On May 22, 2016, the Public Utility Commission of Texas (“PUCT”) released a report outlining alternative ratemaking mechanisms used in other states to set electric utility rates. The report, prepared by Christensen Associates Energy Consulting, was requested in response to Senate Bill No. 774 of the 84th Legislature, Regular Session in 2015, which requires the PUCT to analyze ratemaking mechanisms adopted by other states that serve as alternatives to traditional cost-of-service ratemaking and to provide a report to the legislature detailing the findings by January 15, 2017. A current rate adjustment mechanism that permits timely recovery of distribution infrastructure costs—the distribution cost recovery factor or DCRF—is scheduled to expire on September 1, 2019. Before the expiration, the Texas legislature plans to explore the various types of ratemaking mechanisms that could be used to ensure timely cost recovery while maintaining incentives to achieve other ratemaking goals.
While the report was prepared for the purpose of informing electric utility ratemaking policy in Texas, it contains information about the structure and comparative advantages and disadvantages of alternative ratemaking mechanisms that may be useful in any number of state or federal venues and may be applicable to gas and other utilities as well.
The Christensen report begins by reviewing a number of factors that have raised interest over the years (in Texas and elsewhere) in alternative ratemaking mechanisms. These factors include: (1) the desire to improve performance incentives among utilities, (2) the deregulation of wholesale electricity markets, (3) public policy support for renewable energy, (4) technological progress, and (5) the declining rates of electricity sales growth.
Next, the report examines a variety of ratemaking policy goals, some of which are compatible with each other, and some of which are mutually exclusive, that could drive alternative ratemaking proposals. The goals examined include the reduction of procedural costs, the establishment of reasonable procedural timetables, decoupling cost recovery from variations in electric load, assuring cost recovery, assuring the prudency of costs, assuring reasonable rates of return on equity (“ROE”), assuring service quality, promoting energy conservation, and maintaining rate stability.
At its core, the report evaluates six broad revisions to traditional cost-of-service ratemaking and five small incremental revisions to cost-of-service ratemaking.
The report focuses extensively on six broad alternatives to traditional cost-of-service ratemaking.
- Formula Rate Plans: The formula rate plan mechanism operates using pre-defined formulas to adjust rates automatically to keep the utility’s actual ROE within a specified band near the authorized ROE. Benefits of the formula rate plan mechanism include the reduction of both the frequency and cost of rate cases, the ability of customers to gain an early share of cost efficiencies that a utility may acquire between rate cases, and the reduction of a utility’s financial risk by assuring a reasonable ROE.
- Straight Fixed-Variable Rates (“SFV Rates”): SFV Rates allow the utility to recoup nearly all fixed costs through fixed monthly charges (per customer-month) or peak demand charges (per peak kW) that are independent of the volume of electricity consumed. Benefits of SFV Rates include improving utility recovery of fixed costs, mitigating the need to adjust rates in response to load changes, and removing disincentives for utility promotion of energy efficiency. The report identifies the SFV Rates mechanism as one of the principal mechanisms for achieving the goal of decoupling cost recovery from load variations.
- Revenue Decoupling: Revenue decoupling adjusts energy prices to compensate for differences between actual revenues per customer and test-year revenues per customer. Revenue decoupling accomplishes two main goals. First, decoupling encourages energy efficiency by consumers by maintaining an energy-sensitive charge and removes disincentives to utility promotion of energy efficiency. Second, decoupling protects utility recovery of fixed costs from changes in customer sales. Additionally, the report recognizes revenue decoupling as one of the mechanisms that could potentially decouple cost recovery from load variations.
- Lost Revenue Adjustment Mechanisms (“LRAMs”): LRAMs adjust utility rates between rate cases to address the impacts that conservation has on utility sales that were not considered during the general rate case forecast. LRAMs, like other mechanisms, remove utility disincentives for promoting energy efficiency. In addition, LRAMs reduce the need for frequent rate cases. LRAMs are also identified as a mechanism that could help decouple cost recovery from load variations.
- Multi-Year Rate Plans: Multi-year rate plans work by holding full rate cases every three to five years and having automatic rate adjustments in between cases that focus on external factors such as changes in a utility’s business environment. The advantage of multi-year rate plans is that they incentivize utilities to cut costs and improve performance, while also providing more predictable utility revenues and customer rates.
- Price Cap Plans: Price cap plans are designed to encourage utilities to reduce costs by tying price increases to some measure of inflation while also accounting for some measure of productivity improvement in the power industry. The main benefit of price cap plans is that they provide a large incentive for utilities to seek production efficiency.
In addition to the broad alternatives, the report evaluates five smaller, incremental changes to cost-of-service ratemaking.
- Future Test Years: Under a future test year mechanism, the data used in general rate cases would come from the first twelve-month period during which new rates would apply. The principal benefit of using future test years is that the data will be appropriate for the time period to which it will apply.
- Earnings Sharing Mechanisms: Earnings sharing mechanisms allow for rate adjustments outside of the general rate case when the utility’s actual ROE falls outside of a pre-determined band. Earnings sharing mechanisms provide lower procedural costs for assuring that utilities’ actual ROEs do not drastically differ from authorized ROEs, thereby helping to assure reasonable ROEs.
- Cost Trackers: Cost trackers use a formula or predefined rule to allow utilities to recover specific costs outside of general rate cases. The main advantage of cost trackers is that they provide a timely recovery of costs, which reduces utilities’ financial risk, while not creating any incentives to reduce performance.
- Infrastructure Surcharges: Infrastructure surcharges allow utilities to recover a portion of their capital costs before the completion of a facility’s construction. The infrastructure surcharges help mitigate future rate shock and avoid delays in capital cost recovery.
- Performance Incentive Regulation: Performance incentive regulation offers financial incentives to utilities—such as adjustments to ROE—to improve service quality and performance.
As we read the report, it suggests a preference for SFV Rates as a broad-based revision to Texas’ rate setting mechanism. According to the authors of the report, SFV Rates have three main advantages. First, they provide “a close match between retail price components and the ways (i.e., fixed or variable) that costs are incurred.” As a result, “changes in sales lead to roughly equal changes in revenues and costs.” Second, the rates that are set need not change as load changes. Third, SFV Rates impose a low administrative burden. However, the report also points out that a major disadvantage of SFV Rates is that they require significant revisions to present rates, which may have an adverse impact on low-volume and low-income customers.
The PUCT has opened Project No. 46046 to consider the report and will convene an Open Meeting on August 10th, 2016 at 9:30 a.m. to discuss the report and receive general comments. The PUCT has solicited feedback on two specific questions: (1) is the report sufficiently comprehensive or are there ratemaking mechanisms not covered in the report that the PUCT should consider, and (2) in addition to the findings and recommendations contained in the report, what further recommendations, if any, should the PUCT make to the Texas legislature?
The PUCT report on Alternative Electricity Ratemaking Mechanisms Adopted by Other States can be found here.
Please contact one of the authors below or your Baker Botts relationship attorney with any questions. The authors wish to acknowledge the assistance of Baker Botts summer associate, Carlos Marquez, in preparing the above summary.