Issue 2: How should the Commission set revenue requirements?

Once we determine that the use of revenue requirements and balancing accounts offer the best way of complying with § 739.10, our task becomes one of setting this requirement. For the year 2002, even though all parties support the establishment of a revenue requirement and balancing account, the parties hold very different views on how to set the revenue requirement. For the period from June 14, 2001 to December 31, 2001, the disagreement between parties is even greater. We briefly review the position of each party.

Edison proposes very similar processes to set revenue requirements for both 2001 and 2002. For 2001, Edison recommends that the Commission apply the existing PBR formula, i.e. the change in the CPI less the productivity factor of 1.6% to the recorded 2000 PBR revenues. Edison also states that the revenue requirement should also provide for a forecast customer growth in 2001, with an allowance of $657 per new customer. For 2002, Edison also proposes that the Commission escalate its proposed 2001 revenue requirement by the change in the CPI minus the productivity factor of 1.6% and add an allowance for forecast customer growth of $669 per new customer.

Concerning 2001, ORA argues that the Commission need not set a revenue requirement because "the record does not demonstrate that an undercollection will occur in the absence of such an adjustment."7 Therefore, in ORA's view, the Commission need not set a revenue requirement for 2001, but simply leave the current price cap mechanism in place. ORA believes that for 2001, Edison's estimated distribution expenditures and deferred investments have dropped $170 million more than its revenues, and that establishing the revenue index that Edison requests would result in overearnings. Moreover, ORA notes that adjustments will not have any effect on Edison's 2001 conservation actions, which are already complete.

ORA takes a different approach to establishing a revenue requirement for 2002. ORA recommends that the Commission adopt the recorded 2000 revenues of Edison as the revenue requirement for 2002. ORA supports its position by noting Edison's $237 million reduction in capital expenditures and operations and maintenance expenditures for 2001. ORA further notes that ORA has no firm information on the amount of capital investment program for 2002 that is embedded in current rates.

TURN cites ORA's testimony and states that it supports it. Further, TURN believes that the decrease in expenditures identified by ORA should affect revenue requirements in both 2001 and 2002.8

For the year 2001, we find a very complex situation. Edison's revenues were greatly affected by the efforts of its customers to conserve. Edison shows that without implementing a revenue balancing account effective June 14, 2001 Edison's earned return will fall far below its authorized level.9 Edison's costs, however, were greatly affected by the steps Edison took to avert bankruptcy. As ORA has pointed out, the steps to avert bankruptcy included both reductions in operations and maintenance spending, and the deferral of planned infrastructure investments. Nevertheless, despite these reductions, we find that without some adjustment in revenues for 2001, a material undercollection will result.

Moreover, ABX1-29 became law on April 12, 2001 as an urgency measure effective immediately. Pursuant to the newly codified § 739.10, D. 01-06-038 established a memorandum account for distribution expenses and revenues as of June 14, 2001. Thus, the legislation that has guided our action has been in effect for only part of this year, and June 14, 2001 starts the period of company operations that are subject to our review.

Since Edison cut operating and maintenance expenditures and since ABX1-29 does not cover all of 2001, it would be inappropriate to apply the formula that we have adopted to establish a 2002 revenue requirement to 2001 without any adjustments. Therefore, we will establish a revenue requirement to cover the period from June 14, 2001 to the end of the year that reflects the standard movement of the PBR index, new customers, and Edison's one-time reductions in expenditures. This action is necessary to avoid material under collection of revenues.

On the other hand, Edison's deferral of capital expenditures should not affect the setting of a revenue requirement because during this period the distribution rate base continued to grow and because California's infrastructure will soon require Edison to make the deferred investments.

Taking these factors into account, a revenue requirement for period from June 14, 2001 to December 31, 2001 should include the following items:


    1. A base revenue requirement that equals the year 2000 historic revenues escalated by the CPI-X formula and prorated to cover only the period from June 14, 2001 to the end of 2001.


    2. A customer growth element that equals $657 times the number of new customers added in 2001, but prorated to cover only the period from June 14, 2001 to the end of the year.


    3. A reduction to reflect Edison's decrease in operations and maintenance expenditures. In particular, since Edison reduced its operations and maintenance spending by $28 million over the year 2001, we will reduce the post-June 14 revenue requirement by $15.17 million using the standard prorating approach to reflect the expenditures avoided from June 14 to the end of the year.

Setting the revenue requirement for June 14 until the end of 2001 in this matter determines a reasonable revenue requirement for Edison and ensures that errors in estimates of sales do not result in material over- or undercollections during this period.10

Turning now to the year 2002, Edison's proposal escalates the 2000 revenue requirement by applying the PBR index mechanism for two years plus an allowance based on a forecast of new customers added. We find Edison's proposal to calculate a revenue requirement reasonable for two reasons. First, the heart of the index mechanism is the CPI-X formula that the Commission has repeatedly used during the course of this PBR to ensure the reasonableness of rates. Absent any evidence to the contrary, it is reasonable to continue to use a productivity offset of 1.6%. Second, adding a revenue requirement to compensate Edison for the costs of new customers is reasonable because under the revenue requirement and the balancing account approach, increases in sales by Edison will not lead to increases in revenues. Therefore, it is reasonable to make a specific revenue requirement adjustment for customer growth. Finally the institution of a balancing account tied to an adopted revenue requirement essentially restores the "Energy Rate Adjustment Mechanism (ERAM)" that was in place before the Commission's adoption of the PBR regulations. Like the ERAM, this proposed balancing account provides utilities with protection from all revenue reductions that arise from conservation while ensuring that the utility obtains adequate but not excessive revenues.

In contrast, ORA's recommendation to use the recorded year 2000 revenues to set a 2002 revenue requirement is not reasonable. First, it is clear from the evidence that Edison's reduction of operating and maintenance expenditures is only a temporary measure for 2001. Indeed, the reduction in both operational and capital spending was a response to a financial crisis and cannot reasonably become the basis for setting a revenue requirement in both 2002 and 2001. Second, the alleged $260 million reduction in distribution costs lumps together capital expenditures with operating expenses. This treatment of delayed capital investments as if they were expenditure reductions violates basic principles of cost-of-service ratemaking in which capital investments result in a revenue requirement that reflects a return on rate base and depreciation, not treatment as a one-time expense. Moreover, this policy also fails to note that Edison's weighted-average rate base continues to increase. Under traditional ratemaking, this warrants an increase in revenue requirement. In particular, for the twelve months ending June 30, 2001, rate base increased $130 million from the end of year 2000 recorded value.11 Third, the reductions in capital expenditures identified by ORA in 2001 resulted from the deferral of infrastructure replacement previously planned.12 In order to avoid degradation and to maintain reliability, we find that Edison will need to resume capital expenditures. Indeed, a major purpose of the Commission's settlement with Edison is to restore its ability to "provide reliable electric service as a state regulated utility as it has in the past."13 These three considerations make it clear that setting the 2002 revenue requirement at the year 2000 level is unreasonable.

We find that it is important that the Commission set Edison's 2002 distribution revenue requirement at a level that enables it to pursue normal operations. We believe that the best way to determine such a figure is to use a two-step process applied to the recorded year 2000 revenues to derive a revenue requirement for 2002. The revenue requirement should be calculated using the two-step procedure that follows:

Step 1 - Calculate a 2001 "annualized revenue requirement ":

$Annualized Rev. Req.2001=(1+(_CPI2001-X2001)) x ($ Revenues2000) + $657 x (Number of New
Customers2001)

Step 2 - Calculate a 2002 Revenue Requirement:

$Revenue Requirement2002=(1+(_CPI2002-X2002)) x ($Annualized Rev. Req.2001) +$669 x (Number of New
Customers2002)

Step 1 creates an intermediate number that does not correspond to an adopted revenue requirement, but this intermediate value is needed to calculate the revenue requirement for the year 2002.14 This intermediate number escalates the year 2000 revenues via the CPI-X formula and adds a revenue requirement to reflect new customers added in 2001, with a revenue requirement value of $657 per new customer.15

Step 2 escalates the intermediate number via the CPI-X formula and adds in an incremental revenue requirement to reflect new customers added in 2002, with an added revenue requirement value of $66916 per new customer. The result is the revenue requirement that we adopt for 2002.17

In conclusion, the methodology that we adopt to conform our PBR program to § 739.10 will result in reasonable revenue requirement increases that will enable Edison to recover its costs of distributing electricity and to make necessary investments in infrastructure.

7 ORA, Opening Brief, p. 8. 8 TURN, Opening Brief, p. 1. 9 Edison, Reply Brief, p. 7; Edison, Opening Brief, p. 21; Exhibit 2-A, p. 1. 10 There is evidence in the record that allows us to estimate both the effects of continuing the current mechanism unchanged and the actions we take today on electricity prices for 2001. If the Commission takes no action concerning 2001, Exhibit 2a indicates that the projected Edison PBR distribution revenues for 2001 will equal $1.966 billion, which is less than the $2.016 in distribution revenues that Edison recorded in 2000. Under the methodology adopted in this proceeding and using the information filed in Edison's workpapers and Appendix B and reducing the resulting figure by the $15.17 million in avoided maintenance costs, we estimate that Edison's distribution revenue requirement for 2001 will equal approximately 2.008 billion, which is $8 million less than that recorded in 2000. Alternatively, this is $42 million or 2.1% higher than what Edison would likely receive under the policy of making no adjustments, which is the policy promoted by ORA. Concerning the final impact on rates, since distribution costs currently total less than 25% of the cost of electricity delivered to the customer, under the adopted methodology, the cost of electricity would rise approximately 0.5% (.25 x 2.1%). 11 Exhibit 2-A, p. 1. Although the increasing rate base cannot be sustained without continued investment, the fact that ratebase increased in 2001 is not disputed. 12 Tr. 29/3495 13 C.00-12056-RSWL-Edison v. Lynch, et. al. - Final Settlement. 14 Please note that this intermediate number is not the revenue requirement formula that we adopted above for 2001. We find that it is not reasonable to use the adopted 2001 revenue requirement in this new formula for two reasons. First, the adopted 2001 revenue requirement formula includes an offset that reflects the deferral of operating maintenance under taken by Edison to avoid bankruptcy. Incorporating such a reduction into the formula for calculating a revenue requirement for 2002 would lock in an unreasonably low level of infrastructure maintenance. Second, our 2001 formula also includes only those new customer costs attributable to the post-June 14th time period. Incorporating such a reduction into the formula for 2002 would fail to include the ongoing costs that arise from the additions of these customers - which will be paid throughout all of 2002. Failing to include these costs would similarly lock in a revenue requirement that was too low. 15 The figure of $657 per customer is derived from the $770 per new customer discussed in D.96-09-029 on page 31. The $657 value arises from removing expenses not associated with electric distribution. In this case, these are principally transmission expenses. 16 The 2002 figure of $669 reflects an escalation of the $657 figure for 2001 by the CPI-X formula. 17 Concerning the year 2002, if customer growth continues at approximately 61,000 customers per year and CPI-X2002 equals 1.76%, then the adopted methodology would yield a revenue requirement of $2.161 billion. This amount is approximately $153 million higher than that which will result from the adopted 2001 revenue requirement formula, which will likely lead to a $2.008 billion revenue requirement. This is an increase of 7.6% in the distribution revenue requirement. Once again, since distribution costs equal approximately 25% of the cost of electricity, the affect on prices will be approximately 1.9% (.25 x 7.6%). Modest increases in electricity sales, most likely through the addition of new customers, will further decrease the impact on prices of the adopted revenue requirement.

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