Practical Insights for Existing Utility Retail Pricing and Revising Retail Pricing

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

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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

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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

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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

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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.

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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

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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.

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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

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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

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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.

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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 ] |

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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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

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

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

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

OF THE AUTHOR
End Notes
1

UG 221  NORTHWEST NATURAL GAS COMPANY NW NATURAL‟SApplication for a
General Rate Revision, December 11, 2011.
2
Oregon Public Utility Commission, Oregon.gov,
http://www.puc.state.or.us/Pages/about_us.aspx
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:
http://www.publications.ojd.state.or.us/docs/A140317.pdf
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

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

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

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