.
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Cost Effectiveness and Rate Making GRIDSCHOOL 2010 MARCH 8-12, 2010 RICHMOND, VIRGINIA INSTITUTE OF PUBLIC UTILITIES ARGONNE NATIONAL LABORATORY Rick Hornby Synapse Energy Economics rhornby@synapse-energy.com 617 661 3248 Do not cite or distribute without permission MICHIGAN STATE UNIVERSITY
Introduction Proposed investments in smart meter infrastructure (SMI) typically represent major increases in the revenue requirements of distribution utilities, leading to requests for increases in rates for distribution service. When determining whether to approve such requests, utility regulators consider several standard ratemaking issues. This session will address the following ratemaking issues associated with such proposals: Cost effectiveness. What tests do regulators consider when determining whether proposed investments are cost effective? What are the key inputs to those tests? What is the role of benchmarking and scenario analyses? Rate Making – What are rate implications for consumers? Rate Mechanisms. What rate mechanisms can utilities use to recover the investment in SMI, and their relative advantages and disadvantages? Cost Allocation. What ratemaking principles apply to the allocation of SMI revenue requirements among rate classes? Rate Design. What ratemaking principles apply to the design of rates to collect SMI revenue requirements.
I. Cost - Effectiveness SMI projects typically have six major components In Home Technologies, such as displays and programmable controllable thermostats (PCTs) Smart meters Communication network Back Office Systems, including a Meter Data Management System (MDMS) Customer interface System management and security One high level approach to determine whether these costs are reasonable is to benchmark them against the costs of SMI projects of other utilities.
I. Cost - Effectiveness Many regulators apply the Total Resource Cost test (TRC) to determine whether a proposed investment is cost effective. The TRC test compares, over the life of the investment, the net present value (NPV) of all projected costs associated with the investment, regardless of who pays them, with the NPV of all projected benefits from the investment, regardless of who receives them. (A common discount rate used in the NPV is the utility’s weighted average cost of capital.) A proposed investment is cost effective under the TRC if the NPV of its projected benefits exceeds the NPV of its projected costs. This relationship is often expressed as a benefit to cost ratio, where a ratio greater than 1 indicates the investment is cost-effective. A b/c ratio much higher than 1 is preferable, as this indicates a project with “robust” economics. This is important because of the uncertainty associated with projecting costs and benefits. A related approach to testing cost effectiveness is to test the sensitivity of the b/c ratio to a change in input assumptions. This is referred to as a sensitivity or a scenario analysis.
I. Cost - Effectiveness Major categories of projected savings from investments in SMI. projected savings in distribution service costs due to SMI alone: Reductions in annual operation and maintenance expenses, primarily meter reading but also meter operations and revenue protection Avoided capital expenditures in “business as usual” meters and IT projected savings in distribution service costs due to SMI plus dynamic pricing Avoided distribution service capacity costs due to reductions in demand projected savings in electricity supply costs Avoided generation capacity costs due to DR in response to dynamic pricing (DP) Lower generation capacity costs from lower capacity prices due to DR from DP Avoided generation energy costs due to EE in response to feedback Lower generation energy costs from lower energy prices due to EE from feedback Other benefits are often mentioned but rarely quantified. These include reductions in emissions of greenhouse gases (GHG), improved reliability of distribution service, enabling of plug-in hybrid electric vehicles (PHEV) and enabling of distributed generation.
I. Cost - Effectiveness Investments in SMI typically have to justified based upon projected savings in distribution service costs plus projected savings in electricity supply costs. The need for both categories of savings can pose a problem for “Distribution Service” only utilities, who have no control over rates for supply service.
I. Cost - Effectiveness The fact that projected savings in distribution service capacity costs, and all of the projected savings in electricity supply costs, hinge upon assumptions regarding customer sustained response to prices and feedback is a source of substantial uncertainty since there is limited empirical evidence regarding that response. It is helpful to determine how sensitive the cost effectiveness of a proposed investment is to changes in input assumptions. Not every proposed SMI is cost-effective.
II. Rate Making -What are the rate implications for mass market consumers? Investments in SMI that are cost-effective will still typically result in requests for increases in rates for distribution service. The level of these increases, and the design of the distribution service rates set to collect them, will affect the attitudes of mass market consumers towards smart meters.
II. Rate Making -What are the rate implications for mass market consumers?
II. Ratemaking - Rate Mechanisms Base rates are the traditional mechanisms through which utilities recover all of their costs, including return of and on investments such as SMI. Base rates are set in general rate cases which typically only occur every few years Advantages. Regulator and all parties have ample time to thoroughly review projected costs and savings. Projected savings in distribution service costs can be reflected in rates. Utility bears financial risk if its actual net costs are greater than revenues it collects from base rates. Disadvantage. General rate cases are expensive and time consuming Utilities often request permission to recover the costs of their investment in smart meters through fully reconcilable surcharges which would be reset every year, if not more often. Advantages. Utility has greater assurance of recovering costs. Utility can pass savings through to customers as they occur. Disadvantages. Regulator and all parties may have less time to review costs and savings. Level of savings credited to customers may be less than projected. Ratepayers bear financial risk if actual net costs are greater than projected.
II. Rate Making -What are the rate implications for consumers?
II. Ratemaking - Allocation of Costs among Rate Classes According to generally accepted ratemaking principles, costs should be allocated among rate classes according to cost causation. Analysts can, and do, disagree over the factors that “cause” certain categories of costs. SMI costs are one such category. What factor(s) “cause” a utility to incur SMI costs - number of customers, demand, energy, or some combination of those three? The answer to this question has very different implications for mass market customers, as indicated below for an illustrative utility.
IV. Ratemaking - Rate Design Distribution utilities collect their revenues through three basic types of rates - a customer charge $/month), a demand charge ($ per kW per month), or an energy or delivery charge ($/kWh). Most tariffs for mass market customers only have customer charges and energy charges. According to general ratemaking principles, after the amount of revenues to be collected from a particular rate class has been determined, the decision regarding the portion of the rate class revenue requirement to recover via the customer charge and the portion to recover via the delivery and/or demand charge should be based upon the results of a cost-of-service study plus an analysis of bill impacts. Ratemaking principles call for the exercise of judgment when determining the level of increase in each type of rate in order to avoid too sharp an increase. The customer charge can represent a significant portion of the monthly bill of mass market customers.
Contact Synapse Energy Economics 617 661 3248 www.synapse-energy.com Rick Hornby (ext 243) rhornby@synapse-energy.com
