NRRI 16-08 Multiyear Rate Plans

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Create DateOctober 24, 2016

Regulatory experts generally agree that ratemaking should strive to achieve high economic efficiency by utilities, fairness, and reasonable regulatory costs. These three outcomes have characterized good ratemaking going back to the beginning of public utility regulation. Economic efficiency requires utilities to create or adopt new technologies, achieve excellent operating performance, and set rates that correspond to marginal cost. All of these outcomes benefit the long-term economic well-being of utility customers in addition to advancing the public interest. Fairness means that neither customers nor utility shareholders unduly shoulder risks or retain the benefits of utility activities. Fairness is essential for the public credibility of the regulatory process and regulation itself. A large part of regulatory costs are the expenses incurred by utilities and other stakeholders during the course of general rate cases.
Traditional rate-of-return ratemaking has undergone critical review at least since the early 1960s. Various stakeholders and academic economists have offered proposals to improve, replace, or supplement it with mechanisms that attempt to redress the supposed deficiencies underlying traditional ratemaking. The primary question for utility regulators is whether these mechanisms are compatible with the objective of setting just and reasonable rates.
One such mechanism is multiyear rate plans (MRPs). MRPs are a price mechanism that sets a utility’s base rates and revenue requirements for longer than a single 12-month period. MRPs specify rates beyond the rate effective year of a rate case by applying a formula or index, or detailed forecasts for allowable rate changes over the duration of the plan. For example, instead of a utility filing a new general rate case when conditions change, an MRP may forecast what these conditions are and adjust rates within a single rate case.
More state utility regulators, for example Georgia, Minnesota and Washington, in recent years have either approved MRPs or have expressed interest in them. The issues surrounding MRPs are more complex than what first meets the eye. Whether MRPs are in the public interest is the ultimate question for regulators to answer, but one that has no clear answer. Since MRPs involve so many facets of regulation, their merits come down to the features of a specific plan. Other countries, for example Australia, Canada and Great Britain, have relied on MRPs more than the U.S., often citing the deficiencies of traditional rate-of-return ratemaking.
The major supporter of MRPs in the U.S., electric utilities, have advanced different arguments. Their main one is that MRPs would improve the regulatory process and their financial condition (e.g., from less regulatory lag). From a regulatory perspective, their arguments seem to fall short of making a compelling case for how their customers would benefit. For example, utilities have emphasized the need for MRPs to facilitate recovery of capital costs between general rate cases. While this may benefit customers, MRPs have other effects on utility customers, either positive or negative. The mixed results from MRPs preclude a prima facie case for their approval by regulators.
This paper lays out a general approach for regulators in evaluating MRPs as a ratemaking mechanism with the potential to advance the public interest. It first discusses the expected benefits and outcomes of MRPs over traditional ratemaking practices. The paper then takes a more critical approach by accounting for the downsides of MRPs. The fact that relatively few utilities are currently operating under an MRP suggests that like most other mechanisms it has its costs as well as benefits. An overall evaluation therefore requires a cost-benefit review, which is not part of this research paper.
Utility customers can potentially benefit from MRPs in four major ways:
1. Lower prices;
2. More moderate price changes over time;
3. Utility supply of more services;
4. Higher reliability and improved customer service; and,
5. More immediate price benefits from improved utility performance.
For regulators, the question is: What would it take to produce these benefits? This paper attempts to answer this question, although some issues are beyond the scope of this paper.
This paper suggests that conceptually MRPs have attractive features that warrant serious attention by regulators. They represent a potentially sound approach to ratemaking that can improve the regulatory process and benefit utility customers. Having said that, a caveat is that the benefits to utility customers come down to on how MRPs are structured and executed. Certain features should be in place, for example to protect customers from excessive rates, to give utilities incentives for cost-efficiency, and to ensure customers that utilities are performing satisfactorily in vital areas such as service quality. When badly structured or implemented, MRPs can wipe out the benefits that potentially would flow to customers. As a crucial factor, when regulators are unable to determine whether a utility’s revenue requirement forecasts reflect prudent management and are unbiased, they should discount the capability of MRPs to benefit customers. A positive public-interest outcome, in the end, turns to the details, which this paper identifies. A number of things can go wrong that would jeopardize the efficacy of MRPs to promote the public interest. That might, at least partly, explain why MRPs are relatively uncommon in the U.S.
Finally, although this paper does not definitely answer the ultimate question of whether MRPs are in the public interest, it aims to move ahead the dialogue on a ratemaking mechanism that represents a major if not radical departure from traditional ratemaking. More than anything, this paper attempts to educate state utility commissions on MRPs. It hopes to guide them by identifying those key elements of MRPs that are most crucial in affecting the long-run well-being of utility customers. Appendix A contains a list of generic questions about MRPs, some of which this paper tries to answer. Appendix B lists specific questions that regulators can ask about MRPs when initiated by them or proposed by stakeholders.

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