Tariff Development I: Overview of Rate Regulation and Basic Ratemaking Process

1. Tariff Development I:Overview of Rate Regulationand Basic Ratemaking Process Energy Regulatory Partnership Program Abuja, Nigeria July 14-18, 2008 Ikechukwu N. Nwabueze, Ph.D. Director, Regulated Energy Division Michigan Public Service Commission

2. Rate Making Principles Principles of Rate Regulation • Fairness to both the regulated utility and the ratepayers • Avoidance of unjust or undue discrimination between rate classes or customers

3. Rate Making Principles (Continued) Objectives in Setting Rates • Protect the ratepayer’s interest by assuring safe, reliable and reasonably priced services • Fairly apportioning cost among customers • Protect the shareholder’s interest by allowing the utility a reasonable opportunity to earn a fair rate of return on its investment

4. Determining Revenue Requirements • Revenue Requirement = r(RB) + Expense + Depreciation & Depletion Expense + Taxes • R(RB) = Income Requirement = Rate of Return multiply by Rate Base • Rate Base represents the investor-supplied plant facilities and other investments required in supplying utility service to consumers • Rate of Return can be defined as a judgmentally determined percentage that, when multiplied by an established rate base amount, provides a return that is intended to allow a utility (1) to meet its obligations to present capital investors (interest and dividends) and (2) to compete on reasonable terms in the financial markets for future capital requirements • REVENUE REQUIREMENT must be sufficient to cover the COSTS OF SERVICE, which are comprised of TOTAL OPERATING EXPENSES (including all taxes and depreciation charges), and a FAIR RETURN on the net plant rate base authorized for the utility

5. Utility Company Case No. U-### Calculation of Revenue Requirement Total Line Description Amount Amount Revenue Requirement = r(RB) + E + D + T r(RB) = Income Requirement = Rate of Return times Rate Base 1 Rate Base $1,904,152 2 Rate of Return 7.1924% 3 Income Requirement (Line 1 x Line 2) $136,954 $136,954 Expenses (from Page 3 of 6) 4 Company Use and Lost Gas Expense $32,313 5 Operation and Maintenance (O&M) Expense $298,316 6 Uncollectibles Expense $24,274 7 Depreciation and Depletion Expense $90,546 8 Federal and Other Income Tax Expense $8,041 9 Other Taxes $53,216 10 Other Items (Amortization of Debt Discount) $1,500 11 Allowance for Funds Used During Construction (AFUDC) -$1,400 12 Other Revenue (Column D, From Non-Ratepayer Sources) -$103,014 13 Additional Income Taxes from Page 1 (the Revenue Multiplier) $18,400 14 Other (not reconciled) -$1 15 Total Revenue Requirement $559,145 Revenue Requirement Calculation - Commission 16 Revenue Deficiency (from Page 1 of 6) $50,160 17 Gas Sales Revenue (from Page 3 of 6) $417,788 18 Transportation Revenues (from Page 3 of 6) $91,197 Total Revenue Requirement 19 $559,145

6. Expenses • Operations and Maintenance Expenses • Booked O&M Expense • Remove Disallowances • Remove Items Adjusted Elsewhere • Apply Inflation Factor • Employee Benefits • Depreciation and Amortization • Federal and City Income Tax • Property Tax

7. Utility Plant Used and Useful • For property to be classified as PLANT, it must be in use and useful • Property not in use or not useful is placed in Construction Work in Progress or Held for Future use

8. Cost of Capital and Associated Issues

9. Cost of Capital Concept • Defined as the minimum rate of return that is necessary to attract capital to an investment. • Forward looking concept • Opportunity cost – it is the cost of alternative investments that were forgone • Determined in the markets – it is demand for and supply of capital that determines the price for capital • Depends on the risk of an investment • Goal is to allow the utility to earn a rate of return which is fair and consistent with its investment in plant and equipment • Utility’s cost of capital is the return investors expect, or require, in order to provide the utility with capital • Equity consists of shares that are issued to the public and any applicable premiums and retained earnings

10. Types of Return • Authorized: The rate of return regulators have determined to be the company’s overall cost of capital, including the rate of return investors require on common equity in a rate proceeding. • Required: What investors desire as a return for investing their money in the common stock of a company. • Expected: What investors believe the investment will return. • Actual: What the books of account reflect at the end of the accounting cycle.

11. Capital Structure • The overall rate of return of a utility company depends on the capital structure that is used to finance its investment. • The permanent capital structure or capitalization of a firm is represented by long-term debt, preferred stock and common equity.

12. Capital Structure (Continued) • The correct mix of debt and equity in a utility’s capitalization is important because debt is cheaper than equity. The tax advantage of debt makes equity about twice as expensive as debt. • Long-term Goal for Permanent Capital Structure • Debt: 50% • Preferred Stock: 0-5% • Common Equity: 45-50%

13. Ratemaking Capital Structure • Components • Long-term Debt • Preferred Stock • Common Equity • Short-term Debt • Customer Deposits • Other Interest Bearing Items • Deferred Income Taxes • Deferred Federal Income Taxes • Job Development Investment Tax Credits

14. Overall Rate of Return

15. Capital Costs • To determine the cost of debt we look at the interest rate or coupon rate that the utility paid to finance that debt. • Preferred stock carries a fixed commitment and its cost is calculated the same way as debt. • Determining the cost of common equity is more complex than determining the cost of debt. Since a stockholder is not guaranteed a cash flow or a return, there is higher risk involved in holding the stock of a company.

16. Common Equity Cost Rate • Determining a company’s required rate of return on its common equity is defined by a general equation. • Required Rate of Return = Risk-free Rate + Risk Premium • - Risk-free Rate: Real rate of return on riskless security + inflation. • - Risk Premium is composed of: • Interest Rate Risk Premium Market Risk Premium • Business Risk Premium Regulatory Risk Premium • Financial Risk Premium Liquidity Risk Premium

17. Legal Guidelines • In the Bluefield Water Works and Improvement Co. vs. Public Service Commission, 262 U.S. 679, 692-693 (1923) case, the Court stated: • “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 part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties; but has no constitutional right to profits such as are realized or anticipated in highly profitable enterprises or speculative ventures.”

18. Legal Guidelines (Continued) • In the Federal Power Commission vs. Hope Natural Gas Company, 320 U.S. 591, 603 (1944) case, the Court stated: • “From the investor or company point of view, it is important that there be enough revenue not only for operating expenses but also for the • capital costs of the business. These include service on the debt and • dividends on the stock. By that standard the return to the equity owner should be commensurate with returns on investment in other • enterprises having corresponding risks. That return, moreover, should • be sufficient to assure confidence in the financial integrity of the • enterprise, so as to maintain its credit and to attract capital.” • Supreme Court established an “end result” doctrine which surmised that how a capital structure and rate of return is determined is not important so long as end result is appropriate and reasonable for the case at hand.

19. Cost of Equity Approaches • Comparable Earnings: Return commensurate with those investments in enterprises of comparable risk. Historical Approach. • Discounted Cash Flow Method (DCF): Return based on hypothesis that the market price of stock will equal the discounted value (present value) of all future earnings. DCF model equation is: • K = (D1 / P) + g

20. Cost of Equity Approaches (Continued) • Capital Asset Pricing Model (CAPM): • - KS = RF + B (Km-RF) where • - KS = Cost rate on equity capital of the firm • - RF = Risk free rate of return • - Km = Market rate of return • - B = Market risk of the stock • Risk of a portfolio of assets is less than the average of the risks of individual assets. • Risk-Premium Approach: • KS = RF + Risk Premium

21. Bond Rating Agencies Moody’s – Fitch – Standard and Poor’s Non-Financial CriteriaFinancial Criteria Market/Service Territory Leverage Fuel Supply Cash Flow Operating Efficiency Earnings Protection Regulatory Treatment Financial Flexibility Management Accounting Quality Competition Construction Spending

22. Ratings of Michigan’s Two Largest Utility Company’s S&PMoody’sFitch DTE Energy BBB- Baa2 BBB Detroit Edison A- A3 A- MichCon BBB+ A3 A- CMS Energy BBB- Ba1 BB+ Consumers Energy BBB Baa1 BBB-

23. Balance Sheet Plant Remove Depreciation Reserves Related Account Balances Working Capital Rate Base Determination

24. O&M adjustment (remove known & measurable, and add in inflation) Uncollectibles Disallowances Plant adjustment Recalculate depreciation Construction Work in Progress Held for Future Use Tax adjustment To take in affect the above adjustments Test Year and Adjustments

25. Commission ordered periodic filings Audit requests Discovery questions Motion to Compel Data Collection and Processing, Monitoring

26. Developing Chart of Accounts and Instructions for Regulated Utilities • We use the Uniform System of Accounts(USoA) (Generally accepted or applied by all the states) • USoA is a set of rules that prescribe the types of accounting records that must be kept by utilities. There are USoAs for both electric and gas utilities. • USoA prescribe a uniform set of account numbers for all balance sheet and income statement accounts • USoA also provides detailed descriptions of the types of items that should be included in each account. • USoA prescribes the accounting period. Income Statement detail must be segregated on a monthly basis, and balance sheet accounts must be measured at the end of each month. Utilities must close their books at the end of each year. • Finally, USoA has instructions to aid utilities in properly recording transactions.

27. Questions?