Earnings Sharing Mechanism

We reject SDG&E's proposed earnings sharing approach. The calibration method could lead to potentially unintended consequences. We reject SDG&E's proposal for several reasons. SDG&E's proposed revenue sharing (or earnings sharing) deadband (100 basis points above and below the authorized ROR) is too wide and the percentage of revenue sharing by ratepayers (a fixed 20% outside the deadband) is too low. There are certain perverse incentives inherent in SDG&E's proposal. SDG&E may have a disincentive beyond a certain point to continue lowering costs if it knows that rates will go down on a permanent basis, since rate reductions will make it more difficult to achieve favorable rates of returns. Even SDG&E concedes that this problem exists and recommends that the Commission allow a lower ratepayer share to avoid this disincentive. (SDG&E's brief, pp. 5-6.)

SDG&E's proposed revenue sharing (or earnings sharing) deadband (100 basis points above and below the authorized ROR) is too wide and the percentage of revenue sharing by ratepayers (a fixed 20% outside the deadband) is too low. The deadband is approximately four times that adopted for Edison (Exhibit 17, p. 8.) or SoCalGas. Gains or losses would have to be relatively large before being shared with customers. (Exhibit 17, p. 9.) As UCAN points out, very little sharing of revenues above the benchmark has occurred under SDG&E's current PBR, due to the 100 basis point deadband and the low percentage of sharing with ratepayers in the first tier. We have made the same finding in Resolution E-3562, issued on December 17, 1998.

The 20% sharing calibration method does not comport with our regulatory goals, because there is not an equitable sharing of benefits. As FEA points out, under the calibration method, decreases in rates one year would have a negative impact on net operating income the following year. This effect could lead to a lowered incentive to continue to reduce costs, which is contrary to a primary goal of PBR regulation.

The 100 basis point deadband is intended to account for the gains and losses associated with routine operations, including sales and throughput fluctuations. (Exhibit 19.) We prefer to implement a narrow deadband and to eliminate the GFCA as discussed above. We adopt a progressive sharing mechanism, similar to the progressive sharing mechanism that is established for SoCalGas. PU Code § 728 imposes a duty upon us to ensure that utility rates are maintained at a level that is just and reasonable. Under incentive regulation, profits and thus rates, must be maintained at reasonable levels. In D.97-07-054 we explained:


"A sharing mechanism is the ultimate `safety net' for ratepayers, as it corrects for the possible adoption of a productivity factor that turns out to be overly conservative, understating the productivity increases which the utility is actually able to achieve. With a sharing mechanism, if the utility attains productivity increases that exceed the adopted productivity factors the resultant profits must be shared with the ratepayers rather than going solely to the utility. ... If the utility is actually able to reap benefits above the level reflected by the adopted productivity factor, it would not be `just and reasonable' to require ratepayers to be satisfied with only the share of savings based upon attaining the productivity estimate made at the outset of the program." (D.97-07-054, mimeo. at p. 24.)

The progressive sharing mechanism protects ratepayers in the event that the adopted productivity factors are low, provides a mechanism to encourage SDG&E to stretch for higher levels of cost savings and revenues, and provides the proper incentives by allowing shareholders to retain progressively greater amounts of its earnings. The easy cost savings provide relatively small shareholder benefit, and the progressive tiers would provide a strong incentive for the utility to strive for more difficult savings. (Exhibit 32, pp. 37-38.)

Exhibits 100 and 101 compared the revenue sharing proposals under several scenarios, using the parameters established by the SDG&E proposed mechanism, the SoCalGas mechanism, and the Edison mechanism. While complex, these comparisons demonstrate that a mechanism modeled after the PBR mechanism adopted for SoCalGas is superior to both the Edison mechanism and the SDG&E proposal. Ratepayers receive much smaller shares and are exposed to downside risk under the SDG&E proposal, compared to the SoCalGas mechanism, while shareholders stand to gain huge benefits under the SDG&E proposal.

ORA suggests that SDG&E's sharable earnings go to reducing transition costs in order to allow ratepayers to share in the "windfall" associated with certain sales increases. However, the Commission rejected this idea previously. Further, SDG&E expects transition costs to end this year (and ORA's method would adjust for more than just sales windfall). We prefer instead to adjust the sharing mechanism to allow ratepayers to capture more of the earnings that would likely come from exogenous sales increases. We will widen the first sharing band from 25 basis points to 50 basis points, where ratepayers receive a higher percentage of sharing. The resulting sharing mechanism would be as follows:

Therefore, we adopt a progressive sharing mechanism with a deadband of 25 basis points above the benchmark rate of return. Shareholders shall receive 100% of earnings up to the level of 25 basis points above the benchmark rate of return and an increasing percentage in steps from 25 up to 300 basis points, above which level shareholders will also receive 100% of the earnings. Similar to our approach in SDG&E's prior base rate PBR mechanism, and as acknowledged by parties in the performance indicator settlement, the calculation of rewards and penalties and the earnings sharing mechanism will be based on a full year for 1999.

Like the mechanism adopted for SoCalGas, we will adopt eight bands between 25 basis points above the benchmark rate of return and 300 basis points above the benchmark rate of return. The first band shall be from 25 to 75 basis points above the benchmark. Shareholders shall receive 25% of the marginal revenues in this band and ratepayers shall receive 75% of the marginal revenues. Each of the next five successive bands shall be 25 basis points wide and increase the incremental share allocated to shareholders by 10% and decrease the incremental share allocated to ratepayers by 10%. The sixth band shall fall between 175 and 200 basis points above the benchmark, with shareholders receiving 75% and ratepayers 25%. The seventh band shall be between 200 and 250 basis points above the benchmark, with shareholders receiving 85% and ratepayers 15%. The eighth band shall be between 250 and 300 basis points above the benchmark, with shareholders receiving 95% and ratepayers 5%. These bands result in sharing amounts that change in step functions, rather than in a linear fashion, as was adopted for Edison.

This progressive sharing mechanism creates a "win-win" for both shareholders and ratepayers. For earnings above 300 basis points above the benchmark, there is unlimited upside potential for SDG&E. As we determined in D.97-07-054:


"Under this system, shareholders may gain up to 68% of the increment up to 300 basis points above the benchmark. However, as shareholder may keep all of the increment above 300 basis points above the benchmark..., it is possible for shareholders to gain significantly more than 68% of the increment. For example, if returns are 400 basis points above the benchmark, shareholders would retain 76% of the increment. This system given an excellent and increasing incentive to shareholders, and is fair to ratepayers who receive both the `consumer dividend' in the productivity formula and a larger share of early (and presumably easier) productivity gains." (D.97-07-054, mimeo. at p. 40.)

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