Insights for rate design using a retail gas utility’s rate filing 12 2-13
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Insights for rate design using a retail gas utility’s rate filing 12 2-13



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This is a draft that is currently being submitted for publication. You may contact me if you wish to use any portion of it.



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Insights for rate design using a retail gas utility’s rate filing 12 2-13 Insights for rate design using a retail gas utility’s rate filing 12 2-13 Document Transcript

  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR Practical Insights for Existing Utility Retail Pricing and Revising Retail Pricing By Robert J. Procter, Ph.D. I. Paper Overview Pricing (ratemaking) for a regulated retail utility provides a fascinating window into the overlapping arenas of economics, public policy, and legal requirements. In this paper, arguments are summarizedthat both support and provide insights into rate regulation for the practitioner with little or no background in this subject matter. Additional insights are gained into the overlap between economics, public policy and legal requirements by examining how one utility rate proposal1weaves together arguments from these three broad areas to support its rate proposal. This author has attended numerous meetings, workshops, and conferences where some participants have little or no grasp of the most basic issues in this subject matter and speak about the need to „de-regulate the markets‟ to let innovation flourish.I anticipate that the focus on rate setting as an critical element of regulation will continue into the future as this industry continues to see advances in grid modernization, movements to integrate products such as transactive energy,and increasing telecommunications requirements to sustain and improve utility operations continue advancing. While the case filed by NWN is the „straw man‟ for this paper, the issues raised herein extend to both public utility commission review and deliberations of both electric and gas utilities generally. Section I examines the role of the Commission as that has been expressed in administrative rule, statute, and legal decisions. It also contains an overview of selected actions by The Federal Energy Regulatory 1
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR Commission (FERC) that help provide insight into the role policy plays when developing a rate design. Section II borrows aspects from regulatory economics and the economic theory of the firm that form an analytical footing for the remainder of the paper. This includes a short overview of the relationship between determining a rate design and rate setting, once a rate design has been proposed by the utility. Section III examines in more depth several issues that arise about rate design and rate setting using material presented in Section II. Specifically, six explicit or implicit assumptions in NWN‟s testimony supporting its LRIC Study are critiqued. Finally, Section IV will present a selected set of conclusions and recommendations. I. Legislative Action and Court Rulings Define The Role of the Commission How the legislature and courts have previously opined on the issues of fair and just rates bears on the review of NWN‟s approach to defending its rate proposal. This short overview of legislative direction and court rulings helps to define how much latitude NWN (or any utility rate making under Commission jurisdiction) has to define both a proposed rate design and set of rates. It also helps to define the necessary scope of testimony used to argue affirmatively in support of a proposed rate design and set of rates. Starting with the Commission‟s Mission Statement, it describes its role as one focused to "Ensure that safe and reliable utility services are provided to consumers at just and reasonablerates”2[emphasis added]. This statement raises a question about how one determines if a set of proposed rates meets this standard.3 Referring to Oregon law, the “The legislature has authorized the PUC, in regulating the rates of public utilities within its jurisdiction, to„make use of the jurisdiction and powers of the office to 2
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR protect [utility] customers, and the public generally, from unjust and unreasonable exactions and practices and to obtain for them adequate service at fair and reasonable rates. The commission shall balance the interests of the utility investor and the consumer in establishing fair and reasonable rates.‟”4 The justices go on to note that “...rates are fair and reasonable for the purposes of this subsection if the rates provide adequate revenue both for operating expenses of the public utility *** and for capital costs of the utility, with a return to the equity holder that is:(a) Commensurate with the return on investments in other enterprises having corresponding risks; and(b) Sufficient to ensure confidence in the financial integrity of the utility, allowing the utility to maintain its credit and attract capital.”5 The ruling goes on to note that since the Legislature‟s direction to the Commission is quite broad on this issue and the Court‟s review of rates previously established through Commission Orders is typically very limited. It also notes that even if an aggrieved party files suit and the Court remands the Commission‟s Order, the Commission is free to review the case using its existing delegated authority, unless the remand has specifically limited its discretion. Interestingly, the ruling also notes, “…as to ratemaking by the [Oregon] PUC, the [Oregon] Supreme Court has noted that it is the legality of the end result of the ratemaking process, and not the legality of each calculation or input used during that process, that controls.”67 [Emphasis added] How does one distinguish between unfair and unduly discriminatory, on the one hand, from fair and reasonably discriminatory, on the other? In Oregon, that determination lies primarily with the Commission. Oregon courts have acknowledged that the Commission is acting within its legal authority if it balances the competing 3
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR objectives embedded within a set of rates, even if one or more aggrieved party believes that those rates are unfair, unjust, and unduly discriminatory. This grants a good deal of latitude to the utility to determine a set of rates as long as the utility is able to mount a persuasive defense that their proposed rates, along with their proposed rate design, are just and reasonable and not unduly discriminatory. While The FERC has no authority over the setting of retail rates by the Commission (or any other state‟s utility commission), it has adopted various solutions to the policy question of what amount of fixed cost should be recovered using a customer charge versus what amount of fixed cost should be recovered using a commodity charge.8 The FERC rightly notes that the issue of what amount of fixed cost is recovered using a commodity charge has implications for the total cost of servicefor various customer classes, and customers within a class. They also rightly note that the total cost of service of a given customer will depend on that customer‟s load factor. As a result, the amount of fixed cost included in a commodity charge will have differential impacts on various customers reflecting differential load factors between those customers.9 The FERC first assigned all fixed costs to the commodity charge and over the years shifted between all fixed costs being assigned to the customer charge to having a portion of them included in the commodity charge and a portion assigned to the customer charge. It‟s interesting to note that these various approaches to allocating fixed costs were sometimes supported on the basis of whether peak use or annual consumption was paramount in planning, while at other times a particular allocation of fixed costs between the variable and the fixed charges was justified on the basis of how 4
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR they supported a particular policy goal, such as increasing consumption. This short overview of The FERC approaches illustrates that in the rate design and rate setting policy arena, such factors as how the existing system is currently operating and what policy goals are in play have been crucial considerations when allocating fixed costs between a fixed charge and a commodity charge. II. An Overview of Economic Theory for Rate Setting and Judging Fairness Rate setting refers to determining the overall pattern of prices (rates) that are contained in a utility‟s rate schedules or tariffs. As such, that pattern also reflects the utility‟s cost allocation and rate design. Rate design includes what „billing factors‟ are used for residential versus industrial rates, for example, as well as the structure of rates within one segment of the utility‟s customer base. For example, are rates flat across hours of the day, day of the week, week of the month, and/or month of the year?Will there be a price levied that reflects the cost the utility faces when deliveries are at a peak? Will there be a fixed charge per customer? What will be the pattern of charge per unit of consumption, otherwise known as the volumetric charge? Rate design refers to the process of translating costs that are allowed recovery from a given customer class through rates into specific prices.10 Since utilities have relatively high fixed costs as a proportion of total costs, rate design should include at least two components: a fixed component and a variable component. The fixed component would recover some portion of the utility‟s fixed costs and the variable component would recover the utility‟s variable costs and possibly some portion of its fixed costs. 5
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR Often, there are multiple variable components. For example, for an electric utility it‟s not uncommon to find a fixed customer charge combined with a variable charge for capacity, referred to as a demand charge, and a second variable charge for energy, referred to as an energy charge. For a gas utility, it‟s also not uncommon to find a fixed customer charge per meter, and a commodity charge measured in dollars per therm of gas delivered. There may also be a separate demand charge. Now, turning to micro-economic theory (MET) among the management decisions addressed include optimal pricing, organizing production, and optimal input combinations. The figure below, titled „Monopoly,‟ illustrates the economic goal of regulation. Economic regulation of retail electric or gas utilities has two primary goals: lower price from Pm to Pf and increase output from Qm to Qf. While the retail electric or gas utility must stand ready to serve whatever amount of consumption its customers desire at the prices contained in its rate tariffs, this diagram still illustrates these two primary goals of economic regulation.11 6
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR Note that when a large portion of total costs are fixed costs, the utility underrecovers revenues if it proposes rates by equating the proposed rate to marginal cost, P=MC, (Pr in the graph). Yet, in MET, students are trained that the valid pricing and production rule is to set production where P=MC, in both the short-run and the long run. This result is illustrated in the graph where P=MC lies below the „fair return price‟ of P=AC. Yet, in the case of the regulated firm, such a decision leads to a cost underrecovery. This presents a dilemma to the regulator. Rates set using MC under-recover costs while rates set using average costs (AC) send price signals that do not reflect costs for any incremental change in consumption. Therefore, the regulator must either use a separate charge to recover many or all of these fixed costs, and/or set rates using average cost pricing (ACP). P=AC is often the solution to this revenue under-recovery problem, and we will return to this issue in Section III. One very important part of MET, and one that is a significant element in rate setting in regulated industries, is the issue of cost causation. Assuming that a retail gas utility sets rates using costs (rather than some form of market-based rates), how various expenses are treated becomes crucial to assessing if the rates are just and reasonable. At first blush it might appear that cost based rates constrain the options for rate setting, and support a conclusion that cost based rates are inherently fair and just (since they are cost based). However, we will see that the reality is quite a bit more complex. The complexity is driven, in part, by how the following issues are resolved: (A) Determining what costs are fixed and what costs are variable; (B) Determining what fixed costs are included in the rate base; (C) Determining marginal costs; and (D) Determining how to assign „joint‟ costs. 7
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR Regarding „fair and just,‟ Section I summarized existing legislative and legal guidance on this issue, which at the retail level in Oregon, kicks the issue back to the Commission for resolution. As will be discussed later, some of the testimony filed by Commission staff argues that assigning costs to the party causing those costs achieves the dual goals of efficiency and equity. This approach to defining equity will also be addressed.12 We will also examine how it is that fair and just rates or prices, what in economics is referred to as equity lies outside the scope of the MET A. Determining what costs are fixed and what costs are variable. By convention, fixed costs are those that are impossible to change in the short-run and variable costs are those that can be changed „quickly‟ in the short run. By convention, MET defines the long run as that point in time when all costs are variable. As a result of these conventions, the issue of what costs are fixed and what costs are variable overlaps with the next one, how to determine what is a short run versus a long run cost. How these two issues are resolved will significantly affect the Long-Run Incremental Cost(LRIC) study and therefore also affect cost allocation and rate design. In MET, inputs to production and their associated costs are separated into fixed and variable categories. The reality is it‟s not as straightforward as one might imagine based on the simple examples used in illustrating the concepts of short run costs and long run costs. It isn‟t as simple because there is no clear dividing line between them. Each input used to produce and deliver a kWh of electricity or therm of gas will likely have different lengths of time over which they are fixed. For example, replacing one power pole or one line switch 8
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR due to failure of the equipment are examples of capital equipment that may be treated as a variable cost and included in short run variable cost (SRVC).13 Some examples of fixed costs include the existing transmission and distribution system pipes or power lines, gas compression stations, generating plant, central office building, fixed maintenance and operating expenses, back office support systems including mainframe computers and existing human capital. Some examples of variable costs include fuel for the existing power plant, gas in the existing pipelines, some maintenance and repair expenditures associated with the existing system. For a given rate filing, constructing the utility‟s short run total cost schedule (SRTC) is developed using the costs associated with the resources used in production and delivery that are fixedin the short run (SRFC) plus those variable costs (SRVC) that pertain to its rate filing. In contrast, the long-run total cost schedule (LRTC) should be constructed using the costs of those inputs used to produce and deliver a product that can only be changed in the long run. B. How short-run costs are distinguished from long-run costs Recall that on a close reading of economic theory, a business‟s LRTC are those costs that are associated with the amount of each input used to produce and deliver the needed quantity of kWh of electricity or therms of gas in the long run. What is tricky is identifying the long run. As was mentioned above, there is no clear demarcation between the short run and the long run. We can say that the long run is when all inputs are variable. Identifying that point in time, or span of time, for an actual analysis isn‟t straightforward. Some crafting 9
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR of a long run scenario is the usual solution. While future costs may be used for LRTC, historical costs may also be used when they are believed to reflect expected future costs. One additional complication is how to deal with the utility‟s historical costs. Recall that in the long run, if all costs are variable, fixed costs, by definition, are non-existent. Yet, in the context of rate setting for a retail electric or gas utility, there are historical costs that must be recovered the rates. For example, returning to the „Monopoly‟ graph, the amount of the firm‟s historical costs, or what is also sometimes called sunk costs, is approximated by the area (Pf – Pr)*Qf.14 C. Determining how to assign „joint‟ costs Joint costs can be a particularly challenging area when determining the total cost of a given segment of the utility‟s production and/or delivery process. They often also pose a challenge when assigning costs to different products and/or user groups, such as between different groups of customers (e.g., residential, large commercial, industrial, street & area lighting, etc.). Economic theory recommends that these types of costs, as with any cost, be assigned to the various functions and customers based on the extent to which that function and/or group of customers give rise to that cost. This is a principle enunciated in microeconomic theory irrespective of market structure. While that direction sounds quite clear, putting it into operation can be another matter entirely, which we will explore later in this paper. 10
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR D. Determining Marginal Cost Before we can determine marginal cost, MC, we need to identify total cost. Total cost can be determined separately for SRTC and for LRTC. A simple form for LRTC associated with the production and delivery of a kWh of electricity or a therm of gas is in formula (1) below, (1) LRTC(Qi) = P1*X1 + P2*X2 + . . . + PN*XN Where, LRTC(Qi) = Long Run Total Cost at outputQi, Pn = Price per unit of Input Xn used to produce output Qi, Qi = Output quantity i, Xn = Quantity of Input Xn required to produce Qi. Long-run average and marginal costs are then derived using this LRTC schedule. If long-run total cost is LRTC(Qi), then long-run average cost, LRAC(Qi), equals LRTC(Qi)/Qi. In turn, long-run marginal cost, LRMC(Qi), equals [d(LRTC(Qi)]/d[Qi].Take note that output, Qi is in the denominator of LRMC. There is no requirement that d[Qi] > 0. It can either be positive, 0<d[Qi], or negative, d[Qi]<0. This is an important observation because it opens the possibility to determine MC, for either SRMC or LRMC, using decrements in sales. Therefore, we can determine a LRMC for the last unit of output without that last unit of output serving sales growth, as is required in NWN‟s testimony. Assuming a discontinuous cost curve, LRMC(Qi) is approximated using Long Run Incremental Cost, LRIC, (2) LRIC(Qi) = | [LRTC(Qi) - LRTC(Qi-j)]/[Qi –Qi-j ] | 11
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR where, Qi can either be > Qi-j or < Qi-j. In (2), LRIC(Qi) depends on the slope of the LRTC curve, which depends on the slope of the business‟ production and delivery functions under fixed input prices.15 As we have just seen, load growth, either by adding customers or increasing consumption per customer, is not a necessary condition to be able to estimate LRIC(Qi).16 Additionally, for the business that produces multiple products that are delivered to various customer groups, there essentially is a corresponding LRTC, LRAC, and LRMC for each product and customer group combination.17 Distinguishing short-run costs from long-run costs does not depend on whether a power or gas transmission or distribution line is being installed to meet new customers, or growth among existing customers, or replacing old or outdated equipment, or making upgrades to existing equipment, or replacing existing equipment due to wear and tear. Capital expenditures that lie outside the scope of replacing a defective part (as was addressed above) should be included in long-run total cost irrespective of whether they arise from expansion of the existing infrastructure to meet growth or are needed simply due to wear and tear to maintain service quality.18 III. Economic Theory and the NWN Initial Testimony As we have seen, arriving at a set of rates is based on more than economic theory. Section II summarized several key issues that help to determine a set of rates once we have a rate design. When the analyst moves from theory that is largely based on the principle of cost causation, and into the practice of developing 12
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR a set of rates, the goals and objectives of the business become quite significant. While cost causation remains a guiding principle within MET, in practice cost causation should be based largely on policy guidance from the executive committee that should be informed by analysis. Let‟s now turn to examining arguments made in the NWN rate filing and compare those arguments to the framework laid out in the previous sections. There are six sub-sections below and each sub-section addresses a different explicit or implicit assumption in NWN‟s arguments. Each section‟s title represents one of the assumptions. Each section‟s content is a critique of that assumption. A. The MC Study does not reflect actual costs Included in NWN’s initial filing was a LRIC study and supporting testimony (Feingold testimony).19Early in Feingold‟s testimony, he argued, “Marginal cost studies do not reflect actually incurred costs, but rely on estimates of the expected changes in cost associated with changes in utility service.”20Recall that section II (D) illustrated that MC could be estimated using the business‟s existing LRTC data at a given level of existing output, denoted Qi. Doing so reflects its current production and delivery capabilities. As a result, requiring that MC be forward looking and based on estimated costsunduly limits the scope of the utility‟s MC studies. MC calculated on future costs, are also useful in rates designed to help limit consumption before design day requirements are reached by signaling to customers the incremental cost of that added consumption.Pricing using a MC calculated from the existing production and delivery functions does provide a 13
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR signal to the market about the cost of system expansion when the expansion costs are reasonably approximated by the business‟s existing LRTC. B. The MC Study should exclude equipment repair and replacement costs Feingold argues that including distribution mains replacement costs in MC becomes relevant when “…new customers are added to the system…[which] may increase design day requirements above…[what] existing facilities can serve…”21Feingold‟s argument that there should be no cost included in the LRIC associated with transmission and distribution (T&D) when consumption by existing customers lies below peak delivery capability buries a policy issue in the analytics of the LRIC study. Rather, existing customers should face some cost associated with meeting peak system use in order to assure the existing system is being used effectively.Existing customers should also confront costs incurred to maintain service quality. C. Uses must be in conflict for common (joint)costs to arise Feingold argues, “Common costs occur when the fixed costs of providing service to one or more classes, or the cost of providing multiple products to the same class, use the same facilities and the use by one class precludes the use by another class”[Emphasis added]. When a good or service is bought and sold in a market, like electricity and gas are, common costs arise when the use of a particular facility, say a distribution line, by one class (or one customer within a class) does not preclude its use by another class (or another customer in that same class). It is non-exclusivity in use that makes a given cost a common cost, not exclusivity in use as Feingold argues. 14
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR D. The Stand Alone Cost test can be used to find cross-subsidies Allocating joint product costs is a well-traveled road in regulatory economics. As such, there is no reason to delve into the pros and cons of one method versus another method any further. Rather, the overlap between joint cost allocation and subsidy free pricing is one worth exploring. Feingold argues that a subsidy free price is one where the price of the service exceeds MC but lies below the stand-alone cost (SAC) of that service. In this writer‟s professional opinion it is highly unlikely that a panel of experts would find a real-world rate schedule that is absolutely free of all cross-subsidization. There is quite a bit of literature on using the SAC test for determining the presence or absence of any cross-subsidies of either products or customers. One such paper is titled, “Against the Stand-Alone-Cost Test in U.S. 
 Freight Rail Regulation.”22AuthorPittman calls the use of SAC into question with railroads on two points: First, while the companies face a revenue adequacy constraint, they are not constrained to earn zero economic profit. Second, other businesses must able to enter the industry and offer all or a sub-set of services to the railroad‟s customers. Regarding the first point, he says, “…once firm-wide economic profits exceed the estimated cost of capital … that fact is (obviously) not the same as a regulatory constraint on company profits.” In retail gas and electricity regulation, while the companies are provided an opportunity to earn a specified rate of return (ROR), they may earn a ROR above or below the allowed level embedded in a set of rates. Earnings in excess of the allowed ROR are economic 15
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR profits. These quasi-rents will likely not attract entry at least in part due to the regulatory impediments to entry and exit. Setting aside any legal issues surrounding a third-party working directly with the utility‟s existing customers (which can be significant), entry and exit into the utility business is anything but free. Since the SAC methodology requires developing a proxy utility in order to have a reference for cost comparisons, Heald argues that it is virtually impossible to construct such a benchmark able to determine if a subsidy exists.23 Reviewing various methods to assess whether cross subsidy is an issue, Heald argues against the use of SAC for several additional reasons above and beyond what Pittman argues. While Pittman focused on the violation of key assumptions that underlie SAC, Heald focuses on the complexity inherent in the SAC methodology. First, the cost functions of the existing and alternative technologies are required. Second, the SAC method is data intensive. Third, asymmetric information between the existing business, regulators and potential entrants makes accurate SAC testing virtually impossible. Fourth, comparing each output of the existing firm to the possible cost of each product produced separately by potential entrants can result in very different conclusions partly depending on how rapidly technology is changing and the strength of economies of scope and scale enjoyed by the incumbent firm.24 His conclusions rightly include the observation that cost allocation is partly technical and partly political. More to the point, he argues that efforts to find technical solutions to this problem of determining if subsidies exist, where 16
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR they are, and how large they are will only generate frustration. The crucial issue for Heald is the challenge in developing comparable cost data. In his words, “Without comparable cost data, the cross subsidy problem cannot be satisfactorily addressed.”25 Jamison echoes Heald‟s conclusion noting, “…it is infeasible for regulators to establish subsidy-free prices with any degree of confidence.”26 Jamison also supports Heald arguing that to develop subsidy-free prices requires the regulator to know “…the utility's cost function, its competitors' cost functions, their competitors' cost functions, and so on until all combinations of products which could have economies of joint production and that could be affected by the utility's prices, have been considered.”27 In a separate paper, Ralph notes that Faulhaber (who authored a seminal article on the topic of cross-subsidization)demonstrated that the test for subsidyfree prices “…must be applied to all possible groupings of consumers (or products) as well as to each individual consumer, since each individual may cover their incremental costs, and yet some group of consumers may not…”28 It is little wonder that both Jamison and Heald were less than sanguine about the ability of a regulatory body to determine whether or not a set of proposed prices contained any cross-subsidies. Falhaber himself felt the need to weigh in on the cross-subsidy debate with a short paper, which he begins by noting a tendency for analysts and researchers to incorrectly apply some of his principles that underlie his approach to testing for cross-subsidization. After presenting a simple example, he 17
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR reiterates a crucial conclusion from his 1975 paper that, “both the SACand the IC [incremental cost] tests must be applied not only to each service individually, but to all possible groups of services.”29He then hammers home the point that applying these tests to individual services in isolation, which he notes has tended to be the case in the regulatory arena, is a fatal error and cannot be considered a reasonable approximation, or „good enough‟ approach. E. Economic theory requires that fixed costs be recovered using a fixed charge Feingold turns toMET to find justification for his argument that all fixed costs should be recovered using the fixed customer charge and all variable costs should be recovered in the commodity charge. What is rarely noted is that when setting P=MC,results in P=MC=AC, in equilibrium. This means that the MET supports the recovery of fixed cost using a price that captures both fixed and variable costs.30 This conclusion is the opposite of what Feingold argues.What this means is that in the theory of monopolistic markets, setting the price of a good to include some amount of fixed costs leads us to set a price where the MR=AC, which is completely within the scope of MET. Finally, recall that Section I contained a short review of various approaches to fixed cost allocation by the FERC that illustrated the role policy objectives have played in their various solutions to allocating fixed cost between a fixed versus a variable charge. F. When no cross-subsidy exists, the rates are just and reasonable We have previously seen that “just and reasonable rates” is an important consideration in rate design and rate setting. In Section I, it was noted that in Oregon determining what rate design and set of rates are just and reasonable 18
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR rests almost exclusively with the Commission. We also saw that the FERC allows rates to be discriminatory as long as they are not unduly discriminatory. It was also noted that the load shape of different customers that face the same tariff is a critical factor when assessing how a set of proposed rates actually affects those customers. Further, Feingold implicitly argues that rates should be considered just and reasonable when costs have been assigned to the product and group causing those costs. When this standard is met, it also means that there is no cross-subsidy. Let us consider two competing rate designs in light of the important standard of just and reasonable. The two alternatives are crafted to highlight the inherent subjectivity of the just and reasonable standard. For simplicity, assume there are the following two competing rate designs,31 Rate Design One: 100 percent of allowable fixed costs are recovered using the customer charge. Rate Design Two: 50 percent of the allowable fixed costs is recovered using the customer charge. The remaining 50 percent of allowable fixed costs are added to all allowable variable costs and recovered using the variable (commodity) charge. Also assume there are two customer groups, A and B. Group A owns a 1,000 sq. ft. house, and Group B owns a 3,000 sq. ft. house. We do not need to know the level of the fixed and variable prices to make several inferences about their impact on existing customers from these two competing rate designs. When 19
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR Rate Design One (RD1) is compared to Rate Design Two (RD2), RD1 (a) implicitly subsidizes the gas use of customer group B with the 3,000 sq. ft. houseat the expense of customer group A with the 1,000 sq. ft. house;32 (b) encourages greater gas usage; (c) reduces the incentive for Energy Efficiency,33 and (d) reduces the utility‟s near term revenue recovery risk. Even ifthere is agreement about cost allocation, a reasonable observer may argue that RD1 discriminates against Group A since it subsidizes the usage of gas for space heating by Group B. Conversely, Group B might argue that RD1 is unfair since it penalizes them relative to RD2 simply because they can afford to purchase a larger home.34 Fairness here goes beyond any debate about whether the resulting rates are or are not subsidy free. They may be subsidy free and still be argued to be unfair. Customer group A is more likely to be represented by a consumer advocacy group that may also argue that RD1 is discriminatory because it results in an equivalent fixed charge to each residential customer even though they have very different degrees of ability to pay. It will also likely be argued that since RD1 encourages greater consumption, future fixed cost will likely be higher than would be the case under RD2 due to that higher usage, and Group A should not be penalized by Group B‟s choices. If it can be shown that Group B‟s usage led to higher costs on a per unit basis, Group A would likely also argue they are also being penalized due to the profligate behavior of Group B. While these arguments are potentially endless, they point to likely arguments claiming undue discrimination that go beyond debates about whether 20
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR or not a set of prices are subsidy free. Ultimately, these debates are often resolved either in a settlement acceptable to most or all parties to the rate case, or by the Commission in the absence of such a settlement. Arguments about the inherent fairness of one of these two rate designs, i.e., the absence of undue discrimination, are positional, not factual. Regarding the fuel choice decision (either in new construction or in existing construction where a furnace replacement is contemplated), as the fixed charge fraction of the average monthly bill increases, the incentive to stay with gas heating or install gas furnace in new construction will decline, assuming all else remains constant. These are several reasons why the rate design should be a matter of business and public policy. As we have seen, for a given level of costs to be recovered in rates, varying the rate design will affect customers differently and will send differing signals to the market. Oregon PUC Staff initial testimony sponsored by Dr. George Compton (Staff) directly addresses the issue of fairness.Staff does note that when cost causation remains murky, the method to use that retains fairness requires assigning those costs to the different products and customer classes based on benefits received.35 This method too represents a judgment that society prefers this assignment rather than other possible assignments. While such a rule may at first blush appear objective, it is not. There is nothing about such a rule that is inherently more or less fair than a competing rule that assigns costs proportional to customer‟s ability to pay. One example of 21
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR such an assignment might be a lifeline residential utility rate usingcustomer income data to qualify for such a rate. IV. Conclusions Considering the significance of the issues raised herein, the analysis contained in this article, and its conclusions should be relevant to other regulated utilities, commissions, and interveners in states other than Oregon. Further, this paper also illustrates the complexity involved in addressing proposals to alter the existing rate regulation. No doubt, some will point to this complexity as prima facia evidence for the need for reform. That is in the eye of the beholder. It is my hope that expositions such as are contained in this paper will at least help elevate those discussions. Finally, there are a number of arguments made in NWN‟s initial testimony that are called into question in this paper. A series of specific conclusions follow. 1. Even though this paper examined a narrow set of specific issues that affect debates on a rate proposal, it will hopefully help illuminate the complex issues involved with proposals to alter retail rate regulation. Advocates of retail de-regulation should familiarize themselves with these types of basics of existing regulation in order to better argue their proposals. 2. Policy choices, such as, how fixed costs are recovered, should be explicitly identified as policy choices rather than attempting to frame them as analytical issues that have a technical solution. Identifying them as policy choices should be accompanied by explicit analysis that illustrates the ramifications of each policy alternative. 22
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR 3. If a rate proposal is submitted that requests recovering fixed cost in a fixed charge, that proposal should be analyzed in comparison to other possible approaches to recovering fixed costs. Additionally, adjusting the utility‟s allowed rate of return to reflect differing amounts of revenue recovery risk should be part of that evaluation. 4. Fairness is a moral issue not an analytic issue. As such, it is important to address such issues as who decides what rates are fair and identify what rule(s) is (are) used to make this determination. 5. Reducing the commodity charge and increasing the customer charge does not result in greater conservation incentives.36Economic theory supports a charge that reflects the costs that arise at the point in time when the decision has to be made. If a city is considering charging for parking, economic theory supports charging per use rather than offering a monthly pass. Offering a monthly pass (a fixed payment) encourages greater use of parking than will be the case with a fee paid per visit for a specified length of time, all else held constant. 6. Themarginal costs (MC)in a LRIC Study may be forward looking, though they need not be forward looking. They may also be based on historical datafrom existing production and delivery technologies. This allows incremental costs may be determined even when there is no expansion in deliveries. Identifying a MC in the absence of sales growth is one important factor in signaling the costs of such growth to the market prior to its occurrence. 23
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR 7. Allocating common costs is more art than science. No objective criteria exist to use to reach an unimpeachable allocation of common costs between one or more customers, or customer groups, and/or products. 8. The stand alone cost test cannot be relied on to identify cross subsidies. Further, assuming that all parties were to agree that no cross subsidy exists, rate case parties can be expected to have differing positions about rate fairness. 9. Including replacement costs in LRIC study is important since those costs are incurred to sustain service quality. 24
 NORTHWEST NATURAL GAS COMPANY NW NATURAL‟SApplication for a General Rate Revision, December 11, 2011. 2 Oregon Public Utility Commission,, 3 What follows is based largely on “GEARHART v. PUBLIC UTILITY COMMISSION OF OREGON,” Frank GEARHART; Patricia Morgan; Kafoury Brothers, Inc.; and Utility Reform Project, Petitioners, v. PUBLIC UTILITY COMMISSION OF OREGON and Portland General Electric Company, Respondents. 08487; 09093; A140317. Argued and submitted Feb. 03, 2012. -- February 06, 2013. See: 4 Ibid, at 85. 5 Ibid. 6 Ibid., at 94. 7 This ruling by the Oregon Supreme Court appears to follow the same ruling previously made by the U.S. Supreme Court in a 1944 case, FPC versus Hope Natural Gas Company. See: Deloitte Center for Energy Solutions, “Regulated utilities manual A service for regulated utilities,” February, 2004, p. 7. 8 A concise summary of the various approaches and rationales appears in the previously noted FERC Cost-of-Service Manual, pp. 30-33. 9 Ibid, p. 29. 10 The term „regulatory body‟ is meant to be inclusive. It applies to state utility commissions with jurisdiction over investor-owned utilities (IOUs) as well as regulation of consumer-owned utilities (COUs) by their customers, or board of directors, or city councils, and so forth. While there are some differences in some details of determining the amount of cost to be used to develop the rates, the alternatives discussed in this article also apply to COUs. 11 If the industry was competitive, price would be even lower and output even higher, but that isn‟t relevant to the case of the retail electric or gas utility. 12 Within economic theory, one must turn to a specialized body of research and writing called Welfare Theory to find a significant body of work that addresses the issue of fairness from a broader, societal, perspective. Outside the narrow confines of economic theory, writings on issues of fairness abound. Judging fairness involves making a moral judgment. Determining that one or another set of rules or set of outcomes is or is not fair requires that I make a moral judgment. For example, some citizens find the growing income and wealth disparity in the U.S. morally fair while other find it morally repugnant. While economists have involved themselves in assessing economic impacts of such disparity, and have been involved in research on social and political as well as economic aspects of income and wealth disparity, reaching any conclusion about fairness, equity, requires making a moral judgment. This is equally true for rate setting in regulated industries. 13 The existing power lines and gas transmission lines are typically examples of short run fixed cost (SRFC) and the cost to replace a power pole damaged in an auto accident, for example, can be treated as a short run variable cost (SRVC). 25
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR 14 Ideally, we would estimate FC by the difference between SRTC and SRVC at the optimal level of output. Using the formula specified in a reasonable approximation when variable costs are not provided. 15 Why this is important will become clear later in this paper. 16 It is also not a sufficient condition because it may be possible to meet that growth with the existing fixed inputs and therefore no incremental cost arises from that growth. However, if existing resources are inadequate to meet load growth, and new investments are required whose life extends beyond the proposed rate period (for example), those new investments should be included in long-run total cost. 17 In this case, the LRTC for the business will be the sum of all LRTC schedules for each combination of product and customer group. 18 Note that investments due to wear and tear are made to avoid a decrement in Qi. Therefore, in this case, d[Qi]<0. 19 Exhibit 1100 – Direct Testimony – Long-Run Incremental Cost Study / Rate Design, Direct Testimony of Russell Feingold, NWN/100. 20 Ibid, pp. 5 - 6. 21 Ibid, pg. 6. 22 Russell Pittman ,”Against the Stand-Alone-Cost Test in U.S. 
 Freight Rail Regulation,” EAG 10-1 CA April 2010. 23 David Heald, “Contrasting Approaches to the „Problem‟ of Cross subsidy,” Management Accounting Research, 1996, pp. 53-72. 24 Ibid, p. 58. 25 Ibid, p. 69. 26 Mark A. Jamison, “Theory and Application of Subsidy-Free Prices,” fromIndustry Structure and Pricing: The New Rivalry in Infrastructure, Kluwer Academic Publishers, 1999, p. 140. 27 Ibid. 28 Eric Ralph, “Cross-subsidy: A Novice‟s Guide to the Arcane,” Duke University, July 27, 1992, p. 15. 29 Gerald R. Faulhaber, “Cross-Subsidy Analysis With More Than Two Services,” The Journal of Competition Law &Economics, August, 11, 2002, p. 442. 30 From the standpoint of cost recovery risk, cost recovery risk is reduced using the method proposed by Feingold. However, that argument does not appear in his direct testimony. 31 Several other simplifying assumptions are: The utility servers only one state and has no unregulated entities; Agreement has been reached about how both allowable fixed and variable costs have be allocated between the two customer groups; There are only two products, the capability to deliver gas represented by the billing factor used for the fixed charge, and the delivery of gas represented by the billing factor for the variable charge; Group A has a peakier load factor than Group B; All gas delivers are to homes; Residences are grouped into two groups with an average residence size of either 1,000 sq. ft. (Group A) or 3,000 sq. ft. (Group B); All residences are built to the same energy code specifications and are alike in every other respect that affects gas consumed for space heating; and, gas is only used for space heating. 32 The term „subsidizes‟ is used to denote one argument that rate case parties will argue that goes beyond the more rarified debate about subsidy free pricing presented earlier. 33 „Conservation‟ and „Energy Efficiency‟ are two different factors that affect consumption. 26
  • DRAFT 3 (12-3-13): NOT FOR ATTRIBUTION WITHOUT PRIOR WRITTEN CONSENT OF THE AUTHOR 34 The point of this exercise was to provide a simple example of how the assignment of fixed cost between a fixed versus a commodity charge will likely have differential impacts on different customers within a given customer group and/or between customer groups. 35 Staff testimony Compton/15-Compton/16. 36 See: Feingold, pp. 63-64. 27