Utilities can be prepared for complex rate cases
by Michael A. Laros
Prudence investigations became high-stakes proceedings for regulated electric utilities in the 1980s and 1990s. After the nuclear power plant construction boom in the early “70s, there was an increase in the quantity of rate proceedings intended to recover a utility”s investment in these new facilities. These rate cases were controversial–most of these projects suffered extensive schedule delays and cost overruns from their inception to final completion. Often there were significant disallowances of costs incurred for “imprudent” practices allegedly contributing to these cost increases. Consequently, it was not unusual for project participants to litigate amongst themselves in an attempt to reallocate both blame and economic loss following a regulatory disallowance.
Currently, there”s a pent-up demand for increased capital expenditures for new and cleaner generation and transmission and distribution infrastructure upgrades to improve the reliability and economics of the nation”s electrical system. By some estimates, over the next 15 years new capital expenditures will exceed today”s entire U.S. electric industry rate base, and much of this investment will be made by regulated utilities needing to seek approval for recovering costs through a formal rate proceeding. This factor alone will cause a dramatic increase in the number and complexity of rate cases administered by utilities and their regulators in order to determine the reasonableness of costs to be recovered in rates.
Unfortunately, most utility companies have avoided any significant rate-setting proceedings for many years, and consequently have lost the pool of resources familiar with the complexity of the rate case process. Many of today”s utility operational managers and executives have not participated in these complex prudence-related legal battles and are unfamiliar with the impact the outcomes can have on their company”s financial health. For those who realize the significance, and are reminded of this history and the potential for a resurgence of attention on the prudence of investments and operating expenses, one can almost hear a collective industry groan pleading, “Please, not us, not again!”
Rate recovery disallowances
According to a 2005 Lyon and Mayo study published in the Rand Journal of Economics, between 1981 and 1991 there were more than $19 billion of prudence-related rate recovery disallowances associated with three dozenplus new power plant construction projects. More than 95 percent of these disallowances related to nuclear power plant construction delays and cost overruns, but there were also sizeable disallowances associated with cost overruns on fossil and hydro power plants projects. Disallowances ranged in magnitude from under $1 million–Sunflower Electric Cooperative”s Holcomb 1 coal plant–to more than $2.1 billion disallowed at Nine Mile 2 Nuclear Plant. A 1986 Department of Energy review of 12 nuclear projects found that the average prudence disallowance for these plants was almost 16 percent of the cost of construction.
It is important to note that these disallowances relate only to construction costs found to have been imprudently incurred and do not account for significant amounts also not allowed to be included in rate base because all or some portion of a plant was not found to be “used and useable” by the respective regulators. For example, $443 million in costs associated with 945 megawatts of the Susquehanna 2 Plant were disallowed by the Pennsylvania Public Utility Commission as excess capacity even though the owner was found to have prudently managed the design and construction of the facility.
The question for utility executives, then and today, is whether these disallowances were the result of regulators opportunistically breaking the so-called regulatory contract with regulated utilities or the result of legitimate challenges to the reasonableness of the costs incurred. By analyzing the investment patterns of utilities that were the subject of disallowances as well as those that were not, the Lyon and Mayo study concluded that “the empirical results do not support that there was a violation of the regulatory contract … most utilities apparently saw the disallowances as indicative of bad management by the affected firms, and saw no reason to change their own investment practices.” My own contemporaneous observation from this period was that lax utility management practices at some projects were appropriately identified as the nexus to avoidable delays and/or cost overruns that resulted in significant regulatory disallowances.
In other words, some utilities did a better job of managing these complex projects than others.
What were some of the “unreasonable practices” that contributed to cost overruns?
Poorly structured contracts not matched to project needs and utility and/or contractor resource capabilities
Failure to effectively organize owner oversight or interfaces with contractor resources
Over-reliance on contracts and litigation to remedy problems after the fact rather than taking corrective action before problems got out of control
Inadequate financial planning and financial resources to match project needs
Lack of information to make informed decisions: inadequate cost, schedule, quality and/or regulatory compliance information
Poor and untimely resolution of engineering problems
Inability to end the project and for the owner to accept operational responsibility
A 1986 DOE review of 12 nuclear projects found that the average prudence disallowance for these plants was almost 16 percent of the cost of construction.
The Cambridge Energy Research Associates recently projected that more than $900 billion in new capital expenditures will be required over the next 15 years in the electric power industry to meet infrastructure, environmental and supply needs. Today”s utility regulators understand that new facilities will be needed to improve reliability and meet customer demand. However, utility managers must demonstrate that they have diligently considered alternatives and have taken steps to minimize rate impacts associated with capital expenditures associated with these facilities. Such oversight includes putting appropriate contracts in place and taking steps, on a timely basis, to assure that problems are addressed when they do occur.
In recent years, Engineering Procurement Construction (EPC) contracts have become the medium of choice for all types of large, complex construction projects. Today”s EPC contracts typically attempt to pass all or most design development and construction risks to the contractor. Some utilities may believe using EPC for the new wave of major capital expenditure projects will significantly help satisfy regulatory concerns about the potential for cost overruns or project delays.
EPC contracts are not new to the utility industry. Prior to the nuclear construction boom of the 1970s, a structured, though not universal, method of construction developed that is very similar to today”s EPC mindset. Back then, as now, most utilities considered themselves to be in the generation and distribution business and relied heavily on design firms and construction contractors to provide “turnkey” or ready-to-use facilities. The utility typically concerned itself only with overall specifications, site selection, capital acquisition and contractor selection. While some early nuclear projects were built using fixed-price contracts, this practice disappeared quickly once the magnitude of cost overruns incurred by vendors trying to enter the market became evident as having masked the true cost of nuclear plant construction.
Cancellation, renegotiation, and unavailability of firm-price contracts on large, complex projects effectively shifted the risk of construction back to the owner in the form of cost-plus contracts. Although owners assumed the risk of construction, they were still highly dependent on their contractors to provide the staff and systems necessary to monitor project progress. A factor that contributed to performance differences among utilities was that it took longer for some owners to recognize that even the best contractors did not have systems for coping with the magnitude of construction problems on these major projects or, perhaps more importantly, the motivation to actually solve problems given the cost-plus nature of the contracts in place.
In the regulated utility arena, while an owner can attempt to manage risk by delegating work to an outside supplier, the utility retains ultimate responsibility to the ratepayer for results. This does not mean that any cost increases or schedule delays are imprudent or that an owner will not have recourse if an EPC contractor fails to perform its job as expected. However, if an owner expects to recover costs in a regulatory proceeding, it must demonstrate that it has taken reasonable steps throughout the process to both avoid problems and to minimize the impacts of problems, once discovered. Hence, an additional complication for the utility in making and committing to a major project strategic sourcing decision is convincing the regulator that it has appropriately considered both the upfront aspects of managing risk as well as the need for and ability to take corrective action for problems arising over the life of the project.
What are some of the steps utility managers should consider in order to gain the confidence of their regulators that they have instituted appropriate measures to minimize risks and costs to protect ratepayers?
Plan Demonstrate that the utility has considered an appropriate range of project contractual options given the legal and regulatory environments and project realities. Show that it has evaluated how this project differs from previous projects and that it has organized resources and developed policies and procedures to clearly define responsibilities and accountability.
Prioritize Identify risk exposure areas, develop contingency plans for problems and maintain flexibility to adapt to changing project conditions.
Manage Develop a framework for effective project management using resources, tools and reporting requirements, including timely corrective action when required.
Collaborate Involve regulators and key stakeholders early in the process and where possible, obtain pre-approval or certification from regulators regarding the project. Crucial aspects: demonstrate the need for the project, how the alternative chosen matches the need, and that mechanisms are in place to monitor project conditions and take corrective action as issues arise.
Document Recognize the need to document decisions and supporting rationale for actions throughout the planning and project process. This demonstrates that the utility acted reasonably in preparing for and executing a major project. An integral part of the execution plan is putting in place an effective “prudence assurance” framework to advise project participants of the type of documentation required and the mechanisms for documenting the complete project history.
Major construction projects have always presented significant challenges to utility managers and their regulators. The exponential growth in new capital expenditures projected over the next 15 years is going to challenge the capabilities of utility managers to source and secure contracts for project design and construction and for the commodities required during construction.
There will also be an increase in the frequency and complexity of rate cases required to recover the costs of these new investments. Utilities must expand their concept of strategic sourcing for these major project investments to encompass not only resource selection and appropriate contractual agreements for facility design and construction, but also for tying together their needs and regulators” needs to assure that the project will be managed effectively throughout its execution. Inherent to the strategic sourcing process is the continuous and meticulous documentation required to make an affirmative showing at the rate recovery proceeding that the expenses incurred were reasonable and necessary.
Utility managers must remember that history does not have to repeat itself with regard to the disastrous rate-case environment of the 1980s” but it will, unless they take steps to prevent it.
Michael Laros is a managing director with Huron Consulting Group and leads Huron”s utility consulting practice. He may be reached at mlaros@huroncons ultinggroup.com.