REVENUE REQUIREMENT 2016 CGA Regulatory Course

Home , Amortization (business), Depreciation

Michelle Carman FortisBC Energy Inc.

1 Introduction Presentation Objectives

. Part 1: Explain and demonstrate the calculation of revenue requirement for the cost of service form of regulation

. Part 2: Explain Regulatory Approval of Capital Expenditures

2 Revenue Requirement Part 1

Revenue Requirement

Explain and demonstrate the calculation of Revenue Requirement for the Cost of Service Form of Regulation

3 Revenue Requirement Part 1 : Presentation Overview

 Introduction  Generally Accepted Regulatory Principles  Rate Base  Cost of Capital  Cost of Gas Sold  Operating, Maintenance and Administration Expense  Depreciation and Amortization Expense  Revenue Forecast  Income Tax  Regulator’s Decision

4 Part 1: Introduction Natural Gas Industry Schematic

Producing Basin Gas Wells Transmission Lines

Gas Processing Plant LNG

Large Volume Customer

Compressor Stations

Meter/ Regulator

Residential Customer Underground City Gate Storage (Meters / Regs) Commercial Customer Distribution Mains

5 Part 1: Introduction Customer-Related Activities

Customer Account Management

Meter Billing Financial Reporting Management

Accounts Payments Collections Bad debt Receivable

Collection Agencies

6 Part 1: Introduction Integrated Energy Utility

Areas of Focus

7 Part 1: Introduction Regulatory Compact

. Bargain between

regulator and regulated Regulator utility . Private property put to

use in the public interest Shareholder Utility /Owner . Government will protect the interests of both the consumer and the utility Customer . Utility has both rights and responsibilities Part 1: Introduction Revenue Requirement

Revenue Requirement: The revenue that a regulated utility needs to earn in a test year in order to provide adequate service to its customers and a fair return for its shareholders.

9 Part 1: Introduction COST OF SERVICE / RATE OF RETURN REGULATION

Forecast of Revenues at Existing Rates Residential, Commercial, Industrial (sales and transportation) + Other Revenue = “Revenue Forecast”

Forecast of Expenses for the year Cost of gas + OM&A + property taxes + Depreciation / Amortization + Income taxes + rate base return (interest, ROE) = “Revenue Requirement”

If Revenue Requirement < If Revenue Requirement > Revenue Forecast Revenue Forecast Utility applies for Utility applies for Rate Decrease Rate Increase

10 Part 1: Introduction Cost or Value

Who determines the price? . The provider - Cost based • Price determined by the cost incurred by the provider of the product or a service and not by the price the purchasers are willing to pay. . The purchaser - Value based (market value) • Price based on what purchasers are willing to pay. • Purchasers make decisions by comparing prices of similar products or services offered by other competing providers. • In a perfectly competitive market, the cost-based price of the most efficient producer will set the market price. Less efficient producers must meet this price to stay in business; an incentive to be efficient.

11 Part 1: Introduction Top Down vs. Bottom up

Competitive Business Regulated Gas Utility

Revenue = Revenue Requirement + Cost of Gas - Cost of Goods Sold + OM&A - Operating expenses + Depreciation - Depreciation + Interest - Interest

- Taxes + Taxes

= Net income Net income (ROE)

12 Part 1: Introduction Rate Case Evidence

. Test Year – budget forecast for future year . Bridge Year or Base Year – budget estimate for current year . Historical Year – financial results for the last completed year

13 Part 1: Introduction Common Terms

Rate Base • Construction & purchase of assets Earned • Return & interest on investments in Return assets Cost of • Return of and other costs of owning & Service operating assets and delivering energy Revenue • Revenue needed to recover cost of Requirement service, including earned return Test Year • Year for which rates are being reviewed

14 Part 1: Introduction Revenue Requirement Formula

RR = G + OMA + D + T + r(RB) RR = revenue requirement r = return on rate base RB = rate base = (OC - AD) OC = original cost of assets when placed in service AD = accumulated depreciation on assets since placed in service G= cost of gas sold OMA = operating, maintenance and administration expense D = depreciation and amortization expense T = income tax expense r(RB) = return on rate base or cost of capital G + OMA + D + T is sometimes referred to as “cost of service” while others refer to revenue requirement as “cost of service”

15 Part 1: Introduction Typical Corporate Structure

Parent Energy Company

Unregulated

Subsidiary Subsidiary Gas Company Energy Services Company

Gas Distribution Division Commodity Marketing Division Regulated Utility Unregulated

Gas Storage Division Retail Services Division Regulated Utility Unregulated

Gas Transmission Division Regulated Utility

Non-utility Business Division Unregulated

16 Part 1: Introduction Regulated Gas Utility Example

. Gas Distribution Division, Gas Storage Division and Gas Transmission Division . Regulated monopoly utility business • Notional entity, need not be a legal entity • For regulated rate setting purposes only • All under one regulator • Regular rate cases

17 Generally Accepted Regulatory Principles

(GARP)

18 Part 1: Generally Accepted Regulatory Principles 1923 Bluefield Waterworks Decision

A public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility and should be adequate, under efficient and economical management, to maintain and support its credit and enable it to raise the money for the proper discharge of its duties.

19 Part 1: Generally Accepted Regulatory Principles GARP

Generally Accepted Regulatory Principles

• Rates based on reasonable costs prudently incurred in providing necessary service to ratepayers • Annual rates are based on annual costs • All costs including taxes are on a utility stand-alone basis • Utility evidence is presented from ratepayer perspective • Fairness to ratepayers and shareholders

20 Part 1: Generally Accepted Regulatory Principles CIAC, AFUDC and IDC

. CIAC: Contribution-in-aid-of-Construction • Funds contributed by a customer toward a capital project . AFUDC: Allowance for Funds Used During Construction • a charge permitted by the regulator to cover the financing of a utility capital project while under construction • AFUDC is based on approved cost of capital (i.e. it has debt and equity components) • AFUDC added to the project capital cost on completion. . IDC: Interest During Construction • Like AFUDC only based on debt interest costs only

21 Part 1: Generally Accepted Regulatory Principles GARP and GAAP Balance Sheet

Left Side Right Side G Assets Liabilities & Owners’ A Net of accumulated depreciation Equity A at a point in time, may include At a point in time P interest but excluding CIAC or Equity Financing Costs G Rate Base Capital Structure A Annual average net of Annual average R accumulated depreciation, P excluding CIAC, but including AFUDC or Interest

22 Revenue Requirement Example

FortisBC Energy Inc. 2015 Test Year

23 Revenue Requirement Example Test Year Rate Base – FortisBC Energy Inc. (FEI) 2015

24 Revenue Requirement Example Test Year Capital Structure and Return – FEI 2015

25 Revenue Requirement Example Test Year Revenue Requirement – FEI 2015

26 Revenue Requirement Example Factors leading to 2015 Revenue Deficiency

18.000

16.000 1.572 15.379 1.522

14.000 4.125 Formula (0.796) 12.000 1.685

10.135 Forecast 10.000 2.440

2.03% 8.000 Delivery Rate 6.000 (1.179) Impact

4.000

2.000

- Demand Other Revenue O&M Depreciation & Financing and Taxes 2015 Deficiency Forecast Amortization Return on Equity

27 Revenue Requirement Example Revenue Requirement and Rate Increase Summary

($millions) RR = G + OMA + D + T + r(RB) RR = 633.2 + (238.6 + 61) + 192.2 + 50.5 + 256.1 RR = 1,431.5 Revenue at Existing Rates (+ Other Revenue) = 1,416.0 Revenue Deficiency or Rate Increase = 15.4 Revenue Requirement or Revenue at Proposed Rates = $1,431.5

28 Rate Base “…the value of the property which [the utility] employs for the convenience of the public…”

29 Part 1: Rate Base Rate Base Components and Categories

$ Rate Base Components Account Categories Millions Property, Plant and Equipment $3,520.4 Storage Plant (forecast average, net of CIAC, net of Transmission Plant accumulated depreciation- net gas plant Distribution Plant in service) General Plant

Allowance for Working Capital & Other 115.8 Gas-in-storage (forecast for the Test Year) Materials & Supplies Inventory Security Deposits Cash Working Capital

Deferred Charges (Regulatory Assets & 20.3 Energy Cost Variance Accounts Liabilities) DSM incentives Non-Controllable Cost Variances Application Costs Accounting Related

Total Rate Base $3,656.4 (total average Test Year assets To Cost of Service providing service to ratepayers)

Revenue Requirement 30 Rate Base: Storage Plant

Liquefied Natural Gas Facility

31 Rate Base: Transmission Plant

Southern Crossing Pipeline Compressor Station

32 Rate Base: Distribution Plant

Service Line Tie-in to Main Meter Installation

33 Rate Base: General Plant

Operations Centre / Office Building

34 Part 1: Rate Base Rate Base Calculation Principles

Rate base - the net value of utility’s assets used in providing service to customers

Average

Contributions Net Gas Accumulated In Aid or Original Cost AFUDC/IDC Plant In Depreciation Contributed Service Capital

Revenue Requirement 35 Part 1: Rate Base Calculation of Rate Base Average

Simple Annual Average • (opening balance + closing balance)/2 Average of Monthly Averages • ((month1 avg) + (month2 avg) + …+ (month 12 avg))/12 • The formula can be restated as follows: • (Jan.1)/24 + (Jan.31+Feb.28+…Nov.30)/12 + (Dec.31)/24 13-Month Average • (Jan.1 + Jan.31 + Feb.28 +…+ Nov.30 + Dec.31)/13

36 Part 1: Rate Base Regulatory Treatment of Work-in-Progress Work-in-progress (“WIP”) is not in rate base (if AFUDC or IDC is charged)

Allowed to charge AFUDC or IDC to recover capital project financing costs

AFUDC or IDC is added to asset cost

AFUDC or IDC is recovered through depreciation expense charged in rates over the life of the asset

37 2015 Revenue Requirements Formula Based Capital Expenditures

2015 Formula Growth 2015 Formula Other Capex Capex Total 2015 $180.0

$160.0 Different Growth Factors $90,131

$140.0

$120.0

$100.0

$80.0

$60.0

$40.0

$20.0

$(20.0) 2014 Base Inflation Customer Growth Non-Formula

38 Part 1: Rate Base Original Cost- Capital Budget vs. Rate Base Additions

Line 2015 No. Particulars Forecast (1) (2)

1 CAPITAL EXPENDITURES 2 Formula 3 Growth Capital Expenditures $ 28,480 Driven 4 Sustaiment and Other Capital Expenditures 117,213 5 Forecast Capital Expenditures 10,611 6 CIAC 6,448 7 Total Regular Capital Expenditures $ 162,752 8 9 Special Projects - CPCN's 10 11 Huntingdon Station 7,654 12 Tilbury Expansion 156,463 13 Total CPCN's $ 164,117 14 15 TOTAL CAPITAL EXPENDITURES $ 326,869 16

Revenue Requirement 39 Part 1: Rate Base Original Cost + AFUDC- Capital Budget vs. Rate Base Additions

Line 2015 No. Particulars Forecast (1) (2)

18 RECONCILIATION OF CAPITAL EXPENDITURES TO PLANT ADDITIONS 19 20 Regular Capital 21 Regular Capital Expenditures$ 162,752 22 Add - Opening WIP 64,926 23 Less - Closing WIP (60,516) 24 Subtotal 167,162 From O&M 25 Add - AFUDC 1,996 26 Add - Overhead Capitalized 32,548 27 28 TOTAL REGULAR CAPITAL ADDITIONS TO GAS PLANT IN SERVICE$ 201,706 29 30 Special Projects - CPCN's 31 CPCN Expenditures$ 164,117 32 Add - Opening WIP 150,677 33 Less - Closing WIP (329,488) 34 Subtotal (14,694) 35 Add - AFUDC 14,694 36 37 TOTAL CPCN ADDITIONS$ - 38 39 TOTAL PLANT ADDITIONS $ 201,706 Rate Base 40

Revenue Requirement 40 Part 1: Rate Base Test Year Rate Base

Allowance for Working Capital & Other 115.8 Gas-in-storage (forecast for the Test Year) Materials & Supplies Inventory Security Deposits Cash Working Capital

Deferred Charges (Regulatory Assets & 20.3 Energy Cost Variance Accounts Liabilities) DSM incentives Non-Controllable Cost Variances Application Costs Accounting Related

Total Rate Base $3,656.4 (total average Test Year assets providing service to ratepayers)

Revenue Requirement 41 Part 1: Rate Base Working Capital Calculation

Accounts for the net financing costs associated with day to day operations

Determined on an Cash working Other Working annual average capital Capital basis • Different from • Allowance for • Primarily gas in financial timing of cash storage statements, inflows & • Determined using which is at a outflows forecast balances point in time • Lead Lag Study of gas in storage (Current Assets – (most common) and forecast Current • Varies amongst forward prices Liabilities) utilities

Revenue Requirement 42 Part 1: Rate Base Working Capital Allowance

2015

Line Existing 2014 Revised No. Particulars Rates Rates (1) (3) (4)

Lead Lag 1 Cash Working Capital Study 2 Cash Required for 3 Operating Expenses $ 11,727 $ 12,097 4 5 6 Less - Funds Available: 7 8 Reserve for Bad Debts (7,927) (7,927) 9 10 Withholdings From Employees (5,292) (5,292) 11 12 Subtotal (1,492) (1,122) 13 13 Month 14 Other Working Capital Items Average 15 Construction Advances (13) (13) 16 Transmission Line Pack Gas 2,251 2,251 17 Gas in Storage 77,811 77,811 18 Inventory - Materials & Supplies 1,567 1,567 19 Refundable Contributions (298) (298) 20 21 Subtotal 81,318 81,318 22 23 Total $ 79,826 $ 80,196 Revenue Requirement 43 Part 1: Rate Base Test Year Rate Base

Allowance for Working Capital & Other 115.8 Gas-in-storage (forecast for the Test Year) Materials & Supplies Inventory Security Deposits Cash Working Capital

Deferred Charges (Regulatory Assets 20.3 Energy Cost Variance Accounts & Liabilities) DSM incentives Non-Controllable Cost Variances Application Costs Accounting Related

Total Rate Base $3,656.4 (total average Test Year assets providing service to ratepayers)

Revenue Requirement 44 Part 1: Rate Base Deferred Charges (Regulatory Assets & Liabilities)

. Common examples of deferral accounts are in the following areas: • Cost of Gas – Purchased Gas Variance Account or PGVA • Taxes - Income or property tax changes not anticipated in the test year • Interest rates • Demand Side Management incentive grants • Extraordinary losses caused by disasters and other unusual circumstances

. Rate base treatment of deferral accounts varies by jurisdiction

Revenue Requirement 45 Part 1: Rate Base Deferred Charges (Regulatory Assets & Liabilities), $ Millions

$150.0 Accounts categorized as follows in FEI:

• Margin Related $100.0 • Variance accounts for Energy & Use Rates $73.3

• Energy Policy $50.0 Margin Related • EEC/DSM incentives Energy Policy Non-Controllable • NGT programs Application Costs $Millions $26.8 $- Other • Non-Controllable Residual • Cost variances and unanticipated events (tax changes, etc.) $(73.3) • Application Costs $(50.0)

• Other $(6.7)

• Accounting related, special projects $(100.0) 2015 Forecast

46 Revenue Requirement Part 1: Rate Base Summary,$ Millions

$20.3 $80.2 $35.6 $24.1

$3,496.3

Opening Net Plant Changes in Net Plant Deferred Charges Working Capital Other Cost of Capital

“…a return … equal to that generally being made at the same time… on investments in other business undertakings which are attended by corresponding risks and uncertainties. The return should be reasonably sufficient to assure confidence in the financial soundness of the utility … to maintain and support its credit and enable it to raise the money for the proper discharge of its duties.”

48 Part 1: Cost of Capital Test Year Cost of Capital and Return on Rate Base

49 Part 1: Cost of Capital Components of Capital Structure

Long Term Debt • Amounts are averages of existing and forecast amounts • Net of un-amortized finance charges and profit/loss on redemption • Existing debt and preference capital – at actual rates • New debt and preference capital – at forecast rates from economic forecast Short Term Debt • Short term debt amount is the amount required to balance rate base – actual and forecast amounts of short term debt are not used • Rate is obtained from the economic forecast of rates on a monthly basis for the test year Common Equity • The amount is usually deemed by the regulator based on the risk of the utility’s business – actual common equity is not used • The utility requests approval of a return on equity (“ROE”) for the test year based on evidence of economists • In some jurisdictions a formula is used to determine the allowed ROE Part 1: Cost of Capital Return on Equity Models

Model Explanation Equity Risk Premium ERP + risk-free rate ERP=historical equity cost vs. long term bond yield risk free rate=long term government bond yield

Comparable Earnings Compared to ROE of comparable non-utility companies over one business cycle (approximately 10 years) Discounted Cash Flow Current dividend yield + present value of future dividend growth

Overall Economists apply different weighting factors to each Recommendation model

51 Part 1: Cost of Capital Formula Based Return on Equity Model

• Benchmark ROE set at 8.75%

• If Long Canada Bond is > 3.80% reset ROE – Benchmark ROE + 50% of change in Long Canada Bond forecast + 50% of change in A rated Utility bond spread

52 Part 1: Revenue Requirement Revenue Requirement Equation

($millions)

RR = G + OMA + D + T + r(RB)

RR = G + OMA + D + T + (7.0% x $3,656.4)

RR = G + OMA + D + T + 256.1

53 Cost Of Gas Sold

54 Part 1: Cost of Gas

Commodity-related costs receive different treatment from the cost of service of delivery-related cost components • Natural gas pricing is market-based. • Commodity options available – customer can select marketer or default utility options. Commodity rate changes handled on a “flow-through” basis • Two commodity-related cost streams for FortisBC- commodity and mid- stream Deferral accounts common to capture commodity cost variances

55 Part 1: Revenue Requirement Sample Customer Bill Part 1: Revenue Requirement Revenue Requirement Equation

($millions)

RR = G + OMA + D + T + r(RB)

RR = 633.2 + OMA + D + T + 256.1

57 Operating, Maintenance and Administration Expense

“…under efficient and economical management…”

58 Part 1: Operating, Maintenance and Administration Expense OM&A Categories

OM&A Account Categories Plant Operating and Maintenance Storage Plant O&M Transmission O&M Distribution O&M General Plant O&M Customer Care and Marketing Meter reading Customer Billing & Administration Call centre Bad debt & Credit Management Program marketing, e.g. DSM

Administration H.O., Finance & General Administration Legal Insurance Employee Benefits

59 Part 1: OM&A Expense

Two main views of OM&A expenses . Activity-based view • What are the activities carried out in a particular department or business unit (e.g. leak surveys, odorant costs, meter reading, billing, responding to service requests and customer enquiries, etc.) . Resource view • What resources are employed in delivering OM&A activities (e.g. labour & benefits, materials, vehicle expenses, etc.)

60 2015 Revenue Requirements Formula Based O&M Expense ($000)

Line Description $ millions 1 2014 Base O&M$ 234.0 2 x (1 + Net Inflation) 0.203% “X” Factor 3 x (1 + Growth Factor) 0.614% 4 2015 Formula O&M$ 235.9 5 Forecast O&M 35.4 6 Total Gross O&M 271.2 To Capital 7 Capitalized Overhead (12%) (32.5) Additions 8 Biomethane O&M transferred (0.6) 9 10 Net O&M$ 238.1

61 Part 1: OM&A Expense – Property Taxes

Property Taxes • Taxing authority granted to various municipal, provincial and other public bodies by statute and regulation. • Property taxes are generally based on assessed property values and mill rates but in some cases there are revenue-based taxes • Utility property tax rates tend to be among the highest

62 Part 1: OM&A Expense Affiliate Transactions Concerns

. Assets or services • Purchased or obtained by the utility from parent company or affiliates • Sold or transferred by the utility to the parent company or affiliates . Concerns Regarding Affiliate Transactions • Transfer of utility earnings, which could have been used to reduce rates, to unregulated affiliate or parent company . Purchases by utility from affiliate at more than utility’s avoided cost or above market value . Sales by utility to affiliate below book value of assets, or below cost of production, or below market value . Two arguments • “No harm to ratepayers test” : transaction must not increase rates • “Benefit to ratepayers test” : transaction must decrease rates or yield other benefits

63 Part 1: Revenue Requirement Revenue Requirement Equation

($millions)

RR = G + OMA + D + T + r(RB)

RR = 633.2 + (238.1+61.5) + D + T + 256.1

64 Depreciation and Amortization Expense

“…the value of the property which [the utility] employs for the convenience of the public…”

65 Part 1: Depreciation and Amortization Expense Test Year Depreciation and Amortization Expense

Depreciation & Amortization Expense $millions Storage Plant $ 7.4 Transmission Plant 30.5 Distribution Plant 87.3 Example General Plant 39.1 Total Depreciation Expense 164.3 Amortization of CIAC (8.9) Amortization of Deferred Charges 36.8 Total $ 192.2

Revenue Requirement 66 Part 1: Depreciation and Amortization Expense General Concepts

Varying Depreciation Rates Code of Amortization Pooled Rate Based determined Accounts as Periods for Assets on “Useful” by Third Determined Deferred Life of Pool Party Study by Regulator Charges

Revenue Requirement 67 Part 1: Depreciation and Amortization Expense Distribution Plant Depreciation Expense

Gross Plant Depreciation Depreciation Balance Rate Expense

$ millions % $ millions Land 4.2 0.0 % 0.0 Services 1,026.5 2.37 % 24.2 Mains 1,311.1 1.55% 20.5 Meters 231.2 7.82% 17.5

Other 451.6 25.1 Total 87.3

68 Part 1: Depreciation and Amortization Expense General Calculation of Depreciation Expense

Adjusted for Timing

Opening Gas Gas Plant Gas Plant Depreciation Depreciation Plant Additions Retirements Rate Expense Balance

Revenue Requirement 69 Part 1: Depreciation and Amortization Expense Net Mains Cost in Rate Base

Opening Additions Retirements Retirement Closing Balance Costs Balance

$millions $millions $millions $millions $millions Gross Plant 1,311.1 29.5 (1.4) 1,339.3 Accumulated (416.6) *(20.5) 1.4 (435.7) Depreciation

Net Plant 894.5 9.0 **0.0 903.6

* Accumulated depreciation additions are the annual deprecation expense **Note that ordinary retirements do not change rate base

70 Part 1: Depreciation and Amortization Expense Asset Retirement

Ordinary Retirements • Plant is retired near the end of its economic life • No change in rate base • Depreciation expense is reduced Extraordinary Retirements • Plant is retired prematurely due to external events beyond management control • Rate base is reduced by the net book value of the retired plant • Depreciation expense is reduced • Loss on retirement (net book value + disposal cost – salvage value) is recovered from ratepayers in the year incurred (or can be amortized over several years to mitigate rate impacts)

71 Part 1: Revenue Requirement Revenue Requirement Equation

($millions)

RR = G + OMA + D + T + r(RB)

RR = 633.2 + (238.1+61.5) + 192.2 + T + 256.1

72 Revenue Forecast

“…under efficient and economical management…”

73 Part 1: Revenue Forecast Use per Customer Rates

FEI Normalized Residential Use Per FEI Normalized Residential Demand Customer

• Use rate forecast x number of customers (per rate schedule) to get forecast demand • Decline in use per customer creates rate challenges as the addition of new customers is currently not great enough to offset

74 Part 1: Revenue Forecast Forecast Volumes and Margin

Notes: 1 Rate Schedule 1 2 Rate Schedules 2, 3, 23 3 Rate Schedules 4, 5, 6, 6P, 16, 46, 7, 22, 25, 27, Burrard Thermal, Joint Venture, BC Hydro/Island Cogeneration Project

75 Part 1: Revenue Forecast Regulation of Other Revenue

. What is other revenue? • Other revenue is generally utility revenue which is not rate regulated, I.e. its rates are not set by an order of the regulator • Utility assets and employees are used to generate other revenue • Examples: NGV programs; appliance sales, rentals and service; agent billing and collection service, transactional services . How is it regulated? • Utility may need to demonstrate that the rate of return (ROR) on utility assets used for other revenue is equal to or greater than the allowed base allowed by the regulator • If ROR is less than the allowed, then the regulator may impute revenue to this business to bring it up to the allowed ROR • Imputed revenue is a notional increase in other revenue which is not earned by the utility and reduces the allowed rate increase

76 Income Tax

77 Part 1: Income Tax Utility Tax Calculation Principles

. Income tax is calculated on utility stand-alone basis, as if the regulated utility was a separate taxable corporation

. Regulators require that taxes be calculated on flow- through basis - current customers benefit from maximum current tax deductions. • Results in un-recorded deferred taxes to recover from future customers • Issue of inter-generational cross-subsidies - current customers are benefiting from CCA tax deductions that should belong to future customers

78 Part 1: Income Tax Utility Income Before Interest and Income Tax

$millions $millions Total Revenue at Existing Rates $1,416.0 Less Expenses: Cost of Gas Sold 633.2 OM&A Expense 238.1 Property Tax 61.5 Depreciation and Amortization Expense 192.2 Total Expenses 1,124.9 Income before Interest & Income Tax $291.1

79 Part 1: Income Tax Taxable Income

Amount $millions Income before Interest and Income Tax $291.1 Deduct: Interest Expense (132.9) Add Non-deductible Items: Depreciation / Amortization Expense 192.2 Other Non-deductible Items 35.5 Subtract Deductible Items: Capital Cost Allowance (tax depreciation) (154.8) Capitalized Deductible Items (overhead costs) (10.8) Grossed-up Part VI.1 Tax (re: Preferred Shares) Other Deductible Items (41.6) Taxable Income $178.7

80 Part 1: Income Tax Income Tax on Forecast Revenue at Existing Rates

Combined Federal / Provincial $millions Taxable Income $178.7 Income Tax Rate 26.0%

Income Tax on Revenues at Existing Rates $46.5

81 Part 1: Income Tax Test Year Income Tax on Revenues at Proposed Rates

$millions $millions Cost of Capital r(RB) $256.1 Expenses before Income Tax G+OMA+D 1,124.9 Income Tax at Existing Rates 46.5 46.5 Subtotal 1,427.5 Less Revenue at Existing Rates 1,416.0 Net Revenue Deficiency 11.5 Gross Revenue Deficiency Net deficiency/ (1-marginal tax rate) = 11.5/ (1-0.26) 15.4 Income Tax on Gross Revenue Deficiency (15.4 x 0.26) 4.0 Test Year Income Tax at Proposed Rates 50.5

82 Revenue Requirement Example Revenue Requirement and Rate Increase Summary

83 Part 1: Revenue Requirement Recovery of Revenue Requirement from Ratepayers

Revenue Requirement increase is allocated to customer classes

Rates are designed to recover all of the Revenue Requirement in the test year based on forecast volumes • Revenue/year = number customers x volume/customer/year x revenue/volume • Rate = Revenue requirement / unit volume

More on cost allocation and rate design in later sessions

84 The Decision

85 Part 1: The Decision Regulator Balances Interests

For Customers For the Utility Utility service at Recover costs fair and of providing reasonable rates service without undue including a fair discrimination and reasonable or preference return on the property employed in providing utility service. Part 1: The Decision Regulator Balances Interests

Revenue Rate Design Requirements

Existing Shareholders Customers

Society at Future Capital Projects Large Customers Cost Allocation

87 Part 1: The Decision Regulator Adjusts Revenue Requirement

Potential Areas of Adjustment

Does not approve certain • Effect is reduced rate base, r(RB), depreciation expense, capital expenditures taxes

Decides that the revenue • Increases sales volumes and revenue forecast (with forecast is understated corresponding cost of gas) – revenue deficiency decreases

Decides that other revenue • imputes additional revenue and decreases revenue business should be at the deficiency allowed rate of return

Decides that OM&A cost • reduces OM&A costs and revenue deficiency forecast is overstated

Reduces ROE or debt interest • ROE change affects r(RB) and taxes, interest change affects rates r(RB)

88 Part 1: The Decision Adjustments to Revenue Requirement – FEI 2015

2015 $ % Rate Million Change Proposed Rate Change 15.4 2.03% Adjustments: Update forecast inflation & interest rates to current information 0.4 Increase to forecast Residential Customer use rate (6.0) Decrease to forecast NGT O&M (0.4) Revision to CIAC amortization* (2.2) Update to actual opening plant & deferral balances (1.4) Adjustments related to Amalgamation Decision (0.6) Total Adjustments (10.2) Revised Rate Change 5.1 0.67% *oversight identified by FEI in preparing compliance filing

89 Part 1: Cost of Service Regulation - Review & Summary Regulatory Process

. Annual or regular rate hearings where the company is able to adjust rates on an annual basis in response to changes in costs . Adequate evidence on each revenue requirement item to justify recovery in rates . Forward test year - the company generally only spends what the regulator approves . Company is at risk for forecast accuracy of revenue requirement components which are generally under management control . Costs not under management control or otherwise subject to deferral are deferred and amortized in approved manner • Variance accounts collect variances from forecast costs • Deferral accounts collect un-budgeted costs

90 Part 1: Cost of Service Regulation - Review & Summary Regulatory Process

Decision Arguments Evidentiary Record Closed Oral Public Hearing Pre-Hearing or Procedural Conference Discovery Process Workshop Procedural Conference Intervention Notification Procedural Order Application

Duration can be 3 months to over 1 year Part 1: Cost of Service Regulation - Review & Summary Advantages of Cost of Service Regulation

 Ability to recover the cost of providing service to existing customers  Ability to recover the cost of adding new customers  Ability to minimize risk by the adjustment of forecasts, generally on an regular basis  Ability of utility shareholders to receive a stable ROE over a long period of time

92 Part 1: Cost of Service Regulation - Review & Summary Disadvantages of Cost of Service Regulation

Long and expensive hearings to determine if the utility’s cost forecasts are reasonable. Suspicion that the utility is overstating costs and understating revenues in its forecasts. Little incentive for the utility to cut costs since future savings are passed on to customers. Prone to micro-management of the utility by the regulator

Limited flexibility to respond to changing market conditions.

It is difficult for utility investors to earn a greater than allowed ROE even for superior performance. PBR may be a solution to some of these problems.

93 Approval of Capital Expenditures Part 2

Regulatory Approval of Capital Expenditures An Overview

94 Part 2: Approval of Capital Expenditures Capital Expenditure Justification

Present value (PV) of future revenues is greater than the PV of all costs (capital expenditure, O&M, taxes, etc.)

PV of future savings (capital or O&M) or avoided costs is greater than the PV of all costs.

The capital expenditure is necessary to deal with a safety hazard or system reliability concerns.

The capital expenditure is necessary to replace an obsolete asset which is necessary but no longer serves its purpose.

Signed contracts from customers or shippers requiring new facilities to be constructed.

95 Part 2: Approval of Capital Expenditures Cost Estimates of Capital Expenditures

. Engineering estimates based on similar recent projects . “Courtesy bids” from contractors . Quotes from vendors, preferably more than one . In addition to the direct capital costs the estimate includes: • Environmental costs • Contingency costs • Overhead costs • Regulatory approval costs

96 Part 2: Approval of Capital Expenditures Economic Feasibility

. Project life . Length of contract with customer . Set by regulator in a previous decision . Life of assets, such as gas mains = 40 years . Discount factor . After tax weighted average cost of capital . Net Present Value (“NPV”) . NPV = Present Value (“PV”) of Operating Cash Flow + PV of CCA Tax Shield - PV of Capital Expenditure . Profitability Index (“PI”) . PI = (PV of Operating Cash Flow + PV of CCA Tax shield) / (PV of Capital Expenditures)

97 Part 2: Approval of Capital Expenditures Decision by the Regulator

. The regulator balances the interests of shareholders, current customers, prospective customers, and the society at large. . Generally a capital project will increase rates in the near term with current customers bearing the burden of the higher rates initially to the benefit of future customers. Later in the project life this may reverse with the cross-subsidy from the new customers to current customers. . The regulator determines what level of intergenerational cross-subsidy is not undue. If the level of cross-subsidy is found to be undue, the regulator may not approve the project or may approve it but require that new customers pay a contribution-in-aid-of-construction. . The regulator may have obligations to review any environmental impacts of the project and how they can be mitigated. . The regulator may have obligations to determine if there are any landowner compensation or First Nations issues and if they have been adequately dealt with.

98 Part 2: Approval of Capital Expenditures Addition to Rate Base on Completion of Capital Project

Are actual costs different than forecast?

Explanation of variances Unforeseen events, weather Poor cost estimates

Is the original justification still valid? Re-do economic justification based on actual costs

Potential disallowance of costs if the regulator is unconvinced Not all costs can be added to rate base.

99 Revenue Requirement and Performance Based Regulation Bibliography

. Bonbright, James C.; Danielsen, Albert L.; Kamerschen, David R.; Principles of Public Utility Rates, Second Edition; Public Utility Reports, Inc, Arlington, Virginia, 1988 . Phillips, Charles F. Jr.; The Regulation of Public Utilities – Theory and Practice; Public Utilities Reports; Arlington, Virginia, 1993 . American Gas Association: Gas Rate Fundamentals, Fourth Edition; AGA, Arlington, Virginia, 1987 . Mansell, Robert L.; Church, Jeffrey R.; Traditional and Incentive Regulation - Applications to Natural Gas Pipelines in Canada; The Van Horne Institute for International Transportation and Regulatory Affairs; Calgary, Alberta, 1995 . Morin, Roger A., Regulatory Finance – Utilities’ Cost of Capital; Public Utilities Reports; Arlington, Virginia, 1994 . Schmidt, Michael R.; Performance-Based Ratemaking: Theory and Practice; Pubic Utilities Reports; Vienna, Virginia, 2000 . Lowry, Mark Newton, Kaufmann, Lawrence: Performance Based Regulation of Utilities; 23 Energy L. J. 399 (2002)

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