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Brown, Williams, Moorhead & Quinn, Inc.

Developing fully allocated rate models requires that all components of the cost of service come together into one set of interrelated calculations. It is at its core a five step process. Confirming rate base is the first step in the process, which sets the stage for return on capital through rate of return and return of capital through depreciation. Investigating operating expenses is the second, which ensures legitimate daily operations expenses are recouped through the tariff rates. Third, the estimation of depreciation accruals determines the pace of recovery of the original costs. Toward the end of the process the weighted average income tax rate derives the allowance for income tax liability for the cost of service. Brown Williams works with scores of pipelines to ensure that the total revenue requirement is just and reasonable, and that ratepayers cover their respective cost burdens.

Cost Evaluation

Developing fully allocated rate models requires that all components of the cost of service come together into one set of interrelated calculations. Assessing the components of rate base is the first step in the process, which can significantly affect the ultimate tariff rates. Operating expenses cover a wide array of otherwise ordinary business expenses within which may lurk a substantial level of unjustifiable costs. Furthermore, the allocation of those costs between jurisdictional and non-jurisdictional operating divisions of the utility, as well as the geographic segments of the jurisdictional divisions, entails a careful analysis of KN Formula weighting scheme for cost sharing. Similarly, the Massachusetts Formula for allocating corporate overheads to the operating units should be examined carefully to ensure all operating units carry their fair share of the burdens. Toward the end of the process the weighted average income tax rate derives the allowance for income tax liability for the cost of service. Brown Williams is the nationally renowned cost- of-service consulting firm serving scores of pipelines through to ensure that the total revenue requirement is just and reasonable, and that ratepayers cover their respective cost burdens.

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Cost of Capital

Under cost-of-service ratemaking, pipelines are given the opportunity to earn a reasonable return on their investment. The return includes an amount which provides a return on the pipeline’s equity investment, as well as including an amount to recover the interest on a pipeline’s debt. The overall rate of return is computed as a function of the following three components: the capitalization ratio of the pipeline, the cost of debt, and the allowed rate of return on the pipeline’s preferred and common equity. Brown Williams employs specialized consultants who have extensive experience with the financial parameters, methodologies and regulatory policies involved in determining costs of capital, including appropriate returns on equity for energy companies given the level of operating and financial risk associated with comparable companies and the particular subject company for the cost of capital study.

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Cost of Service Rates Manual

While much has changed at the Federal Energy Regulatory Commission (FERC) over the past decades with respect to regulation of the interstate natural gas pipeline industry, cost-of-service ratemaking has remained a constant.

Despite its willingness to rely on market forces to address many issues in the industry, FERC still relies on cost-of-service principles in litigated section 4 rate cases (both full and limited cases) to set just and reasonable rates for pipeline services.

The industry the Commission regulates is very dynamic and the Commission is studying whether traditional cost-of-service ratemaking is the best way to set rates for pipeline services in the future.  The Cost of Service Manual is intended to be an introduction to cost-of-service ratemaking which remains the primary methodology used by the Commission to establish just and reasonable rates.

There are essentially 5 steps involved in cost-of-service ratemaking:

  1. Establishing a revenue requirement, or cost-of-service
  2. Functionalizing the cost-of-service
  3. Cost Classification
  4. Cost Allocation
  5. Rate Design

Each of these steps are explained in further detail and show examples of each step by using an illustrative pipeline.

BWMQ believes this document will prove invaluable to company analysts that are preparing to litigate section 4 rate cases at the FERC.


If you would like to obtain a subscription to this manual or would like further information, contact:

Barry E. Sullivan, President of BWMQ at 202-775-8994.

 

 

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Depreciation

The return of investment (as opposed to profits from the investment) over the estimated useful life of the facilities is accomplished through the art of depreciation. Typically, straight-line depreciation is the preferred method for computing the investment via depreciation rate. Behind this line item lies a complex world of data analysis, resource forecasting, mortality pattern estimation, salvage and cost of removal estimates, and analyst value judgment. Depreciation affects the entity’s cash flows, timing of investment recovery, risk, property and income taxes, rate base and the net present value of energy assets. Brown Williams has the specialized software tools, energy resource information, experience and knowledge to perform these studies for its clients.

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Functionalization

Functionalizing the cost-of-service is done by directly assigning or allocating operation and maintenance expenses and other costs incurred by the company to the two primary functions, Storage and Transmission. While O&M expenses are generally directly assigned, A&G expenses often cannot be easily identified with a particular function and are allocated between the functions using the “K-N Method.” Other cost of service elements, like depreciation, taxes, income taxes, return, and revenue credits are functionalized in various ways. Brown William helps clients functionalize costs accurately to ensure adequate and proper cost recovery, as well as move through the FERC settlement process smoothly and efficiently.

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Operating Expenses

A pipeline’s cost of operating and maintaining its utility plant and equipment is always subject to verification in FERC rate cases. These expenses include salaries and wages, office supplies, outside services, regulatory commission expenses, rents and general plant maintenance. In some cases the parent company or main office may assign overhead expenses to pipeline, necessitating the use of the Massachusetts Formula to determine the proper intercompany overhead allocations. Proof of base period and test period cost incurrence for both Operating and Maintenance (O&M) and Administrative and General (A&G) expenses is a standard element of rates analysis. Brown Williams’ experts lead its clients through this process to lay a solid foundation for the overall rate case presentation.

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Rate Base

The rate base represents the total investment of the pipeline and is used to compute the return component of the cost-of-service, which permits the pipeline to earn a return on its investment as well as to calculate the depreciation expense included in the cost-of-service, which permits the pipeline to recover its investment. Rate base also includes the Allowance for Funds Used During Construction, Accumulated Deferred Income Taxes, and working capital. Challenges to rate base on the grounds of test period deadlines or ‘used and useful’ prudency questions are not uncommon. Acquisition Adjustments are another increasingly familiar rate base issue. Brown Williams’ accounting and cost of service staff make sure the t’s are crossed and the i’s dotted to ensure the full recovery of and on investment.

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