2010 NASUCA Mid-Year Meeting

1. San Francisco, CA  Fisherman's Wharf 2010 NASUCA Mid-Year Meeting Panel: Gas Distribution Company Rate Design: What Is In the Customer's Best Interest: Straight-Fixed Variable, Inclining Blocks, Decoupling Presented by: Lee Smith Senior Economist and Managing Consultant NASUCA 2010 Mid-Year Conference Presented to: June 13 - 15, 2010

2. RATEMAKING PRINCIPLES • Generally accepted major 5 principles • Equity or Fairness • Efficiency in price signals • Utility Earnings Stability • Simplicity • Rate Continuity

3. WHY ACTUAL RATEMAKING REACHES DIFFERENT RESULTS IN DIFFERENT CASES • Tradeoffs between principles • Different fundamental conditions between states and utilities • Different interpretations of the principles • Political differences

4. Different fundamental conditions exist between states and utilities • There are significant differences in the gas utility framework between states and even within states, which will affect application of the same principles • Age of Gas Plant • Rate of growth of gas use • Cost of Gas Supply, and ratio of gas supply costs to total customer gas bill • Degree of weather sensitivity • Relationship between residential and C&I (particularly process) load • Energy substitutes for gas, esp. for heating use

5. Impact of different fundamental conditions on ratemaking • The faster the utility is growing the higher is marginal cost • Higher ratio of gas supply costs to total customer bill makes delivery rate less important; also affects decisions regarding hedging policy • Higher degree of weather sensitivity creates more concerns with rate impacts (continuity),also with earnings stability – again will affect hedging policy • Higher proportion of residential load makes average gas cost higher • Whether major substitute for gas is regulated fuel or unregulated (oil) should be considered (more later) • The older the gas system, the more replacement compared to new capacity being built

6. Today’s Major Topic – Inclining blocks rates or not • Depends on interpretation of “efficient price signal” • Depends on interpretation of fairness

7. What makes an Efficient Price Signal – Two Views • View 1 - Customers can make efficient decisions when then are informed of the cost consequences of their decisions – leads to pricing incremental use at marginal cost • View 2 – Gas rates should include inclining blocks whatever the marginal cost • Because marginal costs don’t reflect full societal costs; and/or • Because customers may use less because the inclining block tells them that using less is important

8. Some Qualifiers to Marginal Cost Pricing • Customers can make efficient decisions when then are informed of the cost consequences of their decisions • This theory suggests that customer charge is not a very useful price signal for customers who are already on the system; what matters is the tailblock • Tailblock usage level should be set to capture most discretionary use • There is some thought that most customers do not actually make usage decisions on this basis (economic theory vs. reality • Marginal cost analysis often based on black box approach, not always well scrutinized or understood

9. How Have Some Regulators Moved from View 1 to View 2? • Marginal costs don’t reflect full societal costs; and/or • Customers may use less because the inclining block tells them that using less is important • Massachusetts DPU 08-35 • “the design of distribution rates should be aligned with important state, regional and national goals…” • “and…lower customers’ bills through increased end-use efficiency” • Customers have incentive to be cost effective when rates based on marginal costs • Some customers cannot increase end-use efficiency – the early adopters are stuck

10. Impacts of Ratemaking Based on View 2 • Higher tailblock delivery charges result in less earning stability to utility • If rates are decoupled, the lower earnings stability means that decoupling adjustments will be more frequent and larger • If gas rates don’t signal the supply cost of gas, the actual impact of delivery charges on usage may be small • If tailblock rates are higher than marginal cost, customers will not be incented to make efficient decisions • There will be incentive to switch to other energy sources – particularly a problem if the alternative is oil • Customers may choose lower comfort levels even though the value they place on comfort is higher than the cost of gas

11. Question of the Day – Fixed Variable vs. Inclining Block • Let’s consider three basic questions from the customer perspective: • Is the customer charged fairly • Can the customer control his/her bill • Does the rate let the customer make efficient choices

12. One Extreme – Distribution costs all collected through customer charge; variable collects gas costs • The distribution costs of serving all customers within a rate class are not identical – smaller older customers will be charged more than the cost of serving them • There is a large portion of the bill which the customer cannot control • The rate does not inform the customer of full marginal cost to make efficient choices

13. Other Extreme – Low customer charge; two energy blocks with tailblock above marginal costs • Smaller older customers will be not be overcharged; larger customers may pay more • The customer can control his/her annual bill (although if there is also decoupling there will be annual variability out of control • Rate incents customer to reduce use beyond economically efficient reduction • Rate incents some customers to switch to alternative energy source

14. Setting Rates – a Non Conclusion • The choice is not easy • Your choice will be affected by your regulatory environment • Your choice should be an informed one

15. End of Presentation    Thanks! Lee Smith La Capra Associates One Washington Mall, 9th Floor Boston, MA 02108 617-778-5515, ext. 117 lsmith@lacapra.com Contact Information: