The SCC's Last Crack at Dominion before the Rate Freeze

electric_meterby James A. Bacon

The State Corporation Commission is conducting a two-week hearing to determine whether or not Dominion Virginia Power should rebate $66 million in excess profits to ratepayers, as calculated by the SCC staff.

This review of Dominion’s base electric rates (which cover operating costs, not fuel or rate adjustment clauses) will be the last until 2022. Rates will be frozen until that time as part of a legislative deal designed to provide rate stability as Virginia electric utilities implement Clean Power Plan mandates. The Virginian-Pilot explains the issues at stake here.

According to SCC staff calculations, Dominion earned a profit of 11.34% over the two-year period covered, significantly more than the 10% allowed. The SCC maintains that Dominion owes a refund; Dominion contests the SCC’s accounting. A key issue is how to account for the closure of coal ash ponds at three power stations under the threat of litigation from environmental groups.

The SCC also contends that Dominion will generate a return on equity of 12.9% going forward, which could create $300 million in extra profit each year. Thanks to the rate freeze, the SCC cannot adjust Dominion’s base rate or order rebates for six  years. Dominion maintains that the SCC analysis is flawed, assuming no storm or environmental costs going forward.

The accounting issues are all very interesting, but what’s most fascinating to me is the number that’s not discussed — the 10% Return on Equity (ROE). Earning 10% on your money is a pretty good deal if you can get it, especially given the relatively low-risk nature of the business. While Dominion isn’t guaranteed a profit, the rules are structured in such a way as to make it likely that the company will meet the target. No small-time investor can hope for a risk-adjusted return anywhere near that high. And given the prolonged interest rate suppression engineered by the Federal Reserve Bank, even the braniacs administering the nation’s biggest pension funds are adjusting the projected long-term return on their portfolios downward from 8% or thereabouts to 7%.

Dominion’s 10% ROE compares to 9.76% ROE for the electric utility industry as a whole in the 2nd quarter of 2015, according to CSI Market, up from 8.48% the same quarter in 2014. By a different set of metrics published by New York University, the utility industry (electric and gas) was earning 11.0% as of January 2015. That was higher than 32 other industry sectors and lower than 61.

The electric utility business is undergoing massive change. Environmental Protection Agency regulations are pushing the industry into a shift from coal-fired generation to natural gas and renewables, which entails the shuttering of old power plants and rerouting of electricity flows. Meanwhile, renewables and smart grid technologies are challenging the old business model of building large-scale, centralized power plants and giant transmission lines. It is easier than ever for electric customers to generate their own power. Yet everyone needs backup, and someone has to maintain the electric grid.

These are interesting times indeed for the State Corporation Commission: many questions and no easy answers.

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  1. TooManyTaxes Avatar

    A reasonable rate of return is largely dependent on a utility’s financial risk, as exhibited by its capital structure. A high level of debt, which stands before shareowner equity, creates a higher financial risk to shareowners and, hence, a need for a higher rate of return. The other key factor is business risk. All of the factors listed by Jim relate to Dominion’s business risk and cannot be easily ignored. But, at the same time, Dominion has a retail monopoly. I suspect an expert witness could make a decent argument Dominion’s cost of equity is lower than 10%. With the implementation of a multi-year rate freeze, all of Dominion’s rates should be retargeted to earn no more than 10%. In fact, one could make an argument that, to the extent it is expected earnings will easily exceed 10% during the rate freeze, the current rates should be targeted to earn less than 10%, such that earnings need to grow to 10%.

  2. To be fair remember their revenue from electric operations actually declined about 4.2% in 2014 and from overall operations about 5.2%. They also have a 2:1+ debt to equity ratio.

    There will be significant future costs in closing fly ash ponds, getting into renewables, possibly adding to nuclear, and answering the demand to go subgrade.

    True they have a monopoly but they are subject to demands and criticism a non-monopoly isn’t. Witness the recent flaps over the energy share program and the proposed transmission line over the James near Jamestown.

    And no, I’m no longer a shareholder.

    1. John, I’m wondering about the source of those earnings figures? Here is an article about Dominion’s 2014 earnings, with some comments about the SCC case afterwards.

      RICHMOND, Va., Feb. 6, 2015 /PRNewswire/ — Dominion (NYSE: D) today announced operating earnings for the 12 months ended Dec. 31, 2014, of $2.0 billion ($3.43 per share), compared to operating earnings of $1.9 billion ($3.25 per share) for the same period in 2013. Operating earnings are defined as reported earnings, determined in accordance with Generally Accepted Accounting Principles (GAAP), adjusted for certain items.

      Unaudited reported (GAAP) earnings for the 12 months ended Dec. 31, 2014 were $1.3 billion ($2.24 per share), compared with earnings of $1.7 billion ($2.93 per share) for the same period in 2013.

      Dominion uses operating earnings as the primary performance measurement of its earnings guidance and results for public communications with analysts and investors. Dominion also uses operating earnings internally for budgeting, for reporting to the Board of Directors, for the company’s incentive compensation plans and for its targeted dividend payouts and other purposes. Dominion management believes operating earnings provide a more meaningful representation of the company’s fundamental earnings power.

      The principal differences between GAAP earnings and operating earnings for the full year 2014 include a charge associated with Virginia legislation permitting recovery of costs related to the development of a third nuclear unit at North Anna and offshore wind facilities through base rates; call premiums on early debt redemptions associated with our liability management exercise; a charge related to a settlement offer to incur future ash pond closure costs at certain utility generation facilities; and charges related to the repositioning of our Producer Services business.

      So, two of the big accounting issues the SCC is considering are these North Anna costs and the coal ash pond closure costs. Dominion is trying to write off over $300 million of North Anna 3 costs and $95 million in the coal ash costs to reduce its 2014 earnings and thus escape having to make a refund to customers. It is contending that the coal ash closure costs arose in 2014, although the EPA regulations requiring the pond closures were not issued until May 2015. It wants to bring these costs into 2014 and its argument is that on December 30, 2014, it wrote a letter to the Southern Environmental Law Center offering to settle threatened, but not yet filed, litigation involving the ash ponds. It did not actually spend any $$ at all in 2014 to close those ponds.

      On the nuclear costs, the SCC Staff contends that about $60 million of those costs should not be written off because they are for assets that remain in service to North Anna Units 1 and 2 and will remain in service whether or not Virginia Power ever builds North Anna 3.

      With regard to the rate of return, Jim, state law obligates the SCC to set a rate floor that is based on actual earned returns by the big electric utilities operating in the Southeast, like Duke and Southern Company. The 10% figure was set two years ago in the prior earnings review. Dominion now says its true cost of equity is 10.75%. Other parties in the case say the real figure should be 9.25 to 9.50%.

      John, Dominion Virginia Power has a capital structure that is virtually 50% debt and 50% equity. The figure you cite must be for the parent company, Dominion Resources. Also, all those expected costs you cite that Dominion Virginia Power will incur will be recovered in Rate Adjustment Clauses, another unique feature of Virginia state law, so the company is in no risk of losing money on these items. Even its profit (the return on equity) is guaranteed to be recovered in the rate adjustment clauses. (Other than “answering the demand to go subgrade” which I don’t understand what you mean here).

      Lastly, let me put into context that 10% return. Under Virginia law, the electric utility gets to keep all earnings up to, in this case, 10.7% (70 basis points above the “fair rate of return”). Then, for all the earnings above 10.7%, the utility gets to keep 30% of those, while customers get only 70% of these overearnings in refunds. As Jim notes, the SCC Staff says the refund should be about $66 million.

      Your Virginia General Assembly at work……

  3. LarrytheG Avatar

    well there is a problem with risk and monopoly in that your costs are essentially covered even if you make costly financial decisions and that, in turn, can actually incentivize incompetent, financially costly long-term strategic decisions.

    If Kodak were a regulated monopoly – it probably would still be in business and still shielded from innovation and disruption.

    Is the SCC working to protect ratepayers from Kodak-type decisions?

  4. Here is a good VOX article series about utilities. Now I can’t remember if I am just repeating something I already found here on BR. But anyways:

    1. Excellent article. The author addresses the mega-issue of our time: will the electrical grid of the future be centralized or decentralized? If the future is a decentralized, smart grid we need an entirely new regulatory structure and a radically reorganized electric power industry. I’m sure Dominion and AEP are thinking about the issue and positioning themselves to cover their bets, but none of Virginia’s political leaders are.

  5. LtG, I can’t believe you are serious especially with respect to as conservative a company is as Dominion when you state: “… can actually incentivize incompetent, financially costly long-term strategic decisions”.

    1. LarrytheG Avatar

      “incompetent” was a poorly-chosen word. What I’m saying is that how a regulated utility strategically plans basically presumes that the regulators will keep them whole even if they end up on the wrong side of technological evolution and that’s not necessarily in the best interests of rate payers nor investors.

      the referenced article discusses exactly what I’m talking about – that huge changes are afoot and the utilities have feet of clay.

      so my assertion is – that there IS opportunity for investors and benefits for consumers if a company exploits evolving technologies rather than having the regulator protect them from the inevitable changes.

      Not changing, not adapting, is available as an option to regulated monopolies but it’s not a benefit, it’s an achilles heel.

      There is a company that is “competently” doing this – that has evolved as a company as technology has. That company is GE.

  6. Rowinguy, I got the numbers from Dominion’s Investors page on their official web site. I have to believe their veracity although I did not look at their 10K.

  7. Rowinguy, I hit enter too fast. The numbers were “corporate” wherein 48% is generation and 22% VEP (total 70%). All other is just 30%.

    1. TooManyTaxes Avatar

      Different businesses have different capital costs. My experience in utility regulation suggests the risks of generation and capital costs for generation might be someone higher than for distribution, which should be fairly low given interest rate costs and risk. Moreover, if the VSCC would adopt a requirement for anyone connected to the grid to pay something towards standby connection costs, the business risk would be much lower.

      Any risks for unregulated businesses should be ignored for setting allowed returns on regulated businesses. And a fair assignment of common costs (overheads) should be made to the unregulated businesses.

  8. LarrytheG Avatar

    Here’s the follow-on VOX article:

    Reimagining electric utilities for the 21st century

    it is pretty good but I do not understand in a distributed business model – who in the group of players “owns” reliability.

    I do not think more open markets – puts a value on reliability but I could be not thinking this through.

    How to markets ensure 24/7 availability of a product – like electricity?

    or is the requirement for 24/7 availability – an artificial and unrealistic expectation of “markets”?

    I’m quite sure if you tell any of the players in a distributed model that 24/7 is a requirement – they’re going to say that they, in turn, have requirements from those who want 24/7 reliability. It’s going to be yet another “service” – with a price and if you try to do it with the grid- the folks who will be accountable – will demand a vertically integrated monopoly status.

    how have I got this wrong?

    1. The Load Serving Entity (LSE) is the one that is responsible for 24/7 reliability. That is the organization sending you the bill. In this discussion that is Dominion Virginia Power.

      For much of the history of the utility business that reliability was best achieved at the lowest cost by allowing “natural monopolies”. Over time the federal government allowed for the development of a wholesale generation market which allowed for “merchant generators” to provide power to utilities that they ultimately supplied to their customers. In deregulated states, this is the norm. In regulated states, utilities typically provide most of their power from their own units with additional capacity obtained from a regional “power pool” such as PJM our Independent System Operator (ISO). At one time Virginia was a deregulated state, but it has since changed back. (Can anyone provide me with sources about why that changed? Perhaps it was Enron and the California mess that caused deregulation to come to a halt.)

      Think of a utility as three primary segments: generation, transmission and distribution. In the 20th century most felt that it would be best to combine all of these activities under one company (vertical integration). Samuel Insull was the innovator who first developed the modern utility. He operated the Chicago Edison Company which competed with numerous other companies to provide electricity to customers in the 1880’s to supply electricity to customers in Chicago. In the 1920’s he was the first to convince the politicians that it would be more efficient to have one company serve everyone rather than have many different companies running wires all over town. In return, a regulatory body was established to set fair prices.

      He also was the first to use a holding company structure for utilities. Unfortunately, it all collapsed for him in the early thirties. He fled the country but was arrested and brought back to face charges of double dealing between his various companies to increase prices.

      The main emphasis was for utilities to build ever larger facilities and the economies of scale kept prices low. This allowed volumetric prices (cents per kilowatt-hour) to properly compensate utilities and their shareholders.

      Things started to unravel for several reasons. Bigger stopped being cheaper and in many cases the economies of scale no longer yielded the same benefits. As a result of higher prices, demand stopped rising and energy efficiency decoupled rising GDP from increased energy use. So volumetric pricing no longer was a reliable way to pay the utilities (enter the special rate riders, etc.). As energy use flattened out, building plants in 1000 MW chunks became a poor way of following load growth. Utilities either had too much or too little capacity.

      In the 21st century we saw the value of information. Most of the utility infrastructure is still electromechanical, with information coming in infrequently or not at all. Many meters still require a person to read them and even the so called “smart meters” rely on old technology cellular “mesh” networks which have delays and dropouts and no real-time communication back to the customer about their energy usage.

      For over a hundred years, the central station power plant model gave us the reliability we desired. Both utilities and regulators embraced this model. Innovation was stifled but the lights stayed on (usually). But the introduction of information technology and distributed generation has altered the playing field. The assumptions that have shaped the industry are no longer true. The barriers to entry in developing generation are no longer high. Customers can now generate their own power at a competitive price and transaction costs are significantly declining. The justifications for vertical integration have disappeared. In fact they may be adding to costs.

      In looking at the three main segments we can see how things have changed:

      Generation – distributed, customer and third-party owned generation is cost competitive with or cheaper than utility owned generation and can be more reliable. With the established ISO model (such as PJM) there is no reason not to open up the provision of energy to all players, subject to the discipline of the marketplace (and certain operating standards).

      Transmission – PJM is also the Regional Transmission Operator (RTO) in our region and is responsible for the reliable operation of our regional transmission network. PJM does the planning and coordination of the network whose pieces are owned by various utilities. FERC and the SCC set the rates of return. This system has been working for some time and is continually optimized. New transmission is expensive and difficult to site, but distributed generation will reduce the need for additional long runs of new transmission.

      Distribution – this is the happening place for innovation nowadays – the so called “Grid Edge”. Those who see the possibilities for a more modern energy system are focusing here. They liken this to the internet which provides freedom of access to both providers and users. Discussions of new utility and regulatory models (such as the REV process in NY) see this as the appropriate place for one entity (the Distribution System Operator – DSO) to provide equal access for the flow of energy and information to a wide range of providers: generators, energy services companies and customers (for efficiency, usage information, and selling back to the grid).

      If we choose to continue our business as usual approach, the utilities might remain healthy (assuming the right choices are made), but our state economy will suffer. If we adapt slightly, but still allow the utilities to compete at all levels we might have a system with more energy sources (renewables), but the utilities could use their size and political clout to shut out other competitors and keep prices higher than they otherwise would be. Or we could choose the well-being of all of our citizens and design a modern regulatory and energy system that would produce a healthy utility and a vibrant state economy.

      The best way to make energy inexpensive and provide jobs is to emphasize energy efficiency. This lowers customers bills and requires less generation (plus deals with CO2). Utilities usually do not approach efficiency aggressively (not like an ESCo would) because it reduces their revenues. As long as Dominion has DVP as a subsidiary they will want to maximize its cash producing abilities to support their unregulated subsidiaries. Perhaps the holding company model is also an artifact of the past.

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