“TEEING OFF” OUR DISCUSSION ON RETHINKING NATURAL GAS UTILITY

RATE DESIGN

The National Regulatory Research Institute

Ken CostelloSenior Institute Economist

AGF/NARUC sponsored Executive Forum at Ohio State

University

Columbus, Ohio

May 23, 2006

May 23, 2006

Three Key Features of the Forum

• “Rethinking”

• “Rate Design”

• “Natural Gas”

May 23, 2006

The Meaning of Rate Design

• The third and last stage of ratemaking• Involves determining how a utility will

recover its revenues in line with (1) a pre-determined revenue requirement and (2) cost allocation to different classes of customers and services

• Specifies how utility services are priced• Four examples – SFV, declining block rate

structure, inverted rates, seasonal rates

May 23, 2006

Why Rate Design Is Important

• Helps to achieve important regulatory/social objectives, which prominently include the financial viability of utilities and the efficient use of natural gas

• Rate design is imperative for promoting economic efficiency (for example, in providing correct incentives for consumer behavior) – As many economists would say, if you price a

commodity or service solely on the basis of marginal-cost principles, many of the problems would go away; but few others, including regulators, would agree

May 23, 2006

Why Rate Design Is Important -- continued

• Serious consequences from poor rate design – major ones include– “Wasteful” consumption– Excessive/deficient utility earnings– Uneconomic bypass– Inequity– Undue price discrimination

May 23, 2006

Why Rate Design Is Important -- continued

• This is recognized by both utilities and regulators, although they may disagree not only over – What is good and bad rate design, but

also – The gravity of adverse outcomes

May 23, 2006

Two-Part Tariffs: The Foundation for Rate Design

• Basic Structure: TBi = F + pqi,

– Where the total bill for customer i (TBi) equals the sum of the customer charge (F) and the volumetric charge (p) times the amount of gas consumed (qi)

– Non-linear in the sense that average expenditure per unit consumed (TBi/qi) falls as qi increases

– Can do much better from an efficiency perspective with two-part tariffs than with second-best Ramsey linear pricing

May 23, 2006

Two-Part Tariffs -- continued

• Basic Structure: TBi = F + pqi -- continued

– Ideally, from an economic-efficiency perspective

• At the margin customers would pay a usage price equal to marginal cost, with the difference between revenues generated from usage charges and the utility’s total costs covered with a fixed fee (e.g., customer charge) that acts as a lump sum tax

– As long as the fixed fee is less than consumer surplus net of usage expenditures, consumers will pay the fixed fee and consume at the efficient level

May 23, 2006

Two-Part Tariffs -- continued

• Basic Structure: TBi = F + pqi – continued

– Non-linear pricing has been used in the pricing of electricity, gas and telephone service since early in the 20th century

– Early proponents of non-linear pricing such as Samuel Insull saw this pricing method as a way to expand demand and lower average costs while meeting a break-even constraint

– In advancing various social objectives, this rate design has evolved over time to where typically a gas utility recovers much of its fixed costs in the volumetric charge

Examples of Rate Designs: Conflicts in Objectives

Flat Rate per period, no usage charge

Uniform: Flat Rate per unit

Declining Block Inverted Block

$

Q

$

Q

$

Q

$

Q

Examples of Rate Designs -- continued

Seasonal or Time of Use

$

Period1

Period2

Q

May 23, 2006

Regulatory Objectives and the Role of Rate Design

• Changing major regulatory objectives -- priorities change over time, as well as the specification of objectives

• Rate design from different perspectives – a conflict among stakeholders

• Tasks for regulators– Listing and prioritizing of rate-design principles– Integrating rate-design principles with

regulatory objectives

May 23, 2006

Rate-Design Objectives: The Usual List

• Public acceptability • Equitable

• Revenue sufficiency • Efficient competition

• Rate stability • Promotion of specified social goals

• Efficient consumption • Avoidance of undue discrimination

May 23, 2006

Why This Forum and the Recent Interest in Natural Gas Utility Rate

Design?

HIGH GAS PRICES, HIGH GAS PRICES, HIGH GAS PRICES

ALONG WITH VOLATILE GAS PRICES!

Consequences of High Gas Prices• Fewer customers able to afford natural gas for home use

• Bad-debt expenses increase

• Energy conservation becomes more important

• Increased risks to both utilities and consumers

• Fuel-switching becomes more imminent

• Greater emphasis on hedging

• Elasticity effect becomes more pronounced in terms of reducing gas consumption

• Overall, the industry becomes less stable with outcomes (e.g., consumption and consumer gas bills, utility earnings) more volatile and uncertain

Recent Rate Design Proposals and Issues

• Increases in the level of monthly service or customer charge

• Low-income rate structures

• Block rate adjustments (declining, flattening, inverted)

• Weather normalization adjustment mechanisms

• System benefits charges (DSM programs, low-income assistance)

• Budget billing programs

• Unbundled or ancillary-service rates

• Revenue decoupling (e.g., “conservation tariffs”)

May 23, 2006

Why This Forum? -- continued

• This forum is timely – A dialogue on rate design issues is critical to

reach consensus and for utilities, regulators and other stakeholders to become better informed

• Delaying the implementation of new rate designs can inflict a high cost on society – Prevailing rate designs may result in

undesirable outcomes from a public-interest perspective (e.g., outcomes inconsistent with regulatory or public policy objectives)

May 23, 2006

Things to Keep in Mind

• Over time, rate design in the utility sector has evolved to accommodate market, technological and regulatory/governmental changes – We have seen this in not only in the public utility

industries but in other industries as well

• Historically, regulators have responded to changed conditions by entertaining and accepting new rate designs when compatible with prevailing objectives

May 23, 2006

Things to Keep in Mind -- continued

• Conditions in the natural gas industry have changed significantly over the past several years, warranting a review of prevailing rate designs

• Specifically, these changed conditions have shifted priorities of regulatory objectives

• To repeat from earlier, the status quo in rate design may carry high costs for utilities, consumers and society as a whole

May 23, 2006

Things to Keep in Mind -- continued

• Regulation has many objectives, with some conflicting, and priorities (ranking of objectives) changing over time

• Rate design in practice reflects a compromise of the multiple objectives such as economic efficiency and equity – The “balancing act” of regulation or “sausage

making” in applying both basic principles and judgment

May 23, 2006

Things to Keep in Mind -- continued

• We should assume that regulatory objectives differ from utilities’ objectives– Both in terms of what gets on the list and where

on the list each objective ranks (e.g., utility financial viability, promotion of energy efficiency, risk allocation to consumers and the utility)

– If this were not so, regulation would have no reason to exist, as the “invisible hand” of the marketplace would guide a utility’s actions toward the public good

May 23, 2006

Things to Keep in Mind -- continued

• The reasons for regulators reluctant to change rate design– Inertia– Uncertainty over the outcome

– Disinformation/deficient information • Changed rate design should accommodate

the new realities and conditions in the natural gas industry