Alternative Ratemaking

Overview

In recent years, many state public utility commissions have authorized a host of alternative rate
mechanisms in order to assist in the accomplishment of a wide variety of policy objectives. Among
other benefits, these mechanisms help to reduce the frequency of rate cases, aid in facilitating new
investments and decrease regulatory lag, helping to mitigate large increases in customer bills. These
increases are commonly referred to as “rate shock”.

Three major reasons help to explain the growing deployment of alternative ratemaking techniques.
First, rate of return ratemaking – frequently referred to as “traditional ratemaking” – often gives
inadequate attention to new regulatory objectives. Frequently-employed objectives include
accelerating infrastructure replacement, enhancing energy efficiency programs and expanding access to
natural gas service. As many of these new objectives cause utilities to incur vast expenditures between
rate cases, policy goals may be best accomplished through an alternative ratemaking paradigm.
Declining sales growth has also contributed to the rise in alternative ratemaking. As gas utilities
continue to increase the efficient delivery of natural gas and offer programs that aid customer efficiency
and conservation efforts, traditional ratemaking can make it difficult for utilities to advance these
objectives and recover their fixed costs. This policy dilemma arises because the traditional ratemaking
model links utility revenues with natural gas sales which can lead to a number of undesirable regulatory
and financial issues should natural gas sales decline. Lastly, an increase in capital expenditures, some of
which – including pipeline replacement – are non-revenue producing, offer the third major explanation
for the growth in alternative rate mechanisms. Under traditional ratemaking, forcing utilities to defer
the recovery of these costs until the completion of a future rate case can lead to cash-flow problems,
regulatory lag, and ultimately, “rate shock”. This paper will outline some common uses of alternative
rate mechanisms, and illustrate how states are using these mechanisms to better achieve policy
objectives.

Infrastructure Replacement

America’s natural gas utilities are dedicated to upgrading and modernizing our nation’s natural gas
infrastructure. Alternative rate mechanisms are often utilized to expedite and streamline this process.
Many utilities utilize infrastructure replacement cost trackers, which allow a utility to recover specific
costs from customers outside of a general rate case. Others utilize Infrastructure replacement
surcharges, which allow for cost recovery for large capital projects prior to completion and spread over
time. A number of utilities are permitted to recover infrastructure replacement costs through rate
stabilization mechanisms, which annually adjust base rates – either up or down – to move a utility’s
return on equity toward a prescribed dead band.

Connecticut Natural Gas Corporation (“CNG”) offers a recently-authorized example of an alternative

infrastructure replacement rate mechanism. On January 22, 2014, the Public Utilities Regulatory
Authority (“PURA”) approved a Distribution Integrity Management Program (“DIMP”) mechanism in
CNG’s gas distribution rate case (Docket No. 13-06-08). DIMP is a program for accelerating the
replacement of cast iron and bare steel mains and services. The DIMP mechanism is a revenue tracking
 Alternative Ratemaking
and true-up mechanism that ensures that CNG has adequate revenues to fund its annual schedule of
pipeline replacement.

DIMP allows CNG to recover its revenue requirement for scheduled main replacement activity between
rate applications as well as forecasted activity for the following year. The DIMP rate appears as a
separate line item on customer bills and takes the form of a volumetric charge for firm residential
accounts and a demand charge for other firm classes of customers. The annual revenue requirement for
DIMP will include depreciation, return on investment, accumulated deferred income taxes (ADIT) as well
as income and property taxes. The DIMP revenue requirement will be allocated among customer
classes using the main and services allocators approved in the Company’s latest Cost of Service Study.
CNG will file its first DIMP true-up on or before April 1, 2015. PURA will approve the new DIMP charge
effective May 1, 2015, which is subject to change following a complete, detailed review.

While PURA was authorizing a DIMP mechanism for CNG, the Maryland Public Service Commission (“the
Commission”) was contemporaneously approving an infrastructure replacement surcharge for Baltimore
Gas and Electric Company (“BGE”) in Case No. 9331. Based on the Strategic Infrastructure Development
and Enhancement (“STRIDE”) legislation passed by the 2013 Maryland General Assembly – which
enacted Section 4-210 of the Public Utilities Article, Annotated Code of Maryland – BGE filed an
infrastructure replacement plan and surcharge proposal designed to accelerate safety and reliability
improvements to its natural gas distribution system. The Commission approved this program on
January 29, 2014.

BGE’s plan targets five areas for improvement: bare steel mains, cast iron mains, bare steel services,
copper services and “Ski-Bar” service risers. The plan calls for the replacement of all bare steel mains
(42 miles) in 15 years and all cast iron mains (1,292 miles) in 30 years. The Commission approved the
first five years of this plan. Under BGE’s plan, cast iron and bare steel mains, as well as bare steel and
copper services will be replaced with plastic mains and services, which are less susceptible to leaks,
corrosion and breakage. Overall system safety and reliability will be enhanced further due to the
conversion of portions of the system from less reliable low-pressure systems to more reliable high-
pressure systems. The table below (from Commission Order No. 86147) details the effects that BGE’s
STRIDE Plan will have on its infrastructure replacement efforts:
 Alternative Ratemaking

As the table indicates, this STRIDE Plan enables BGE to drastically accelerate its replacement efforts,
especially as they pertain to the replacement of cast iron main. Once the Commission approves BGE’s
2014 replacement project list and BGE begins undertaking its initial STRIDE replacements, a surcharge
will be included on customer bills. Under the formula in §4-210(c)(4), the STRIDE statute limits any
surcharge to a maximum of $2 per month for up to five years for residential customers. The
Commission determines the appropriate surcharge amount for all other customer classes. The rate of
return utilized in this surcharge is based on the capital structure and weighted average cost of capital
approved in a utility's most recent base rate case, with surcharge-related cost recovery to be transferred
to base rates in the context of the requisite rate case. Based on an annual Commission review and
independent audit of actual progress, if the actual cost of the STRIDE plan is less than the amount
collected through the surcharge, customers will be refunded the difference, plus interest.

As previously noted, rate stabilization mechanisms can also be used to assist in accelerated replacement
efforts. South Carolina opted to pursue this policy choice in 2005, when it enacted the Natural Gas Rate
Stabilization Act (“RSA”), which was designed to reduce fluctuations in customer rates by allowing for
more efficient recovery of the costs regulated utilities incur in improving, maintaining and expanding
natural gas service infrastructure. Since 2005, pursuant to the RSA, Piedmont Natural Gas Company and
South Carolina Electric and Gas Company have filed annual base rate updates in lieu of a general rate
case. This annual rate update enables South Carolina’s natural gas companies to earn a return on
infrastructure investments made during the twelve month period prior to March 31 st.

DIMP, STRIDE, RSA and other innovative alternative ratemaking mechanisms, help to support the costs
of implementing the Pipeline and Hazardous Materials Safety Administration’s (PHMSA) federally-
mandated gas pipeline safety and integrity program. As of May of 2014, 38 states allow gas utilities to
recover costs through a form of alternative rate mechanism.
 Alternative Ratemaking
Non-Volumetric Rates

As natural gas utilities continue to promote energy efficiency – with programs currently being offered in
41 states – traditional regulation can lead to unintended disincentives for the utility promotion of end-
use efficiency, as revenues are directly tied to the throughput of gas sold. To counter this disincentive, a
number of states have implemented alternative approaches intended to align their utilities’ financial
interests with the delivery of cost-effective energy efficiency programs.

The most commonly-used method to remedy this issue is through the implementation of a decoupling
mechanism. A decoupling mechanism is a rate adjustment mechanism that separates (decouples) a gas
utility’s fixed recovery from the amount of gas it sells. Under decoupling, utilities collect revenues based
on the regulatory-determined revenue requirement, most often on a per customer basis. On a periodic
basis, revenues are “trued-up” to the predetermined revenue requirement using an automatic rate
adjustment. As of May of 2014, 21 states have authorized decoupling mechanisms for gas utility
companies.

The Washington Utilities and Transportation Commission (“UTC”) has authorized decoupling for multiple
natural gas utilities in Washington State. Most recently, on June 25, 2013, the UTC permitted Puget
Sound Energy (“PSE”) to implement a Revenue Decoupling Adjustment (“RDA”) mechanism, citing the
reductions in the frequency of cost-intensive rate cases and the promotion of cost-effective energy
conservation methods as the primary policy drivers behind its decision (Consolidated Dockets UE-
121697 and UG-121705).

On a monthly basis – separately for decoupled residential and non-residential customers – the approved
mechanism reconciles the differences between PSE’s monthly actual delivery revenue and its allowed
delivery revenue. This is accomplished by applying the monthly allowed delivery revenue per customer
by the active number of customers in each group for each month. The difference resulting when the
actual delivery revenue is subtracted from the allowed delivery revenue is accrued monthly in an RDA
balancing account. The monthly amount accrued is divided into sub-accounts so that net accruals for
decoupled residential and decoupled non-residential customers can be separately tracked. These sub-
accounts accrue interest at a rate equal to that determined by the Federal Energy Regulatory
Commission pursuant to 18 CFR 35.19a.

Straight-Fixed Variable (“SFV”) Rate designs – currently utilized in 9 states – are another way that
Commissions have worked to address this issue. These structures eliminate all variable distribution
charges and instead enable cost recovery through a fixed delivery services charge or an increase in the
fixed customer charge alone. Under this approach, it is assumed that a utility’s revenues would be
unaffected by changes in sales levels if all its overhead or fixed costs are recovered in the fixed portion
of customers’ bills.

With respect to SFV rate design, Ohio provides a salient example, as its major gas utilities all operate
under SFV rate structures. Of these utilities, Columbia Gas of Ohio (“COH”) was most recently
authorized to implement SFV rates. In its December 3, 2008 Opinion and Order in COH’s gas distribution
rate case (Docket No. 08-72-GA-AIR et. al.), the Public Utilities Commission of Ohio (“PUCO” or “the
 Alternative Ratemaking
Commission”) directed COH to implement a two-step phase in of SFV rate design. As it had in Duke
Energy and Dominion East Ohio’s SFV requests, the Commission determined that a rate design that
separates a gas company's recovery of its cost of delivering the gas from the amount of gas its
customers actually consume was necessary to align new market realities with important regulatory
objectives – including energy efficiency and conservation.

PUCO held that an SFV rate design would best accomplish these policy goals by removing from rate
design the built-in incentive that COH had to increase revenues through increased gas sales. The
Commission also determined that SFV rate design offered benefits to customers by producing more
stable bills throughout all seasons, allowed for even recovery of COH’s fixed costs and provided a clear
charge to customers. PUCO also touted the equitable cost allocation among customers – regardless of
usage – that SFV rate design produced. As such, the Commission authorized COH to implement a
monthly delivery charge for Small General Service class customers with a small volumetric charge. In
December of 2009, the second phase of this plan, the monthly delivery charge was increased and the
volumetric charge was eliminated.

As with infrastructure replacement, other utilities are permitted to account for these variations through
the use of rate stabilization mechanisms.

Other Applications

Alternative rate mechanisms have been employed for a variety of other uses, including promoting
distribution system expansion and reducing weather-related volatility on customer bills. Many states
have allowed gas utilities to implement annual adjustment mechanisms to recover a variety of costs that
otherwise might necessitate a general rate proceeding. Contemporary examples of a number of these
mechanisms are examined in the sections to follow. It is worth noting that rate stabilization
mechanisms generally allow natural gas utilities to recover costs associated with the policy issues
outlined below.

Infrastructure Expansion

With natural gas prices at near-historic lows, many states have sought ways to expand access to natural
gas for their businesses and residents. A number of Public Utility Commissions have utilized alternative
ratemaking to buttress these efforts. The Mississippi Public Service Commission (“PSC” or “the
Commission”) recently provided a particularly innovative example of alternative ratemaking in this
space. On July 11, 2013, the PSC authorized Atmos Energy (“Atmos”) to utilize a Supplemental Growth
Rider (“SGR”) in Docket No. 2013-UN-023. The SGR is designed to encourage industrial development
and job creation in Mississippi by providing Atmos with an incentive to extend gas service to potential
industrial sites which are not otherwise economically feasible for the Company to fund. SGR
investments are authorized to earn a return on equity (“ROE”) equal to 12% for a 10-year period. This
figure represents an increase over Atmos’ normally-utilized ROE.

Under the SGR, Atmos may invest up to $5 million annually in Mississippi without prior Commission
approval to extend gas service for industrial projects deemed otherwise economically infeasible. These
 Alternative Ratemaking
invested funds will be in addition to the Mississippi Division's normal capital budget that would have
otherwise been approved by the Company's Board of Directors. The projects will be selected by Atmos
based upon their potential for economic development. Atmos consults with and considers the
recommendations of the Mississippi Development Authority, the Commission and Commission Staff in
selecting the sites.

Atmos may invest in excess of $5 million annually in such projects with advance approval by the
Commission. In the event that any new project is subsequently identified by Atmos as high priority and
time-sensitive, expedited approval from the Commission may be sought. The Commission aspires to
approve or disapprove such requests within 45 days. Upon approval, Atmos may undertake
construction of the project on a timely basis and include the actual or projected capital expenditure in
its next SGR filing. The SGR rate is collected through a surcharge added to customer bills.

Natural Gas Vehicle Infrastructure

In addition to traditional utility infrastructure expansion, some states have explored using alternative
ratemaking to expand natural gas vehicle infrastructure. Utah offers a leading example of an innovative
approach. On March 28, 2013, Utah enacted Senate Bill 275, which will allow natural gas utilities to
recover expenses related to the building of natural gas refueling infrastructure. Cost recovery is
contingent upon a utility demonstrating that at least 50% of the revenue requirement can be covered
through incremental revenues at that station. Expenses for such projects may not exceed $5 million in a
calendar year.

Weather Normalization

A weather normalization adjustment is a method of adjusting customers' bills to reflect normal – rather
than actual – weather conditions during a set period of time. Weather normalization adjustments have
a leveling effect on customers' gas bills by reducing bills in months with colder-than-normal
temperatures (when customers' gas usage tends to be higher) and increasing bills in months with
warmer-than-normal temperatures (when customers' gas usage tends to be lower). As a result,
customers are less impacted by large monthly swings in their gas bills which can occur during the
heating season as a result of increased usage during colder weather.

Pursuant to an approved settlement in its gas distribution rate case (Docket No. R-2012-2321748),
Columbia Gas of Pennsylvania (“CPA”) received authorization to implement a Weather Normalization
Adjustment mechanism (“WNA”) that will operate on a pilot basis. This mechanism will be in place for a
minimum period of three years (commencing October 2013) and will continue until issuance of a final
order in the first rate case CPA files after May 31, 2016. CPA’s WNA is a temperature-based weather
normalization mechanism that is applicable to residential accounts from October through May of each
year. CPA’s WNA methodology adjusts only the temperature-sensitive portion of customers’ bills to
reflect normal weather levels that were the basis upon which non-gas rates were determined, designed
and approved. The WNA is only used to calculate the non-gas distribution charges by adjusting usage
for each residential customer individually to reflect what each residential customer’s usage would have
been if weather had been normal during the billing period. This mechanism includes a 5% deadband,
 Alternative Ratemaking
which allows CPA to adjust for weather changes greater than 105% of normal weather or changes less
than 95% of normal weather.

Energy Efficiency Program Costs

For utilities without decoupling, SFV rate design or a rate stabilization mechanism in place, commissions
have approved methods for recovering the costs associated with the deployment of energy efficiency
measures. This is generally accomplished through the establishment of an automatic rate adjustment
mechanism that is used to annually reconcile program costs outside of a general rate case.

Ameren Illinois (“Ameren”) offers an example of such a program. Ameren operates under Rider GER,
which provides for the recovery of costs, fees and charges for approved Gas Energy Efficiency measures
implemented by the Company and approved by the Illinois Commerce Commission (“ICC”). Ameren files
an annual reconciliation statement with the ICC and presents evidence these costs have been prudently
incurred and collected.

Pension and Other Post-Employment Benefit Costs (OPEB)

As pension expenses can fluctuate annually, utilities do not always recover costs that they actually
incurred and recorded in their accounts. Under-recovered pension expenses can lead to additional
recording of pension liabilities and a loss of income. Several rate design options are available to assist in
addressing this issue, including cost tracking mechanisms and rate stabilization mechanisms – which
recover costs in the time period in which they are incurred – and deferral accounts, which delay the
recovery of expenses, and usually carrying costs, until a future period.

An example of innovative pension and OPEB ratemaking can be found in Massachusetts. The
Massachusetts Department of Public Utilities (“DPU”) has authorized its natural gas utilities to recover
Pension and OPEB costs through the use of a tracking mechanisms. NSTAR Gas (“NSTAR”) offers an
example of how these mechanisms typically function. NSTAR is permitted to fully recover its allocated
share of qualified pension expenses through a DPU-approved reconciling rate mechanism tariff (pension
adjustment mechanism or PAM) that is collected from customers in rates. The PAM removes the
volatility in earnings that could result from fluctuations in financial market conditions and Plan
experience. PAM-related costs are a part of NSTAR Gas’ local distribution adjustment clause that is reset
through an annual filing with the DPU.

Bad Debt Expenses

A typical bad debt mechanism allows for the recovery of costs that are usually outside of the control of
the utility, such as taxes and the cost of gas. These tracking mechanisms are implemented without the
need for a rate case and ensure that the utility is made whole. Both higher-than-forecast and lower-
than-forecast bad debt expenses are tracked in a special account and subsequently recovered in the
rates of all customers.

Illinois illustrates an example of this type of mechanism. On February 3, 2010, The ICC approved a bad
debt rate adjustment mechanism for Nicor Gas (“Nicor”). The approved rider provides for recovery from
 Alternative Ratemaking
(or refund to) customers of the difference between the actual bad debt expense Nicor incurs on an
annual basis and the benchmark bad debt expense included in its rates for the respective year.

Summary

The alternative rate mechanisms discussed have helped to support a variety of state policy goals while
aiding natural gas utilities in providing safe, reliable service to customers. These and other innovative
approaches can encourage utilities to make smart investments, reduce long run costs, and improve
service quality while also reducing the frequency of cost-intensive rate cases, decreasing regulatory lag
and limiting exogenous impacts to customer bills.