Questions for consideration in Colorado…
The current level of return is not “necessary to provide service” – Boulder’s 2018 RFIP shows what is available on the open market.
Meanwhile, an excerpt from 2019 document on Managing Stranded Assets and Transitioning Off Gas in California, by EDF and Yale Law Students:
Under the general regulatory compact for utilities in California, the CPUC grants the utility protections from competition for the sale and distribution of gas to customers in its defined service territory. In return, the company is placed under an obligation to serve and is committed to supplying the full quantities demanded by those customers at a price calculated to cover all operating costs plus a “reasonable” return on the capital invested in the enterprise.50
While the Supreme Court has not explicitly affirmed the notion of a regulatory compact 51, it has developed a strong history of case law affirming that utilities operating to provide service and support in the public interest are entitled to fair and reasonable rates with the most notable standards rising out of two Supreme Court cases: Bluefield Water Works & Improvement Co. vs Public Service Commission of West Virginia (1923) 262 U.S. 679 and Federal Power Commission vs. Hope Natural Gas Co. (1944) 320 U.S. 591.
A utility should be able to offer returns to investors comparable to those achieved on alternative investments of comparable risk
The Bluefield decision states that a public utility should be provided an opportunity to earn a return necessary for it to provide utility service. In Bluefield, the Court stated: “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 money necessary for the proper discharge of its public duties.”52
The Hope decision reinforces and expounds upon the Bluefield decision insofar that it emphasizes such returns should be commensurate with returns available on alternate investments of comparable risks. This idea is based on the basic principle in finance that rational investors will only invest in a particular investment opportunity if the expected return on that opportunity is equal to the return investors expect to receive on alternative investments of comparable risk.
As a result of Bluefield and Hope, two standards have emerged related to utility return on investments in the gas system. First, returns should be adequate to enable a utility to attract investors to finance the replacement and expansion of a utility’s facilities to fulfill its public utility service obligation. Second, to attract capital, a utility should be able to offer returns to investors comparable to those achieved on alternative investments of comparable risk. 53
To add clarity to the return on investment question in California, the CPUC adopted and utilized what is known as the prudent manager test. Under this standard, to receive a return on investment, a utility must prove that it acted reasonably, and prudently operated and managed its system. Such a showing must be demonstrated by the utility’s actions, practices, methods, and decisions showing reasonable judgment in light of what it knew or should have known at the time, and that those actions are in the interest of achieving safety, reliability and reasonable cost.54 The prudent manager test is designed so that utility operates in the best interest of its customer and not the shareholder; if the utility acts in a prudent manner, then customers receive the benefit and will pay the costs if there are unanticipated expenditures. The prudent manager test does not demand perfect knowledge nor the benefit of hindsight, but rather reasonable actions given the information available at the time. However, if the utility operates imprudently, perhaps favoring shareholder interests, then shareholders will face the costs for unforeseen circumstances.
49 California Public Utilities Code. (n.d.). PUC § 451.
50 Lesser, J., & Giacchino, L. (2007). Fundamentals of Energy Regulation.
51 Regulatory Assistance Project. (2016). Electricity Regulation in the US: A Guide.
52 Bluefield Water Works & Improvement Co. vs Public Service Commission of West Virginia, 262 (U.S. 679 1923).
53 California Public Utilities Commission. (2017). An Introduction to Utility Cost of Capital.
54 D.87-06-021
summarized in D.18-07-025
To the extent that California has modified the return on investment requirements at the CPUC, the question under the prudent manager test asks whether, and to what extent, gas utilities that purport to be entitled to recovery at the CPUC acted prudently in their behavior. Under the prudent manager test, the utility cannot always predict new policy directions or specific legislation. If the state seeks a new policy direction (decarbonize buildings through electrification) resulting in the gas utilities potentially being forced to retire assets prematurely, the utilities may still be able to recover the value of those assets if it acted prudently. Meaning, the state cannot “cancel” the remaining recovery costs (but not profits) owed to shareholders as long as the utility acted in a prudent manner.
On the flip side, utilities not meeting the prudent manager test will be confronted with a different fate and may be faced with lack of recourse to recover for prior investments in infrastructure, thus resulting in stranded assets. The timing of the utility’s actions vis-à-vis state law being enacted will be a critical threshold for consideration if the continued investment into the asset is prudent and therefore just and reasonable. The establishment of a clear policy signal creates a “bright line” for future investments to be judged against the prudent manager test. The vintage of the investment, those that occurred before or after the bright line, may result in different rate recovery treatment. If after the establishment of the “bright line” the gas utility continues major investments without considering this new policy direction, then there may be new shareholder exposure for acting imprudently.
As a result of the prudent manager test in California dictating utility return on investment, the evolving policy landscape in the energy sector creates market uncertainty which will force investors to demand higher return on equity to make investments in infrastructure – including investments to operate and maintain current infrastructure – less risky. Investors will look at both new state law requiring changes in investment behavior, and the associated investment responses from the utility, from the lens of riskiness. If the state deviates from the “used and useful” and the “prudent manager” standards, it will increase regulatory uncertainty and increase the perception of riskiness associated with new investments. Investors will demand a higher rate of return on future investment, increasing costs to all customers, to overcome the riskiness associated with this uncertainty.
How Does a Gas System Asset become Stranded?
When a prudent investment is made, it is deemed to be “just and reasonable” and therefore eligible for rate recovery. To ensure affordability and full utilization of the asset, the recovery generally is amortized throughout its expected “useful life.” The asset costs are allocated to all customers on a pro-rata basis, and are generally recovered on a volumetric basis. As the number of customers change, the volumetric charge is adjusted so that the utility only recovers the value of the asset (including associated potential profit). If there is a significant increase in the number of customers, the cost per customer declines as long as there is available gas capacity with the asset. If there is a significant decline in the number of customers, the remaining customers’ rate will increase as long as the asset meets the “used and useful” definitions.
In the case of gas infrastructure, particularly on the distribution side for residential and commercial customers, the state approved these assets expecting that they would be needed and would meet the “used and useful” standard throughout their useful lifespan. However, with the policy goal to decarbonize buildings by decreasing gas demand and increasing building electrification, the number of customers demanding gas will decrease, which in turn will reduce the usefulness or that can be recovered from remaining customers’ need for the assets. If the state is successful in its electrification efforts and no more throughput, for example, is needed to be delivered through a given gas line, that line is no longer “used and useful” even if it technically still had the potential for useful life. It is at this point that the asset could be considered “stranded.” This paper conceptually illustrates the issue of stranded assets and their solutions more to demonstrate the mechanics of considering stranded assets and their solutions rather than represent any specific asset or case in practice. The expectation is that the specific values for capital costs and asset profiles will need to be addressed for individual assets as part of a coordinated strategy in the future (more below).
The planned utilization or volume demand (usefulness) of a specific asset or set of assets in the gas system is expressed over the span of its/their intended life. For most gas system assets under normal conditions, the volume or utilization remains the same over time as the investment was made to perform a particular service (i.e. serve the gas demand of a particular community). If however that community decides to shift away from gas system dependency by going all-electric, either over time or all at once, then the volume demand or utilization for that asset declines. Eventually, utilization reaches a threshold level where it is no longer appropriate from an economic or operational perspective 55 to keep the asset in rate base (i.e. the asset is no longer “used and useful”).
(See figure 2 in original document)
Following this, Figure 3 shows the undepreciated costs or unrecovered value of an asset over time. Since electric and gas investments are so capital intensive, the costs of the investment are spread out and recovered over the entire expected useful life of the asset. In its simplest form, the unrecovered value starts at 100% of original investment and declines over time as more of the initial investment value is recovered in rates and the asset depreciates year over year. At the end of its useful life, the unrecovered 55 value should be zero since the asset is paid off and there is no more remaining book value.
Note: Gas systems require both a minimum and a maximum allowable operational pressure, and the graphs presented in Figure 2 and other places are meant to be illustrative. Operational and safety constraints will not be a smooth decline to zero.
Under the baseline conditions, all of the initial investment value was supposed to be recovered from all of the volume and ratepayers the investment was planned for. However, as customers leave the system in an electrification scenario, less utilization/volume is available for recovery and there starts to be a gap (blue arrows) between the planned recovery value and the value that can be recovered from remaining ratepayers. This gap as well as the remaining book value of the asset when it is no longer “used and useful” are known as “stranded value” (orange area) which is unable to be recovered in traditional rate base. The area between when the asset no longer being “used and useful” and the planned end of useful life represents the value that is truly stranded with no customer base to recover from, and the remaining orange area that was planned for but not fully utilized is the cost shift onto the remaining customers.
For illustration purposes, Figure 3 shows all of the gap as stranded value, but in reality at least in the short term, the gas system is robust enough that losing a few customers will not impact the system appreciably. At some point, however, the gap becomes large enough that it needs to be addressed by raising rates for remaining customers or through a different recovery pathway.
Key Areas for Evaluation
While there are many unknowns associated with stranded assets in California, this report highlights five critical areas that California will need to address in order to effect a just and cost-effective transition towards a carbon-free energy system without impeding state goals:
- Valuation of existing assets (including vintage of asset, remaining book value and potential magnitude of stranded asset risk)
- Timeline and strategy for electrification
- Threshold for “Used and Useful”
- Equitable distribution of financial risks associated with the asset
- Appropriate mix of solutions
Understanding these different drivers and leverage points will open pathways forward and suggest what solution sets are available for California. While forward this report is looking at the not yet realized issue of stranded assets, ratepayers and the state as a whole will benefit from as long of a planning horizon as possible to spread out costs, so it is prudent to start exploring these issues as soon as possible. This will likely need to be done through a specific CPUC or legislative pathway as discussed further below.
