Newfoundland Power Inc General Rate Hearing Grant Thornton LLP Supplementary Evidence April 4, 2003

Transcription

1 00 General Rate Hearing Grant Thornton LLP Supplementary Evidence April, 00

2 00 General Rate Hearing The purpose of this supplementary evidence is to provide additional commentary with respect to topics as previously identified in our report of February, 00 related to the operation of the Automatic Adjustment Formula. Ratio of Average Invested Capital to Average Rate Base Inclusion of Deferred Charges in Rate Base Embedded Cost of Debt Period of Operation of Automatic Adjustment Formula Range of Rate of Return on Rate Base Ratio of Average Invested Capital to Average Rate Base In our report dated February, 00 on Newfoundland Power s general rate application (the Report ) we completed an analysis of the operation of the Automatic Adjustment Formula (the AAF or the Formula ) from to 00 (Schedules and A). From that analysis we indicated that the ratio of average invested capital to average rate base deserved further consideration by the Board. This ratio is a primary component of the arithmetic expression used to translate the Company s weighted average cost of capital (WACC) into a rate of return on rate base. This translation is necessary because of the difference which exists between invested capital and rate base. The use of this arithmetic expression, and resulting translation of WACC, adds complexity to the operation of the AAF. The fact that the forecast average rate base and forecast average invested capital components of the Formula are updated annually, introduces a degree of variability to its operation. The Board may wish to consider an alternative approach which would improve the operation of the AAF. References to the alternative approach can be found in responses to RFI s PUB-, PUB-0 and PUB-. The alternative approach involves including deferred charges into the rate base, in effect reducing the difference between the utility s

3 00 General Rate Hearing 0 rate base and its invested capital. This change in approach would reduce the ratio of invested capital to rate base and minimize the variability which it introduces into the AAF. The previously referenced RFIs refer to the two common approaches used in regulatory practice for determining the return component of a utility s revenue requirement: the Total Invested Capital method or the Asset Rate Base method. The Total Invested Capital method is currently, and has been historically used to regulate Newfoundland Power. In this application, the Company s revenue requirement for 00 and 00 includes the full requested return on the individual components of invested capital. The rate of return on rate base is an outcome of the process of determining the required return on invested capital and can be derived by dividing the average rate base into the total return on average invested capital (Exhibit BVP-, pg. of ). The AAF is used to derive the equivalent rate of return on rate base by adjusting the WACC by the ratio of average invested capital to average rate base so as to provide a full return on average invested capital (Exhibit BVP-). Invested Weighted Average Rate of Return = Capital X Cost of Capital + Z on Rate Return Rate Rate Base Base Where Z represents amounts which are recognized in the calculation of either weighted average cost of capital or reate of return on rate base, but not both. These amounts include: (A) Amortization of Capital Stock Issue Expenses (Recognized in the rate of return (B) Interest on Customer Deposits (Recognized in the weighted average cost of (C) Interest Charged to Construction (Recognized in the rate of return on rate base calculation but not the weighted average cost of capital calculation.); 0 Under the Asset Rate Base method all the assets of a utility, which are attributable to regulated activities, are included in the rate base. In theory, under this approach the rate base of the utility and the total required invested capital are essentially equivalent. If rate base and invested capital were the same, then providing a rate of return on rate base equal to the WACC should result in recovery of the full required return on total invested capital.

4 00 General Rate Hearing We have reviewed the two methods described above for determining the return component of the revenue requirement and conclude that the Asset Rate Base method is preferable. Most of the difference between Newfoundland Power s rate base and invested capital is related to deferred charges, specifically, deferred pension costs. If the Board were to order the inclusion of deferred charges in the Company s rate base, this would represent a significant step forward in adopting the Asset Rate Base method for Newfoundland Power. In the attached Exhibit I we have prepared a calculation of the average rate base for 00 and 00 including the deferred charges. As noted in this Exhibit, the rate of return on rate base decreases to.0% in 00 and.% in 00 based on the expanded rate base, while the dollar amount of return remains constant. While the inclusion of deferred charges in rate base would eliminate the majority of the difference between the Company s average rate base and average invested capital, they still will not be equal. In the attached Exhibit II we have provided a reconciliation of the remaining differences between average rate base and average invested capital for 00 and 00. The inclusion of deferred charges in the rate base would reduce the ratio of invested capital to rate base and improve the operation of the Formula. In the attached Exhibit III we have illustrated the impact of this change on the Formula and the derivation of the revised rate of return on rate base for 00 and 00. Inclusion of Deferred Charges in Rate Base As indicated above, moving to an Asset Rate Base method for regulating the return on rate base for Newfoundland Power could begin by including the Company s deferred charges in its rate base. This would add approximately $ million to the rate base in 00. However, the change would not have any impact on the revenue requirement. Under the current method used to determine the company s return, the Total Invested Capital approach, the Company is already recovering in it s revenue requirement the cost of

5 00 General Rate Hearing financing these deferred charges. The inclusion of deferred charges in rate base is consistent with the approach used for Newfoundland and Labrador Hydro where the unamortized foreign exchange losses are included in its rate base (ref. PUB-, pg. of, line -). It is also similar to the inclusion in rate base of the balance of the Weather Normalization Reserve. It would be appropriate for the Board to test deferred charges, in particular the deferred pension cost, for reasonableness and appropriateness. We believe the prudence test would be the appropriate basis for assessing the reasonableness of deferred charges. In applying this test the Board would assess whether any increases in deferred charges provide an overall benefit to ratepayers taking into consideration the additional cost of financing these amounts. In the next five years (CA-00), the Company is forecasting significant increases in deferred charges on an annual basis. From a regulatory perspective it would be appropriate to review the forecast changes in deferred charges on a prospective basis before inclusion in the rate base, similar to the examination of capital expenditures. Accordingly, we recommend that the Board test the forecast changes in deferred charges each year in conjunction with the hearing of the Company s capital budget application. Embedded Cost of Debt From our analysis of the operation of the AAF contained in our Report (Schedules and A), we identified the changes in forecast versus actual embedded cost of debt as a second area, which deserved further consideration by the Board. The cost of debt is one component in the Company s overall cost of capital. Based on the current definition and application of the AAF the forecast cost of debt used in the AAF remains constant from year to year. However, experience has shown that, year to year, the actual embedded cost of debt varies from forecast. When the actual cost of debt is lower

6 00 General Rate Hearing than the forecast cost, the Company has the opportunity to earn a higher return on equity while staying within the limits of the overall cost of capital or rate of return on rate base. The opposite effect, where the actual cost of debt comes in higher than the forecast cost, will impair the Company s opportunity to earn the full cost of equity. One change to the AAF that would compensate for interest effects as described would involve modifying the Formula so it is adjusted annually for changes in the forecast embedded cost of debt. This change may be appropriate if significant variations in the embedded cost of debt were anticipated in future years. However, such a change will increase the complexity of the AAF. For example, a methodology or basis for determining the forecast cost of debt for the next year would have to be identified and incorporated into the formula. Alternatively, rather than modifying the AAF to adjust for changes in cost of debt annually, the Board could consider establishing criteria which would trigger a review of the AAF and the cost of capital. The review would be triggered whenever certain variables or returns generated by operation of the AAF vary significantly from expectations. Our suggestions in this regard are outlined in the following section. Period of Operation of Automatic Adjustment Formula In P.U. (-) the Board established a three year time period for operation of the AAF. The order stated that a full cost of capital hearing would be convened after Newfoundland Power s rate of return on rate base had been set for three consecutive years by application of the Formula. The company is proposing continued use of the Formula for a further three year period (Perry, pg., lines -). CA- provides further clarification on the proposed time period for operation of the Formula, stating that customer rates, and in effect the rate of return on rate base, should be set for 00 and 00 by order arising from this hearing and that the AAF be used to set rates for 00, 00 and 00.

7 00 General Rate Hearing Regardless of the Board s decision on the period of operation of the AAF, the Board may want to consider introducing criteria that would trigger an interim review of the Formula. The Company appears to acknowledge the possibility of an early review by its comments in CA- (lines 0-). However, this does not preclude the company from requesting rate relief, nor the Board from requesting Newfoundland Power to appear before it with respect to rates, depending on the prevailing circumstances at any time. Also, Mr. Perry confirms this position in cross-examination by Mr. Kennedy (March, 00, pg. 00, lines -) when he states clearly, all along the way, each side will have opportunities to assess the operation of the Formula and decide whether it is in line with what was the intention, whether there are any issues. While the Board regulates Newfoundland Power on its rate of return on rate base, a higher than expected return on equity may indicate that the AAF is not operating as anticipated in setting the rate of return on rate base. To the extent a significant variance may be attributed to the operation of the AAF, it could trigger an immediate review of the Formula and the cost of capital. In this regard, we recommend that the Board establish criteria which would trigger an early review of the Formula if actual equity returns reach a certain predetermined threshold. The setting of this threshold should be made in the overall context of the determination of the cost of capital. In this regard the upper limit of the range of return on rate base may be a good reference point for establishing the criteria threshold. Certainly the threshold should not be any lower than the equity return inferred from the upper limit of return on rate base. Range of Rate of Return on Rate Base In its application and prefiled evidence the Company is proposing a range of rate of return on rate base of 0 basis points (Application, para (b); Perry, pg., lines -). The current allowed range of return on rate base is basis points. Newfoundland Power is suggesting that this range is too narrow. It appears that the basis of their proposal is that

8 00 General Rate Hearing 0 0 the use of a wider range of rate of return on rate base would result in greater rate stability and predictability for both the Company and its customers. This proposed change in range of return would have no impact on the determination of the overall revenue requirement for either 00 or 00 as, the allowed return, as ordered by the Board for setting rates, is the mid-point of the allowed range. Expanding the range of allowed return does however, result in a higher threshold for the upper limit of allowed return on rate base. For 00, this proposed expansion of the range would represent an increase in the dollar amount of allowed return of approximately $,00 (0 basis points basis points x $,,000). The proposed range of 0 basis points for rate of return on rate base assumes a 00 basis point range for rate of return on regulated common equity (see BVP 0). The current basis point range has an implied basis point range of return on common equity for 00. In assessing the Company s proposal to expand the range of allowed return the Board should consider the issue in the context of the determination of the overall cost of capital. All of the factors related to rates of return and cost of capital are interrelated and none, including the range of allowed return, should be assessed in isolation. In addition to considering overall cost of capital matters, there are three other factors the Board may consider in assessing the range of return. The first factor, as noted above, is the suggestion by the Company that expanding the range will potentially decrease the number of rate changes and result in greater rate stability and predictability. The second factor, also noted above, is the fact that expanding the range results in a higher upper limit for the allowed return on rate base. For 00 this would provide the Company with the opportunity to earn approximately $,00 additional return on equity. The third factor to consider is the use of a range of return as an incentive device. The use of an incentive range together with a period of regulatory lag can be beneficial to ratepayers in the long term. A range of rate of return can provide an incentive basis points / (.% x $, ) = basis points $,

9 00 General Rate Hearing to the Company to improve productivity and generate operating efficiencies resulting in lower costs which would be passed on to ratepayers in a subsequent rate hearing. The decision as to the size of the range of return therefore, may be influenced by the Board s assessment as to the opportunity for future operating efficiencies and the Company s demonstrated ability to generate efficiencies in the past that have translated into lower costs for ratepayers.

10 Calculation of Rate Base and Return on Rate Base (Excluding and Including deferred charges) Exhibit I Proposed 00 Excluding Including Deferred Deferred Deferred Charges () Charges () Charges Balance - current year 0,,, Balance - previous year,,, Average 0,, Cash working capital allowances,, Materials and supplies,, Average rate base,, Return on rate base,0,0 Rate of return on rate base 0.%.0% Proposed 00 Excluding Including Deferred Deferred Deferred Charges () Charges () Charges Balance - current year,, 0, Balance - previous year 0,,, Average,0, Cash working capital allowances,0,0 Materials and supplies,, Average rate base,0 0,0 Return on rate base,, Rate of return on rate base 0.%.% Notes: - Information taken from BVP-, pg. and of - Information taken from BVP- ("Proposed" less weather normalization reserve)

11 Reconciliation of Average Invested Capital and Average Rate Base (including deferred charges) Exhibit II Proposed 00 Average Invested Capital (as per BVP-0), Average Rate Base (as per Exhibit I ), Difference (,) Reconciliation: Plant (primarily construction in progress), Corporate income tax deposit, Materials and supplies (actual vs.allowance) Working capital (actual vs.allowance) (,) Common equity (book vs.regulated), (,) Proposed 00 Average Invested Capital (as per BVP-0) 00, Average Rate Base (as per Exhibit I ) 0,0 Difference (,) Reconciliation: Plant (primarily construction in progress), Corporate income tax deposit, Materials and supplies(actual vs.allowance) Working capital (actual vs.allowance) (0,) Common equity (book vs.regulated),0 (,)

12 Rate of Return on Rate Base Formula (Including Deferred Charges in Rate Base) Exhibit III Average Invested Weighted Average Rate of Return = Capital X Cost of Capital + Z on Rate Base Average Rate Average Rate Base Base Where Z represents amounts which are recognized in the calculation of either weighted average cost of capital or rate of return on rate base, but not both. These amounts include: (A) Amortization of capital stock issue expenses (B) Interest on customer deposits (C) Interest charged to construction Proposed 00 (BVP-) (BVP-, pg. of ) =, X.% ,, Rate of Return =.0% = 0. X.% + (0.000) Proposed 00 (BVP-) (BVP-, pg. of ) = 00, X.0% ,0 0,0 Rate of Return =.% = 0. X.0% + (0.000)