2. Background on QF Issues

With regard to the determination of avoided cost for purposes of QF pricing, we note here that QFs are subject to a number of federal and state legal requirements. In Decision (D.) 02-08-071, we set forth a brief overview of these requirements germane to QFs, which we find most useful to restate at this juncture:

Federal Law

The Public Utility Regulatory Policy Act of 1978 (PURPA), as codified in the United States Codes (USC) at 16 U.S.C. § 824a-3, requires the Federal Energy Regulatory Commission (FERC) to prescribe and periodically revise rules that "require electric utilities to offer to . . . (2) purchase electric energy from [QFs]."⁴ Rates paid by utilities for purchases of electric energy may not exceed "the incremental cost to the electric utility of alternative electric energy."⁵ PURPA defines incremental cost with respect to electric energy purchased from a QF as "the cost to the electric utility of the electric energy which, but for the purchases from such [QF] such utility would generate or purchase from another source."⁶

The FERC has complied with its PURPA obligation to "prescribe rules" by promulgating in the Code of Federal Regulations (CFR) 18 CFR § 292 et seq. The rules set forth therein provide in pertinent part that: "each electric utility shall purchase, in accordance with [18 CFR] § 292.304, any energy and capacity which is made available from a [QF] . . . "⁷ §292.304, entitled "rates for purchases," establishes a pricing regime for purchases by IOUs from QFs. Consistent with 18 U.S.C. § 824a-3, § 292.304(a)(1) requires first that "rates for purchases shall: (i) [b]e just and reasonable to the electric consumer of the electric utility and in the public interest. . . ."⁸ While rates may not exceed avoided costs,⁹ rates will satisfy the "just and reasonable" and non-discrimination requirements of § 292.304(a) "if the rate equals the avoided costs determined after consideration of the factors set forth in paragraph (e) of this section."¹⁰ Paragraph (e) provides a laundry list of factors to be taken into account in determining avoided costs, "to the extent practicable." These are elaborated upon below.

The FERC's rules require that standard rates for purchases be put into effect only "for purchases from qualifying facilities with a design capacity of 100 kilowatts or less."¹¹ Whether to implement standard rates for qualifying facilities "with a design capacity of more than 100 kilowatts" is discretionary.¹²

Purchases from "as-available" QFs are subject to special pricing rules. QFs may provide energy as it is available, "in which case the rates for such purchases shall be based on the purchasing utility's avoided costs calculated at the time of delivery."¹³ QFs providing electric energy or capacity under a contract are to be paid either avoided costs at the time of delivery, or avoided costs calculated at the time the QF entered the contract, whichever the QF chooses at the time it enters the contract.¹⁴

State Law

PURPA also imposed an obligation on this Commission. "[E]ach State regulatory authority shall . . . implement [the FERC QF rules] for each electric utility for which it has ratemaking authority."¹⁵ It falls to this Commission to implement the pricing provisions just elaborated. This Commission has a lengthy history of setting QF prices, which we need not elaborate here.

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In D.96-10-036, the Commission undertook to bring its QF implementation practices into the restructured world. Of particular significance to the issues in this docket, the Commission terminated as of January 1, 1998 any requirement that utilities enter SO1 or SO3 contracts with QFs. "QFs with design capacity 100 kW or less may negotiate non-standard agreements based upon the standard rates applicable to grand fathered USO1's and tariff Rule 21."¹⁶

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For "grandfathered" QFs, i.e., those with contracts entered prior to December 20, 1995, pricing would continue to be based on the contract terms, which almost universally set price at "short run avoided cost." (SRAC.) With respect to SRAC, the Legislature took a hand when it enacted Public Utilities Code Section 390 as part of AB 1890. Generally speaking, Public Utilities Code Section 390 sets out components (most significantly, gas costs) to use in setting SRAC, pending a shift to the use of PX prices to establish SRAC. The Commission implemented R.99-11-022 to work out the particulars of SRAC pricing under Public Utilities Code Section 390. Events overtook this rulemaking, and the demise of the PX in January 2001 ended any chance of a universal migration of QFs to PX-based SRAC pricing. At present, SRAC is set using a formula based on gas prices.¹⁷ Each utility has detailed QF pricing information (current and historical) on its respective Website.¹⁸

In both D.03-12-062 and D.04-01-050, we discussed the need to review the pricing methodology applicable to QFs. In D.04-01-050, we noted the definition of avoided costs, applicable to QFs, as set forth by FERC:

"`Avoided costs' is defined as `the incremental costs to an electric utility of electric energy or capacity or both which, but for the purchase from the qualifying facility or qualifying facilities, such utility would generate itself or purchase from another source.'" (18 C.F.R. § 292.101(b)(6) (2003).)

In regard to these PURPA mandates, we noted in D.04-01-050 that "as FERC itself has recognized, we must balance the PURPA mandate that utilities are to purchase energy and capacity from QFs with the overarching requirement that electric utilities may only charge just and reasonable rates for the power they supply to their customers" (p. 152).

Moreover, in D.03-12-062, we noted that it is important that the current methodologies to establish QF pricing be modified and that the Commission will be moving forward to examine and propose appropriate modifications to the QF pricing methodology in the near future, a point that we reiterated in D.04-01-050. D.04-01-050 also concluded that certain renewed contracts would be subject to subsequent changes in pricing methodologies that may result from this rulemaking.

With regard to upcoming workshops on avoided costs and QF pricing described in Section 4 below, parties are encouraged to carefully review existing avoided cost pricing methodologies applicable to QFs which determine (1) short run avoided cost (SRAC) energy payments, and (2) As-Delivered Capacity Prices. Parties should comment on the need for, and difference between, short-run and long-run methodologies or considerations thereof, as well as any appropriate methodological (and thus appropriate pricing) differences between firm and as-available power. Parties should also concisely address any practical constraints that arise from any associated legal requirements and the degree of latitude and discretion available to the Commission under the circumstances.

In considering these factors, we direct the parties' attention to the Commission staff's May 1, 2001, Final Report on Workshop to Discuss Alternative Gas Indices.¹⁹ This Report is the outcome of a workshop that staff held on April 19, 2001 regarding the gas index to be used in calculating SRAC payments to QFs. This Report summarizes the written comments that were filed prior to the workshop, as well as the facts and discussion that came out of the workshop.

We also wish to remind the parties of what we noted in D.03-12-062 with regard to the some of the problems with the current SRAC pricing formula:

In fact, Section 390 is now something of an artifact of the AB 1890 electric restructuring landscape, for the reason that Section 390 can never be fully implemented in accordance with the provisions set forth in Section 390(c) due to the demise of the PX.

As the foregoing discussion demonstrates, the SRAC energy pricing formula is now out-of-date. The capacity pricing component of the SRAC formula is also problematic, because the QFs receive capacity payments in addition to energy payments. With SRAC energy prices that can now be above market prices, the additional capacity payments that QFs receive could compound any inequity to the utilities and their ratepayers of the current SRAC pricing formula.

We intend to carefully examine these points within the context of this proceeding, and we shall carefully consider how to modify the SRAC methodology to assure that it results in just and reasonable rates. If the outcome of this proceeding leads us to conclude that the formula mandated by Section 390 cannot allow us to assure just and reasonable rates for the power provided by QFs, we put the parties on notice that we shall seek appropriate legislative changes to Section 390 that will remedy this anomaly.