Managing for Profitable Growth in the Face of Rate Resistance

It is a challenging time for consumers and utilities alike. Energy prices continue to escalate and heightened public awareness has led to rate resistance from utility regulators and customers. At issue also is the fact that many markets and service territories have been under rate freezes and rate caps for an extended period of time. However, in many states these measures have recently expired or soon will, presenting additional concerns for regulators and consumers as they anticipate the possibility of higher electricity bills.

Utilities, too, are facing similar challenges as the cost of doing business continues to rise. Companies must meet customers’ supply needs in a cost-effective and efficient manner while managing incremental pressures, including rising capital costs, inflation, environmental and other non-production cost increases and rising fuel costs, among others.

According to a September 2007 study prepared for the Edison Foundation, utility construction costs jumped significantly between 2003 and 2006, including a 60 percent increase in iron ore and a 150 percent increase in scrap steel. Fuel costs have also risen. Based on the Energy Information Administration’s average commodity reports, the estimated average wellhead price of natural gas has risen from $5.45 per MMBtu in September 2007 to $7.34 per MMBtu in February 2008. The average weekly coal commodity spot price in the Central Appalachian region has risen from the low $40s per short ton a year ago to more than $84 in March 2008.

The reality of rate relief

The crossroads between customers and costs intersect at a general rate case filing. With the expiration of freezes and caps have come filings from various utility companies.

In a recent case proposed by Tucson Electric Power to the Arizona Corporation Commission, the company filed for rate adjustments from one of three potential formats: traditional “cost-of-service” (23 percent increase); market-based (22 percent); or a combination of the two with some power sold on the open market (15 percent). The company sought to recover cost increases incurred during a 10-year rate freeze, which is set to expire at the end of this year.

After testimony from consultants and commission staff, a proposal to the ACC recommended an estimated decrease of 2 percent to 3 percent from current rates. Yet as TEP expects to invest nearly $1.4 billion in capital improvements in the next five years, president and CEO James S. Pignatelli disagreed with the recommendation, stating in a company news release, “the rates proposed would not provide the increases we need to cover our rising costs and serve our customers’ growing energy needs.”

Grassroots campaigns by consumer groups have gained momentum against rate increases, as well. According to recent media coverage, AARP has formally intervened in Illinois Commerce Commission proceedings to oppose a potential rate increase in Illinois by Ameren, an electricity provider in the state. The group claims the company will raise prices for Illinois electricity and natural gas consumers by nearly $250 million. With a strong membership in Illinois and across the country, AARP can quickly and efficiently disseminate information to consumers and help shape the debate.

With potential opposition from regulators and consumers, how can a utility best manage for profitable growth in the midst of a rate resistance era? Companies that focus on efficient strategic planning and consistent communication will have greater success recovering costs.

“- Go back to the future

A utility likely has gained experience filing rate cases in the past. Periodic evaluation of electricity rates helps both the PUC and the industry come to an agreement on appropriate pricing for the market. Anticipating another price assessment should include identifying and engaging key company leaders involved in past rate cases, effective processes, lessons learned and other useful institutional knowledge. Experience and institutional knowledge can enhance a company’s efficiency and approach when entering a new rate case. By improving upon lessons learned from previous filings, a utility can approach the proposed rate increase in a strategic and efficient manner.

“- Don’t wait for the general rate case

Communication, particularly with regulators, is an important element of successful operations, including rate filings. Strong relationships with regulators can ultimately lead to smoother rate cases with fewer regulatory risks. These relationships with regulators should be built both in an open market and during a rate freeze. By laying the groundwork throughout a rate freeze, the utility and the PUC have an established understanding when it expires. Companies should keep regulators informed of the necessary assets for added capacity, growing demand from customers and increasing environmental and other expenditures and investments.

Consumers are an equally important group to keep informed. A steady flow of communication will help consumers understand the complexities of supply and what is required to meet their community’s electricity demands in an efficient and environmentally sound manner.

“- Pursue other cost recovery avenues

Not all cost recovery is through base rates. Most jurisdictions have cost recovery clauses that allow for annual adjustments to recover specific costs, such as fuel cost recovery clauses, environmental cost recovery clauses, and pre-approved capital programs with annual inclusion of construction work in process into rates. Actively pursuing approval for specific cost recovery clauses has many benefits. These can include performance standards that are more clearly defined and demonstrated, thus reducing the likelihood of disallowance, and cost increases in more palatable annual increments rather than the larger increases when general rate cases are three or more years apart. In TEP’s case, ACC’s consultant recommended a rate reduction of nearly 10 percent, but a proposed purchased power and fuel adjustment clause is estimated to bring the rate back up to within 2 percent to 3 percent of current rates.

Another area to pursue is decoupling–the separation of earnings from kilowatt hour sales. Decoupling can provide incentives for energy efficiency and conservation by ensuring that utilities earn expected earnings even as energy efficiency reduces sales.

“- Plan ahead

An impending rate case will probably not be the last for a utility. Continue the process of reflecting and building on rate relief experience and communicating with regulators and consumers for better mutual understanding. Develop a rate plan with multi-year rate phase-ins. It would be prudent to build into strategic plans the ability to demonstrate and document the necessary costs to provide reliable power to customers.

Ultimately, establishing and cultivating both experience and relationships will serve a utility well in this process. A strategic approach will improve a company’s ability to communicate its past, present and future needs and, in turn, allow for profitable growth for shareholders and reliable service to customers.

Author

Ken Novak is a senior manager with Ernst & Young’s power and utilities practice. You can contact him at kenneth.novak@ey.com. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.

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