Evaluation of San Diego Gas and Electric Company's PTY ... › files › pdf › tty_cpuc_sdge... · My resume is attached to this testimony as ATTACHMENT A. II. INTRODUCTION AND

Prepared Testimony of Scott Hempling on behalf of Utility Consumers Action Network Page 1CPUC Application No. 10-12-005 (San Diego Gas and Electric General Rate Case)

Evaluation of San Diego Gas and Electric Company's PTY Incentive Proposals

Prepared testimony ofScott Hempling

417 St. Lawrence Dr Silver Spring, Maryland 20901

on behalf ofUtility Consumers Action Network

California Public Utilities Commission Application 10-12-005

September 22, 2011


Table of Contents

I. QUALIFICATIONS ............................................................................................................................ 4

II. INTRODUCTION AND OVERVIEW .............................................................................................. 6

III. PRINCIPLES: TO ENFORCE THE UTILITY’S OBLIGATION TO SERVE, THE

COMMISSION MUST CONDITION UTILITY COMPENSATION ON RELEVANT

PERFORMANCE......................................................................................................................................... 9

IV. APPLICATION: SDG&E’S PROPOSAL DOES NOT APPROPRIATELY CONDITION

THE UTILITY’S COMPENSATION ON ITS PERFORMANCE.........................................................12

A. THE FOCUS ON COST-CUTTING IS NOT ALIGNED WITH PERFORMANCE ...............................................14

1. Cost-cutting is not a proxy for performance. ..................................................... 14

2. The proposal creates a risk that SDG&E will favor quick cost cuts over long-

term performance improvement................................................................................ 17

3. The proposed distinction between controllable and uncontrollable costs is not

supported by evidence............................................................................................... 19

4. SDG&E's knowledge advantage diminishes its accountability to the

Commission .............................................................................................................. 21

B. THE INCENTIVES PRODUCE SUPRA-NORMAL RETURNS WITHOUT A COMMITMENT TO SUPRA-NORMAL

PERFORMANCE...........................................................................................................................................25

1. The proposed supra-normal return is not calibrated to the value of the

performance produced .............................................................................................. 25

2. The proposed supra-normal return is not comparable to the return available from

a competitive market................................................................................................. 28

3. The proposed supra-normal returns do not meet the test of necessity ............... 31

4. SDG&E’s insistence on extracting high returns from choice-less customers,

without connection to performance, is inconsistent with its obligation to serve ...... 35

C. THE FOCUS ON SHAREHOLDER RETURNS IS CONSISTENT WITH NEITHER A PUBLIC-SPIRITED

CORPORATE CULTURE NOR EMPLOYEE PRODUCTIVITY...............................................................................37

1. None of the proposed "incentives" for productivity go to the real people actually

responsible for productivity ...................................................................................... 37


2. Commission approval would amount to supporting a company culture that

insists on "extra" compensation before fulfilling its obligation to serve .................. 39

D. SUPRA-NORMAL RETURNS CAN BE JUST AND REASONABLE, UNDER CONDITIONS THAT SDG&E

FAILS TO MEET ..........................................................................................................................................41

V. QUESTIONS FOR THE COMMISSION TO CONSIDER, IN EVALUATING THE

CURRENT RELATIONSHIP BETWEEN COMPENSATION AND PERFORMANCE...................44

A. HOW DOES A COMMISSION PICK THE QUALITY LEVEL THAT DEFINES THE UTILITY'S OBLIGATION TO

SERVE?.......................................................................................................................................................44

B. HOW MIGHT WE REDUCE THE TIME HORIZON CONFLICTS BETWEEN RATE CASES AND PRODUCTIVITY

INVESTMENTS?...........................................................................................................................................47

C. DO THE EXISTING MULTIPLE MECHANISMS FOR STANDARD-SETTING AND COST RECOVERY WORK

WELL TOGETHER? ......................................................................................................................................49


CALIFORNIA PUBLIC UTILITIES COMMISSIONAPPLICATION NO. 10-12-005

PREPARED TESTIMONY OF SCOTT HEMPLINGon behalf of

UTILITY CONSUMERS ACTION NETWORK

I. QUALIFICATIONS

My name is Scott Hempling. From October 2006 through August 2011, I

served as the Executive Director of the National Regulatory Research Institute.1

As Executive Director, I was responsible for working with Commissioners and

Commission staff at all 51 state-level regulatory agencies to develop research

priorities in electricity, gas, telecommunications and water; and then to oversee

research papers produced by our internal expert staff and external contractors.

During my five years I was responsible for publishing over 80 research

papers. This role involved the following activities: (a) stimulating NRRI staff

experts, Commissioners and Commission staff to identify unsolved regulatory

challenges; (b) identifying authors qualified to think creatively and write

memorably about those challenges; (c) working with authors to shape the topic

and approach to ensure usefulness to regulatory practitioners and

decisionmakers; (d) ensuring that the end product satisfied NRRI's quality

standards, was objective, and made an original contribution to the regulatory

1 Founded by the National Association of Regulatory Utility Commissioners, NRRI is a Section 501(c)(3) organization, funded primarily by state commissions. Its mission is to provide the research necessary to empower utility regulators to make decisions of the highest possible quality.


literature; and (e) organizing teleseminars aimed at increasing the community's

familiarity with the topic and absorption of the paper's substance.

In addition to leading NRRI's research output, I published several

research papers of my own, advised contract clients (including state

commissions, regional transmission organizations, private industry and

international institutions), and wrote monthly essays on effective regulation.

NRRI has published the first 32 of these essays in a book entitled Preside or Lead?

The Attributes and Actions of Effective Regulators. I also taught several dozen two-

day legal and policy seminars hosted by state commissions, organized and led

teleseminars on electricity law and policy, and gave papers at industry

conferences in the U.S., Canada, India, Nigeria and Jamaica.

Prior to joining NRRI, I had a national law practice, advising public and

private sector clients -- particularly state regulatory commissions -- on utility

regulation, emphasizing electricity issues. I have represented clients in many

cases under the Federal Power Act of 1935 and the Public Utility Holding

Company Act of 1935, before the Federal Energy Regulatory Commission and

the Securities and Exchange Commission, respectively, and before the U.S.

Courts of Appeals. I have testified before Congressional and state legislative

committees many times on electric industry matters.


In September 2011 I retired from NRRI to focus on writing research

papers, providing expert testimony and teaching courses and seminars on the

law and policy of utility regulation. Among other activities, I am an Adjunct

Professor at Georgetown University Law Center in Washington, D.C., where I

teach a practicum/seminar entitled Regulation of Public Utility Monopolies: Legal

Principles, Administrative Procedures and Professional Practices. My resume is

attached to this testimony as ATTACHMENT A.

II. INTRODUCTION AND OVERVIEW

San Diego Gas and Electric (SDG&E) describes a post-test-year (“PTY”)

ratemaking framework proposal in Exhibit SDG&E-46-R (Emmich). Mr.

Emmrich's proposals include (a) a four-year general rate case term (replacing the

customary three-year term), (b) expense escalators, (c) rate base additions and

rate base escalators, and (d) the existing "Z-factor" to recover the costs of

uncontrollable events. The proposal also includes (e) an "earnings sharing

mechanism" and (f) a "productivity sharing mechanism" where SDG&E would

forego a customer growth revenue adjustment in return for having no

productivity factor.

SDG&E's proposals would allow earnings above normal levels. These

supra-normal earnings, SDG&E Witness Emmrich asserts, will create an


"incentive" for higher "productivity." This proposal fails the "just and

reasonable" test because it allows supra-normal returns without proof of supra-

normal performance. Mr. Emmrich's stated focus is to align rates with cost. This

focus misses the central purpose of utility regulation, which is not merely to

align rates with cost, but to align compensation with performance.

My testimony has three Parts: Parts III, IV, and V. Part III establishes

principles. A utility has an obligation to serve. To enforce the utility's obligation

to serve, the Commission must condition utility compensation on relevant

performance. It must establish standards, then design compensation methods

that produce that performance.

Part IV applies those principles to SDG&E's proposal. I provide ten

distinct reasons why the SDG&E PTY proposal does not appropriately condition

compensation on relevant performance. I categorize those ten reasons according

to three main propositions:

A. Cost-cutting is not the same as performance: The proposal rewards

cost-cutting during the four-year GRC term. But cost-cutting an appropriate

proxy for performance; in fact, there is risk that SDGE will favor quick cost cuts

over long-term performance improvement. The proposal seeks recovery of

"uncontrollable" but fails to distinguish between input factors that are

uncontrollable, and the rate effects of those factors, which are controllable, at


least in part. Because SDG&E knows more than the Commission about the

proximity of cost savings, in at least eight key areas, there is risk that the

company can claim improvements from the incentives that would be achievable

without the incentives.

B. The incentives produce supra-normal returns without a commitment

to supra-normal performance: The proposal does not calibrate the size of supra-

normal return calibrated to the value of the performance produced. The result

then will vary from the competitive pressures that regulation is supposed to

emulate. Nor does the proposal meet regulation's test of necessity: that

ratepayers should pay no more than necessary (including a reasonable profit) for

the service they receive.

C. The focus on shareholder returns is not consistent with a public-

spirited corporate culture or with employee productivity: By definition, none of

the accretion earnings will go to the real people whose actions cause productivity

gains. The Commission therefore risks supporting a company culture that insists

on "extra" compensation as a condition of fulfilling its obligation to serve.

Competitive markets do award supra-normal returns, and so can "just and

reasonable" rate regulation. But just as a competitive market's supra-normal

returns are reserved for leaders of the pack, so must regulation reserve those

returns for outstanding utility performance. Because SDG&E never


distinguishes obligatory improvement from leader-of-the-pack improvement, its

proposal fails the “just and reasonable” test.

In Part V, I recommend the Commission open a generic proceeding to

address that relationship. In that proceeding the Commission can address at

least three questions, among others:

A. How does a commission pick the quality level that defines the utility's obligation to serve?

B. How might we reduce the time horizon conflicts between rate cases and productivity investments?

C. Do the existing multiple mechanisms for standard-setting and cost recovery work well together?

III. PRINCIPLES: TO ENFORCE THE UTILITY’S OBLIGATION TO SERVE, THE COMMISSION MUST CONDITION UTILITY COMPENSATION ON RELEVANT PERFORMANCE

The purpose of regulation is to align private behavior with the public

interest. That public interest consists of two chief obligations:

1. A utility obligation to serve the public. This obligation must be defined by commission-established standards for performance.

2. A commission obligation to compensate the utility. This compensation must be based on the utility's prudent costs and on the utility’s performance.

These two obligations yield three main regulatory activities:


1. The Commission (and/or the statute) defines the obligation to serve: The state

establishes the products and services the utility is obligated to provide, and the

quality standards applicable to those products and services. Those performance

standards include quantitative standards like prudent cost levels; and qualitative

standards like "average," "above average," "best practices" or "excellent."

Keeping electric current and gas flowing at reasonable rates is only one

component of the obligation to serve, however. Performance standards also

should include factors like product diversity, innovation, and educating and

empowering customers to make good choices. Performance on these factors is

integral to the utility's obligation to serve.

2. The Commission designs revenue and rate plans that connect compensation to

the utility's performance. This step involves (a) establishing the level of revenues

necessary for a prudent utility to produce the necessary performance, and (b)

designing the compensation scheme so that the utility's profit depends on its

performance.

3. The Commission evaluates the utility's performance, then awards

compensation consistent with that performance. If pay is for performance, there must

be some step in the process where the commission evaluates performance in

connection with awarding compensation. The commission performs this role

within rate cases (e.g., when it conducts prudence reviews), and in investigations


outside of rate cases (e.g., where it might add to or subtract from the authorized

return on equity, or otherwise award bonuses or assign penalties).

In these three activities, the Commission's discretion is bounded by the

"just compensation" clause of the U.S. Constitution's Fifth Amendment,2 as well

as by the statutory “just and reasonable” standard. If the government creates

service obligations and performance standards, it must create compensation

schemes that provide the utility an opportunity to recover its reasonable costs3

and earn a fair return.

In Part IV which follows, I apply these principles to Mr. Emmrich's

proposal for "productivity sharing incentive mechanisms."

2 The Fifth Amendment provides, among other things, that “nor shall private property be taken for public use, without just compensation.” The U.S. Supreme Court has held that the Takings Clause protects legitimate, investment-backed expectations of property owners from diminution of the value of their property by government action. See, e.g., Penn Central Transportation Company v. New York, 438 U.S. 104, 124 (1978) (listing factors involved in the Court's fact-based, "ad hoc" takings analysis, including the "economic impact of the regulation on the claimant and, particularly, the extent to which the regulation has interfered with distinct investment-backed expectations"). 3 I use here the term “reasonable” rather than “prudent”, because the Fifth Amendment does not require rates that allow recovery of all prudent costs. See Duquesne Light Co. v. Barasch, 488 U.S. 299, 307-16 (1989) (upholding Pennsylvania statute authorizing commission disallowance of prudent costs if not “used and useful”; rejecting argument that prudent costs are constitutionally entitled to recovery).


IV. APPLICATION: SDG&E’S PROPOSAL DOES NOT

APPROPRIATELY CONDITION THE UTILITY’S

COMPENSATION ON ITS PERFORMANCE

Mr. Emmrich states:

"... SDG&E is proposing earnings and productivity sharing incentive mechanisms to continue to encourage the utility to invest in innovative technology to improve the efficiency of company operations over the PTY [post-test year] period and beyond. SDG&E is proposing a productivity investment sharing mechanism whereby the utility will invest in technology to reduce capital and O&M costs and share the benefits with customers and shareholders."4

He also asserts:

"Compared to its current PTY mechanism, the proposed mechanism better aligns ratemaking between rate cases with SDG&E's projected cost structure by providing for annual adjustments to specifically identified cost drivers including utility cost escalation, customer growth and necessary capital investments.”5

In these passages, Mr. Emmrich seeks to align "ratemaking" with "cost

structure." This narrow focus serves SDG&E's legitimate interest in cost

recovery, but it does not, by itself, satisfy the public interest in performance. The

central purpose of regulation is not to align rates with costs, but to align compensation

with performance. SDG&E's proposal does not achieve this purpose. Not only is it

4 EXH. 46, p. HSE-1 line 27 through EXH. 46, p. HSE-2 line 2.5 EXH. 46, p. HSE-1 lines 18-21


indifferent to performance (because it lacks any metrics); it undermines

performance.

To explain my conclusion, I will discuss ten distinct concerns, organized

into three main categories as follows:

A. The focus on cost-cutting is not aligned with performance.

1. Cost-cutting is not a proxy for performance.

2. There is a risk that SDG&E will favor quick cost cuts over long-term performance improvement.

3. The proposed distinction between controllable and uncontrollable costs is not supported by evidence.

4. SDG&E's knowledge advantage diminishes its accountability to the Commission.

B. The incentives produce supra-normal returns without a commitment to supra-normal performance.

1. The proposed supra-normal return is not calibrated to the value of the performance produced.

2. It is impossible to tell whether the proposed supra-normal return is comparable to the return available from a competitive market.

3. The proposed supra-normal returns do not meet the test of necessity.

4. SDG&E’s insistence on extracting high returns from choice-less customers, without connection to performance, is inconsistent with its obligation to serve.


C. The focus on shareholder returns is consistent with neither a public-spirited corporate culture nor employee productivity.

1. None of the proposed "incentives" for productivity go to the real people actually responsible for productivity.

2. Commission approval would amount to supporting a company culture that insists on "extra" compensation before fulfilling its obligation to serve.

A. The focus on cost-cutting is not aligned with performance

1. Cost-cutting is not a proxy for performance.

While a utility's performance obligation includes “productivity,” both

performance and productivity involve more than cutting costs. They require

innovation, responsiveness, customer satisfaction, customer empowerment (e.g.,

inducements to manage their own consumption and costs), and accountability to

the Commission and to the public.

Yet under Mr. Emmrich's proposal, rewards accrue to SDG&E only in

response to cost-cutting. He says that "the proposed mechanism better aligns

ratemaking between rate cases with SDG&E's projected cost structure"6; and that

"SDG&E believes that its proposed mechanism does a better job of aligning

SDG&E costs and revenues."7 He thus defines "productivity" narrowly:

6 EXH. 46, p. HSE-1 lines 18-20 (emphasis added).7 EXH. 46 p. HSE-4 lines 29-30 (emphasis added). See also EXH. 46, p. HSE-3 to EXH. 46, p.HSE-4 (listing various cost factors).


reduction in the dollars it costs to produce a kWh. Performance on other factors

is mathematically irrelevant.

This conflation of cost-cutting with performance permeates his use of

language. Mr. Emmrich promises (at EXH. 46R-2) "guaranteed productivity

enhancements at levels equal to customer growth" (emphasis added). In

discovery, UCAN asked: "Isn't it true that your proposal doesn't require such

productivity but that it simply provides an economic incentive to SDG&E for

such productivity?" The company responded forthrightly, acknowledging its

loose use of "guaranteed" by enclosing it in quotes:

"The productivity enhancements are 'guaranteed' because SDG&E will have to absorb customer growth without receiving an increase in base margin to cover that cost, therefore, the only way SDG&E can cover those costs would be to increase its productivity. There is no incentive associated with the mechanism [--] it just means that if SDG&E is to be able to achieve its ROR then it must improve productivity to offset customer growth costs or suffer financial losses.”8

In fact, SDG&E is not “guaranteeing productivity” in any useful definition

of the term. The company is guaranteeing only cost absorption -- that the

revenue requirement will not increase as a result of new customers, at least not

until the next rate case decision. There is risk, therefore, that costs caused by

customer growth would be covered not by "productivity," but by --

8 Attachment B: SDG&E response to UCAN DR48-3 (response dated Aug. 23, 2011).


a. cost cuts that undermine productivity (like cutting employee education and training, or deferring maintenance in manner that increases later costs); and/or

b. reduced shareholder return -- thereby possibly leading to a weaker company whose capital costs then rise, or whose ability to excel diminishes.

The utility might respond “We’ll never allow Item (a) to happen, and the

company is too strong for Item (b) to make a difference.” But nothing in Mr.

Emmrich’s proposal raises that response from aspiration to commitment. These

risks are real; the “guaranteed productivity” is not.

I am not suggesting that SDG&E faces no consequences for poor

performance. The Commission has authority to disallow imprudent costs, levy

penalties and lower the authorized return on equity, But these are blunt tools,

normally applied to major errors like cost overruns, poor customer service and

failure to heed Commission orders.9 They are difficult to apply where the

problem is not major error, but a comfort with moderate improvement rather

9 See, e.g., Acker v. United States, 298 U.S. 426, 430-31 (1936), where the Court upheld regulator's disallowance of certain costs in setting rates for marketing agencies in the Chicago stockyards, because the costs were "extravagant" and "wasteful." See also Investigation of Citizens Utility Company, Docket Nos. 5841/5849 (June 16, 1997). There the Vermont Public Service Board found a persistent pattern of misconduct, violations of law, failure to comply with Board directives and disregard for traditional principles of utility account and management. The Board declared that while revocation of the franchise was justified, it was not necessary to promote the interest of the public in reliable, least-cost, reasonably priced energy. The Board opted for fines and probation, with the threat of revocation, on the basis that a forced sale would result in uncertainty and transaction costs, and would require a new company to correct Citizens's mistakes. The Board imposed $60,000 in fines; reduced rates; ordered a refund; and halved the rate of return on equity, finding that investors should earn no more than ratepayers earn on their passbook accounts.


than continuous innovation and striving for excellence. In fact, a problem with

the “prudence” standard is that it protects from disallowances behavior that is

average; it does not necessarily induce innovation.10 And even the blunt tools

are missing from Mr. Emmrich's plan, which he defends unconditionally as

aligning revenues with “guaranteed productivity enhancement.” When one

defines performance properly, his guarantee is no guarantee. Cost-cutting is not

coincident with performance.

2. The proposal creates a risk that SDG&E will favor quick cost

cuts over long-term performance improvement

SDG&E has an exclusive right to serve, a right legally protected from most

forms of competition. With the exception of California’s retail competition

experiment in the late nineties and early 2000s, SDG&E has enjoyed this right

since at least since the early 1900s. Even during California's retail competition

10 See, e.g., Arizona Public Service Corp., 21 F.E.R.C. para. 63,007 (1982) (initial decision), aff'd in relevant part, 23 F.E.R.C. para. 61,419 (1983), where an administrative law judge stated: "The standard for determining whether utility management has acted imprudently is akin to the common-law standard for negligence: Did the utility act in a manner consistent with the performance of other similarly-situated contemporary utilities? If it did, its action cannot fairly be deemed the result of imprudent management." See also Virginia Electric Power Co., 11 F.E.R.C. para. 63,028 at p.65,189 (initial decision), aff'd in relevant part, 15 FERC para. 61,052 (1981). There FERC allowed recovery of repair costs incurred when the boiler of a new coal-fired generating unit imploded two days after the unit was placed in full commercial operation: "[T]here has been no showing that ... VEPCO violated some standard of good engineering judgment, some norm of prudent public-utility behavior." Consistent with this deferential approach to prudence is the U.S. Supreme Court’s statement in West Ohio Gas Co. v. Public Utilities Comm'n, 294 U.S. 63, 72 (1935): "Good faith is to be presumed on the part of the managers of a business. In the absence of a showing of inefficiency or improvidence a court will not substitute its judgment for theirs as to the measure of a prudent outlay."


years, the utility had the exclusive right to provide standard offer service to most

of its customers.

A utility’s long-term, government-granted right to serve, protected from

competition, has rested historically on the notion of economies of scale; for a

given service territory, unit costs are lower with a single seller than with multiple

sellers. But a long-term tenure should be accompanied by an obligation to make

long-term improvements. A secure seat should not absolve the incumbent of its

duty to engage in the dynamic innovation and long-term improvement that

would be unavoidable if there was periodic competition for that seat.

This duty finds no home in SDG&E's plan. Rather than induce long-term

thinking, the plan rewards short-term cost-cutting. The arithmetic is

unambiguous: The larger and sooner the cost cut, the larger and sooner the

earnings accretion. But quick cuts now can lead to higher costs later: cutting

vegetation management now can produce costly distribution outages later;

reducing employee and management education can mean less productivity later;

deferring maintenance now can cause larger repairs later.

Mr. Emmrich argues that his plan will increase productivity, but there is

no clear connection between the short-term cost cutting his plan rewards, and the

long-term productivity his customers need. The details matter, but his formula is


not concerned with details. Cost cuts, of whatever kind, increase SDG&E's

earnings immediately.

Worse, his plan creates headwind against an entire category of efficiency

productivity options; specifically, options might increase expenses now but

reduce capital needs in the period beyond the fourth year. Under his proposal,

this form of productivity produces a double shareholder penalty. The increase

in expense reduces earnings immediately; the resulting reduction in capital costs

reduces rate base returns later.11

That ratepayers "share" in the earnings does not diminish the distortion.12

To the contrary, the ratepayer-sharing feature instead adds a ratepayer

constituency to the shareholder beneficiaries of the short-term thinking that the

plan induces.

3. The proposed distinction between controllable and

uncontrollable costs is not supported by evidence

Part of SDG&E's proposal rests on the premise that certain cost increases

are inevitable or uncontrollable. This premise appears in two circumstances.

First, Mr. Emmrich proposes cost escalators for "goods and services SDG&E uses

11 Mr. Emmrich forthrightly acknowledges this problem, as I discuss in Part III.B below. But his productivity plan does not solve it. That is a reason for the Commission exploration I recommend in Part V.12 See Part II.B.4 below for comments on the misnomer "share.”


to provide service to its customers"13 and for medical costs.14 Second, he includes

a "Z-factor," referring to "significant events that are beyond the utility's ability to

control and cause large changes in its cost structure and threaten its financial

stability thereby undermining the utility's ability to provide utility services to its

customers while maintaining financial viability."15 The criteria for identifying

these events are enumerated in D. 1-0-12-053.16

This premise of inevitability or uncontrollability is unsupported by his

testimony. It is true that the utility cannot always control many factors

influencing utility costs: factors like fuel, labor, concrete and steel; legislative

and regulatory actions like environmental rules; storms or floods; carbon taxes;

hurricanes. But the uncontrollability of cost factors does not translate mean

uncontrollability of utility costs. How factors affect utility costs is, in part, within

the utility's discretion. The utility negotiates with suppliers, schedules

purchases, influences the mix of generation and non-generation alternatives

13 EXH. 46, p.HSE-5 lines 25-26.14 EXH. 46, p. HSE-5.15 EXH. 46, p. HSE-13 lines 4-7.

16 Mr. Emmrich's footnote 1 states: "D.99-05-030 established the SDG&E Z-factor mechanism, based on the series of nine criteria first identified in D.94-06-011. In D.05-03-023 the Commission continued the Z-factor mechanism established by D.99-05-030 but eliminated one of the nine criteria." As outlined in D. 10-12-053 at p. 9-10, the factors are: 1. Caused by an event exogenous to SDG&E;2. Caused by an event that occurred after the implementation of rates; 3. Costs that SDG&E cannot control;4. Costs that are not a normal cost of doing business;5. Caused by an event that affects SDG&E disproportionately;6. Costs that have a major impact on SDG&E;7. Costs that have a measureable impact on SDG&E; and8. Costs that SDG&E has reasonably incurred.


(generation being vulnerable to input costs, weather and environmental rules),

and manages vegetation (which affects frequency and duration of outages).

This distinction between factors and costs, between uncontrollable and

controllable, has even more layers. A utility's vulnerability to fuel costs depends

in part on how it maintains the plant and provides for alternatives when outages

occur; the rate effects of commodity prices depends in part on construction

scheduling; the effect of carbon policies on customers depends on the utility's

design of resource mix. The company’s medical costs are emphatically capable

of influence by company policies: the quality of its cafeteria food, the proximity

of stairwells vs. elevators, the encouragement of walking and biking over driving

and parking, the quality of the on-site gymnasium, the scheduling of workout

classes. No alert employer is a passive acceptor of medical cost increases.

Mr. Emmrich seeks to build a bridge, linking the inevitability of factor cost

increases to the inevitability of rate increases. But his bridge doesn't make it.

That some cost factors are uncontrollable is undisputed. That SDG&E can't

influence the rate effects of these factors is unrealistic.

4. SDG&E's knowledge advantage diminishes its accountability

to the Commission

Compared to the Commission, SDG&E has greater knowledge about its

costs and cost-saving opportunities. This knowledge gap leaves the Commission


unable to determine whether SDG&E proposed (and resulting) returns are just

and reasonable. Consider eight examples of how the knowledge differential

affects SDG&E's proposal:

1. The base year reflects a cost structure that the Commission is to presume reasonable. SDG&E knows more than the Commission about what it cost to run the utility in the base year.17

2. The cost escalation factors are based on two external data services.18 SDG&E knows more than the Commission about how its actual costs will compare to the external data.

3. SDG&E proposes to absorb customer growth costs as an "implied productivity factor."19 SDG&E knows more than the Commission about its customer growth forecasts, and about its opportunities for cost cuts.

4. The capital-related cost adjustment is intended to "reflect the cost of plant additions."20 SDG&E knows more than the Commission about its capital expenditure trajectory.

5. The medical cost adjustment makes ratepayers responsible for index-derived cost increases. SDG&E knows more than the Commission does about the health conditions and medical costs of its employees.

6. The Z-factor adjustment draws the boundary between controllable and uncontrollable costs, putting the full risk of the latter on the customers. SDG&E knows more than the Commission about what it can control and what it cannot.

17 SDG&E might respond that the Commission must presume the base year cost structure to be reasonable because the Commission approved it as lawful in a prior rate case. That prior approval means only that the cost structure was lawful during the rate period for which it was approved. The prior approval does not make the cost structure a lawful basis for a subsequent rate period. 18 EXH. 46, p. HSE-6 at lines 4-13. 19 EXH. 46, p. HSE-9 at lines 10-11.20 EXH. 46, p. HSE-10 at lines 3-4.


7. The "earnings sharing mechanism" determines the portion of savings, relative to the base year costs, that SDG&E can withhold from ratepayers to increase its return on equity. SDG&E knows more than the Commission about its ability to cut costs relative to the base year.

8. The "productivity sharing mechanism" gives the utility in 2016 half the excess earnings in 2015. SDG&E knows more than the Commission about how much and how likely are these earnings.

Absent comparable access to -- and mastery of -- this utility information,

the Commission cannot credibly assess the utility's performance, especially the

realistic boundaries on its obligation to improve. The knowledge gap disables

the Commission both from establishing realistic standards, and from designing

compensation schemes that induce the utility to comply with those standards.

Information access and information mastery, moreover, are distinct challenges,

since to judge the utility's performance credibly one must herself be informed

about, and an expert in, that performance. A utility-Commission differential in

either category undermines regulatory effectiveness; a different in both

undermines doubly.

By basing rates on these distinct factors for which the utility has an

information advantage, SDG&E's proposal distances itself from accountability.

Here are the facts: The utility has both a long-term monopoly over a life-

preserving product, and an information advantage concerning the product’s

future costs. It then proposes a rate plan allowing returns exceeding the


product's reasonable cost, asking the regulator to approve something it literally

will not fully understand – at least not understand as well as the utility does.

The information advantage allows the utility to create the impression that there

are efficiencies still to discover, when it already knows – or has a good feel for --

where and how to find these efficiencies. (A rational utility would not propose a

plan containing a risk of reduced returns, unless it knew the probabilities were in

its favor.)

We regulate when there is a risk that private behavior will diverge from

public interest. That is why we have speed limits, restaurant inspections and

utility regulation. The problem of divergence is enlarged by information

asymmetry. The greater the differential (and the greater its role in

decisionmaking -- see SDG&E's eight informational advantages listed above), the

greater the utility's temptation and opportunity to exploit it. By holding back

performance data, by deferring performance improvement in the hopes of higher

rewards later for reducing costs relative to external indices, and by timing

investments and rate cases to maximize net income rather customer welfare, the

utility exploits its knowledge advantage without benefiting the public interest.

I am not suggesting dishonesty or lack of good faith. Commercial

relationships often have information asymmetry. A lawyer seeking a fixed fee

arrangement knows better than the client how many hours the work will take.


The same goes for car repair and even teen-age lawn mowing. But in those

markets, the skeptical customer can shop around, building knowledge by

making comparisons. In monopoly regulation, there is little shopping

opportunity. This combination of information asymmetry and customer

captivity requires a regulatory solution -- either a reduction in the asymmetry or

a lessening of its influence. SDG&E’s proposal does neither.

B. The incentives produce supra-normal returns without a

commitment to supra-normal performance

1. The proposed supra-normal return is not calibrated to the

value of the performance produced

SDG&E's proposal encourages cost cuts from a base level, by allowing the

utility to withhold some of those savings from consumers. The withheld amount

increases earnings above the authorized equity return. The size of the earnings

increment depends on two factors: the total cost reduction relative to the base,

and the percentage of that reduction that the utility is allowed to withhold.

In any line of work, compensation should be based on the relationship of

benefit to cost. SDG&E’s proposal ignores this principle. There is no way to

connect the earnings proposed with a benefit-cost analysis of the performance

produced. In fact there is no way to identify the performance produced, because


there is no way to tell what performance would have occurred but for the

earnings withholding. The earnings numbers are literally disconnected from

performance reality.

In contrast to the SDG&E-proposed "share," a zero "share" baseline

(setting rates based on zero earnings above a normal return) has a rationale: The

utility is obligated to take all prudent actions on behalf of the customer, while the

regulator is obligated to compensate the utility with a normal return. The

regulator determines the range of prudent actions by studying industry practices

and drawing data from comparable utilities. The regulator then picks the place

on the performance spectrum (e.g., average, above average, first quartile, top-

flight), and sets the revenue requirement at the reasonable cost level necessary to

produce that performance. If the utility beats the cost level between rate cases, it

keeps the savings. If not, it absorbs the losses. When the Commission sets rates

with a zero-share (of excess earnings) standard, compensation is aligned with

performance. It does take judgment to determine the performance standard and

the cost-minimized revenue requirement, but it is judgment with a rational basis.

By departing from a zero-share baseline, SDG&E's approach produces two

problems. First, once one departs from a savings share of zero (meaning, a

normal return but no extra), there is no standard by which to judge

appropriateness. What makes 20% better than 10%? There is no competitive


market to act as benchmark and, comparing a number to other regulatory

decisions, in-state or out-of-state, will be circular if those state decisions relied on

other state decisions.21

Second, the base performance (which the proposal rewards the utility for

exceeding, by allowing it to withhold cost savings from consumers) is itself

unconnected to a Commission-determined level of performance, other than a

past finding that the costs underlying the revenue requirement were prudent for

the prior period in which that base revenue requirement was in effect. That prior

finding of prudence is not synonymous with a finding that this performance

level is appropriate for future periods. And if in the prior rate case the

Commission focused only on matching revenues to costs, but did not ask the

question “What standard of performance, and what specific outcomes, do we

expect of our utility?” then it cannot assume that the base revenue requirement is

at all connected to performance.

My critique of Mr. Emmrich’s approach applies to the Division of

Ratepayer Advocates as well. I respectfully disagree, for example, with DRA's

proposal (Burns at p.16) that "... the third revenue sharing band is 50/50

21 This problem becomes evident in testimony by the Division of Ratepayer Advocates. The discussion of earnings share, beginning at p.13, correctly discussed the need to line up ratepayer benefit with ratepayer burden (p.15 lines 4-12); and also raises concerns about the asymmetry between upside and downside. But nowhere does it connect its preferred percentages with performance standards.


ratepayer/shareholder. This insures that revenue sharing will be evenly

distributed when there are significant earnings to share." One can view "50/50"

as "evenly distributed" only if one thinks the utility is entitled to a supra-normal

return. Fifty percent of a supra-normal return is still a supra-normal return. Like

SDG&E, DRA does not condition the extra return on extra performance.22

I am not suggesting that zero incentive is the best policy; I am saying that

SDG&E presents no connection between specific customer benefits and specific

company inducements. Part IV.D below discusses when a supra-normal return

would be appropriate.

2. The proposed supra-normal return is not comparable to the

return available from a competitive market

22 DRA does take a conscientious stab at connecting return to performance:

"DRA notes that in a scenario in which there are initially large costs that would result in the ROR dropping below the authorized rate, ratepayers could end up paying for a portion of those losses under the Utilities' proposal; if later there are savings that result in the ROR rebounding, ratepayers would not benefit in the same proportion due to the reduced sharing with ratepayers in the above authorized ROR Inner Band. Alternatively, if a sharing mechanism is adopted, the utilities should identify the costs of a productivity enhancing measure in the early years of an earnings sharing mechanism, and then offset those costs against increased earnings in later years prior to determining the amount to be shared in those years."

Burns at p.15 But even when one resolves the asymmetry between burden and benefit, as DRA seeks to do, there still is missing a justification for the extra return.


A franchised monopoly, enjoying a legal bar to competitors, does not face

normal competitive pressures. Regulation seeks to replicate those missing

pressures.23 SDG&E's proposal does not achieve this goal.

Cutting costs below the base amount – and withholding the savings from

ratepayers – gives SDG&E a return exceeding the normally authorized level.

That normally authorized level replicates competitive market outcomes, as

explained in the famous passages from Bluefield and Hope:

"[A] public utility is entitled to such rates as will permit it to earn a return on the value of the property which it employs for the convenience of the public equal to that generally being made at the same time and in the same general part of the country on investments in other business undertakings which are attended by corresponding risks and uncertainties."24

“The return to the equity owner should be commensurate with returns on investments in other enterprises having corresponding risks.”

…

"Rates which enable [a] company to operate successfully, to maintain its financial integrity, to attract capital, and to compensate its investors for the risk assumed certainly cannot be condemned as invalid, even though they might produce

23 See, e.g., Pierce and Gellhorn, Regulated Industries (1999) at 2 (“[I]f it is thought that the market favors natural monopolies, comprehensive cost-of-service ratemaking by regulatory commissions is imposed as a substitute for the constraints competitors otherwise generate as a matter of marketplace discipline.”). See also id. at 3 (“Government regulation … supplies the elements of responsibility missing from these [monopoly] markets.”).

24 Bluefield Water Works & Improvement Company v. Public Service Comm'n, 62 U.S. 679, 692 (1923) (emphasis added).


only a meager return on the so called "fair value" rate base.”25

Since SDG&E's allows a return exceeding competitive levels -- the levels

that regulation is supposed to produce -- the Commission should ask: Is the

excess return consistent with "just and reasonable" rates? I readily acknowledge

that supra-competitive returns are not necessarily inconsistent with a

competitive market. In a competitive market, it is possible for a cost-cutting

competitor to keep the savings and earn supra-competitive returns, at least

temporarily, rather than giving the savings to consumers through price cuts.

This possibility of extra returns depends, however, on market factors. If

competitors can replicate the cost-cutting action, and there are competitors ready

and able to do so, the first entity's high returns will be temporary. Once the

competitors adopt the cost-cutting actions, they can lower their prices, attracting

customers away from the entity that withheld the savings. If, in contrast, the

cost-cutting action is a special innovation controlled by or known only to the first

competitor (e.g., due to a patent, an exclusive relationship with a unique input

supplier, or an internal expert with non-replicable expertise), the company will

be more likely to keep the savings, at least until a competitor finds a similar

solution. So even in a market which authorizes competition, supra-competitive

25 Federal Power Commission v. Hope Natural Gas Co., 320 U.S. 591, 603-05 (194) (emphasis added).


returns are possible. This reasoning suggests that regulation, to the extent its

purpose includes emulating competition, can tolerate supra-competitive

returns.26

But Mr. Emmrich's approach makes no visible distinction between

ordinary cost savings that could readily be replicated by competitors, and cost

savings that SDG&E deserves to withhold due to their uniqueness. There is,

therefore, no way for the Commission to determine if the excess returns SDG&E

proposes are consistent with the pressures of competition.

3. The proposed supra-normal returns do not meet the test of

necessity

In utility ratemaking, the revenues received should be no more than

necessary to produce the desired performance. Expenses and return should be

sufficient to get the work done and attract the necessary capital: sufficient but no

more than necessary.27 (Caution about interpretation: The phrase "no more than

necessary" does not mean we force the utility to beg and limp, keeping rates to a

bare minimum; it means we should avoid unnecessary revenues resulting from

26 I discuss the conditions for this possibility in Part IV.D below.27 See, e.g., El Paso Natural Gas Co. v. FPC, 281 F.2d 567, 573 (5th Cir. 1960) ("It is the obligation of all regulated public utilities to operate with all reasonable economies."), cert. denied, 366 U.S. 912 (1961); Pacific Gas & Elec. Co., 38 FERC 61,242 at p. 61,789 (1987) (public utility has "a mandate to bring about the production of electricity at the lowest possible cost to the consumer in the long run -- in the economist's terms, to ensure the efficient performance of an industry.") (quoting other authorities); Potomac Electric Power Co. v. Public Service Comm'n, 661 A.2d 131, 138 (D.C. App. 1995) (statute requires service at "lowest feasible cost").


waste or regulatory inalertness.) This rule of necessity applies both to ordinary

ratemaking (where only prudent, necessary costs warrant recovery), and to the

"extra" compensation SDG&E seeks.

Mr. Emmrich nowhere shows, or even argues, that the excess returns are

necessary. He offers no study showing that these "incentives" even produce the

desired result, i.e., improvements that would not occur but for the extra returns.

He offers no study showing that there is no lower-cost way to produce the cost

reductions he assets will result. He views these extra returns as desirable, useful,

perhaps more likely than not to succeed in producing extra performance; but he

does not testify that they are necessary. He does not say SDG&E would be

unable to perform, or would be hampered in performing, if SDG&E cannot

receive supra-normal returns. Disregarding the standard of necessity -- in this

case, causing choice-less customers to pay dollars for any purpose other than a

necessary purpose -- downgrades regulatory decisionmaking from principled to

arbitrary. It creates a regulatory environment where decisions are based on

desires rather than showings, preferences rather than evidence. Such decisions,

unlike effective regulation and the effective competition that regulation is

supposed to emulate, do not align private behavior with the public interest.

To the extent SDG&E anticipates some cost-reducing initiatives involving

risk or uncertainty, the Commission can raise the authorized return on equity to


reflect that risk or uncertainty. That increment is part of normal returns (since

normal returns are higher when risks are higher; see Bluefield and Hope quoted

above); it is not excess returns or justification for them. In any event, Mr.

Emmrich does not offer unique risks that would justify such an increment.

A separate problem is the mismatch between risk and return in 2016 and

beyond. Mr. Emmrich proposes (EXH. 46R-13 at lines 22-24) that "50% of the

above authorized ROR earnings in 2015, if any, should be credited to the utility

in the subsequent 2016 Test Year base margin true-up."28 To the extent any of

those excess earnings are attributable to capital investments which have entered

rate base fully, a mismatch arises: The ratepayers would have paid for 100% of

the investment but received only 50% of the benefit. SDG&E should make clear

that this situation would not arise.

There is another problem with the 2016 proposal: It requires 2016

customers to pay a supra-normal return without any utility commitment of

supra-normal performance. At end of 2015, SDG&E will have received the

earnings that the Commission authorized it to receive, including possibly supra-

28 Concerning the phrase "50% of the above authorized ROR earnings in 2015," there is an ambiguity. The term "authorized ROR earnings" could refer to two different Commission authorizations: (a) the earnings reflecting the return on equity authorized by the Commission in its annual MICAM proceeding; or (a) the supra-normal earnings that the Commission would allow if it approves a "sharing" mechanism. I request that Mr. Emmrich clarify the meaning of "authorized ROR earnings" in this context. The concerns I express in the ensuing text, however, apply either way.


normal earnings, in return for providing whatever performance the Commission

required. Matters will be in equipoise.

The year 2016 then presents a new situation, requiring a new look by the

Commission. As of now, 2011, SDG&E is not making any commitment about its

2016 performance, nor is the Commission establishing any expectations for 2016

performance. SDG&E proposes, however, to lock in now the possibility of a

supra-normal reward later -- without making any commitment to performance.

Put another way, the 2016 SDG&E could rest on its 2015 laurels, make no

improvements on its 2015 performance, and still earn a supra-normal return.

Worse yet, the Commission might find, at the end of 2015, that SDG&E's

performance has not improved enough to even to warrant the returns it received

that year. That 2015 Commission, instead of holding SDG&E accountable for

subpar performance by setting for 2016 a higher standard and allowing only

normal returns, would be pressured by its own 2011 commitment to allow the

supra-normal 2016 reward: pressured, because its 2011 approval of SDG&E’s

2016 proposal would have created “investment-backed expectations” worthy of

constitutional consideration.29 The better approach, therefore, is to set the terms

for 2016 as 2016 is arriving.

29 See Penn Central Transportation Company v. New York, 438 U.S. 104, 124 (1978) (holding that in Fifth Amendment cases, the Court considers, among other things, the "the extent to which the regulation has interfered with distinct investment-backed expectations").


4. SDG&E’s insistence on extracting high returns from choice-

less customers, without connection to performance, is

inconsistent with its obligation to serve

Mr. Emmrich states: "SDG&E is proposing a four-year GRC term to

provide greater incentives to the utility to make productivity enhancing

investments and to focus on operating the business efficiently..."30

The Commission should ask, "'Greater' than what?" Mr. Emmrich does

not say explicitly. He may mean "greater than the normal return we make with a

shorter rate case term." But since the obligation to serve -- the obligation to do

the best job -- is independent of GRC term length, Mr. Emmrich's statement

necessarily means the following: SDG&E will not take feasible, cost-beneficial,

productivity-enhancing actions -- actions it already knows about or is able to find

out about -- unless it can withhold savings from ratepayers and thus earn more

than normal. I see no other logical interpretation of his words.

SDG&E's proposal conflicts with the foundation of its franchise; that its

right to serve includes an obligation to serve. If SDG&E knows of economical

expenditures (i.e., expenditures whose benefits exceed their costs, including a

normal return), it is obligated to make those expenditures. Carrying out an

obligation should produce a normal return on equity, not a supra-normal one.

Mr. Emmrich resists this proposition. This resistance should lead the

30 EXH. 46, p. HSE-2 lines 6-9 (emphasis added).


Commission to investigate the company's culture, not reward its shareholders. A

culture that seeks government support for extracting earnings from its choice-

less customers cannot exist within a company entrusted with the obligation to

serve. (That the term "extract" sounds unnecessarily harsh is only because the

term "share" is inaccurately soft. Enjoying legal protection from competitors,

then insisting on supra-normal returns without connection to performance, is not

“sharing.”)

An example of SDG&E's focus on cost rather than performance appeared

when UCAN asked the utility to compare "SDG&E's investment in this rate case

cycle with the investment in infrastructure in SDG&E's most recent two rate case

cycles…." The utility responded, in part: "The amount of capital investment

made during the rate case cycle will in large part depend on the authorized base

margin that the Commission authorizes the utilities to spend to provide service

to SDG&E's and SCG's customers."31 This answer is not reconcilable with the

obligation to serve. Consider this hypothetical:

1. The Commission directs SDG&E to install 1000 meters.

2. The Commission finds that the associated revenue requirement, for a prudent utility, is $1000, and therefore allows that amount in rates. A court upholds the $1000 finding.

3. Performing less efficiently than the Commission’s expectation, the utility, after spending $1000, has installed only 800 meters.

31 Attachment B: SDG&E response to UCAN DR48-2 (response dated Aug. 23, 2011).


In such a scenario, the utility leaves 200 customers unmetered, contrary to

the Commission’s directive, because "[t]he amount of capital investment made

during the rate case cycle will in large part depend on the authorized base

margin that the Commission authorizes the utilities to spend to provide service

to SDG&E's and SCG's customers." Yet, the Commission has the appropriate

expectation for the utility to install all 1000 even though it will need more capital

investment than provided for in the “authorized base margin.” Otherwise we

would have defined the obligatory performance in terms of dollars spent rather

than mission accomplished. That is the risk of separating cost recovery from

performance.

C. The focus on shareholder returns is consistent with neither a public-

spirited corporate culture nor employee productivity

1. None of the proposed "incentives" for productivity go to the

real people actually responsible for productivity

Not only are the extra returns not necessary; there is no evidence that they

are even rationally related to improvement. The productivity and efficiency

actions under discussion are not inanimate behaviors by abstract forces; they are

efforts undertaken by human beings. I assume that SDG&E is paying its people -


- both managerial and rank-and-file employees -- appropriate compensation:

appropriate rewards for excellence and appropriate penalties for shortcomings,

with such rewards and penalties already reflected in the base revenue

requirement. If so, it is not clear what additional quality is gained by paying

higher returns to shareholders. Shareholders do not run the power plants,

manage call centers, respond to outages, or trim trees. They invest money –

essential to the company – but they do not “produce” in the sense that Mr.

Emmrich means when he uses the term “productivity.”

If SDG&E seeks to boost performance, the boost belongs with the

performers. But Mr. Emmrich’s proposal directs the dollars to the shareholders,

not to the employees. (Higher returns lose their status as returns if they become

expenses paid to employees as productivity awards.) Given SDG&E's separate

proposed “incentive” program that charges ratepayers for employee

performance, Mr. Emmrich does not explain how additional ratepayer dollars

paid to shareholders will make a distinct improvement in performance.

Although SDG&E could use extra returns from one year to pay bonuses for

employee excellence in another year, Mr. Emmrich’s proposal makes no

commitment to doing so.


2. Commission approval would amount to supporting a company

culture that insists on "extra" compensation before fulfilling its

obligation to serve

I return to Mr. Emmrich's statement that the supra-normal returns will

"provide greater incentives to the utility to make productivity-enhancing

investments and to focus on operating the business efficiently...."32

"Greater" than what? The implication is that the company has a choice:

(a) decline to invest in efficiency-improving technology, or (b) commit to invest

in that technology, but only if ratepayers pay not only a normal return but also

an additional increment high enough to convince the utility to make the

expenditure (for which the utility will receive normal compensation anyway,

through recognition as an expense or through an increase in rate base). Put

another way: I interpret Mr. Emmrich to say that SDG&E views its obligation to

improve as conditional -- the condition being the Commission awarding supra-

normal returns. This is the necessary logical implication of his words. The

Commission should seek clarification from SDG&E. Is SDG&E’s position that --

a. Executives, management and other employees do not feel obligated to do their best, as a matter of course?

b. Executives, management and other employees are ready and willing to do their best, but the top executives -- those responsible for establishing culture -- are ordering their

32 EXH. 46, p. HSE-2 lines 5-8.


underlings to withhold that capability until the company receives the extra returns proposed by Mr. Emmrich?

If the answer to one or both of these questions is "yes," the Commission should

not honor this negative attitude with extra returns. If the answers to these

questions is "no," i.e., if the culture is one in which everyone does their best at all

times, the necessity for supra-normal returns disappears. (See Part IV.B.3 above

on necessity.) Mr. Emmrich cannot have it both ways: He cannot (a) claim the

necessity of an incentive to excel while also (b) asserting that SDG&E's

employees always strive to excel, even when shareholder compensation is

merely normal. To ignore this point is to risk supporting (with Commission

precedents) and contributing to (with ratepayer dollars) a utility culture that

avoids improvement absent extra pay.33

Contributing to the problem is the asymmetry of information problem

discussed in Part IV.A.4 above. If the Commission had knowledge and

information equal to the utility, it could prescribe actions or results, then assign

consequences for failure. Given the Commission’s lesser knowledge of

productivity opportunities, top managers, knowing their company was capable

of achieving better performance, can withhold or even block improvement

activities to win higher returns.

33 This is not to say that a commission should never authorize supra-normal returns. I discuss the appropriate conditions in Part V.D. below.


To summarize: Company culture should serve its obligation. The

company's obligation is to improve continuously, just as the Commission's

obligation is to award reasonable compensation continuously. If the company

properly commits dollars in the name of service quality and the commission fails

to compensate adequately, the company can seek judicial review. It cannot

withhold performance to get the compensation it wants.

That is a key difference between competitive markets and regulated

monopoly markets. A competitive company operating in a market where the

payments are erratic, or below-cost or merely subjectively unsatisfactory, has

choices: It can leave the market, lower its costs (and its quality) in line with the

unsatisfactory compensation, or continue high quality performance regardless of

compensation. Then customers can respond: Restaurant goers on a tight budget

can choose places where prices are low, the lines are long, the service slow and

the food mediocre; other customers can go elsewhere. SDG&E does not face

competitors, and SDG&E's customers don't have choices. These customers'

choice-lessness requires a utility's obligation to serve -- an obligation to serve not

conditioned on extra returns.

D. Supra-normal returns can be just and reasonable, under conditions that SDG&E fails to meet

This testimony does not assert that regulators should never authorize

supra-normal returns. Part IV.B.2 explained that even in effectively competitive


markets, supra-normal returns occur when a competitor gets out in front -- with

a patent, a unique employee or work process, faster response times, more

comfortable shoes. By differentiating itself through quality, this competitor can

sustain a price that allows a supra-normal return. But this advantage lasts only

until a competitor catches up, replicating the quality or differentiating in some

other way; then the first competitor must lower its price back to normal

competitive levels, or improve once again supra-normally -- or risk losing

customers.

The distinction, then, is between ordinary improvement and leading-the-

pack-improvement. In any competitive market, ordinary improvement is

obligatory. Competitors constantly seek to outdo each other better burgers,

faster service, longer-running batteries, faster downloads. The reward for

obligatory improvement is survival and ordinary returns. Only the pack leaders

earn higher returns. They do so not with obligatory improvement but with

leading-the-pack improvement.

Turning to regulated utilities: Just and reasonable rate regulation can

accommodate supra-normal returns, temporarily, for utilities whose

performance leads the pack. The problem is that Mr. Emmrich makes no

distinction between obligatory improvement and leading-the-pack improvement.

He does not talk of differentiating, of patents or unique processes, of anything


special. His "sharing" grid has the precision of percentages, but his improvement

talk is generic and non-committal.

The company might counter by insisting: “This is a rate case, not a

performance case.” But that is because of how SDG&E testimony has framed this

case: as a quest for revenues, rather than a push for performance.34 The

Commission should frame this case its own way -- with the public interest at the

center. Since SDG&E has not done so, since it has not proved entitlement to

supra-normal returns through supra-normal performance, the Commission

should reject its proposal and grant a normal return on reasonable investment.

Still, the question remains: What is the distinction between obligatory and

extraordinary performance, between normal profit and supra-normal returns?

Part V below provides ideas on how the Commission can address this question

in a separate proceeding.

34 "Framing a discussion appropriately is 'an ethically significant act.'" R. Frank, "The Impact of the Irrelevant," The New York Times (May 30, 2010) p. B5 (quoting psychology professors D. Kahneman and A. Tversky).


V. QUESTIONS FOR THE COMMISSION TO

CONSIDER, IN EVALUATING THE CURRENT

RELATIONSHIP BETWEEN COMPENSATION AND

PERFORMANCE

Despite my disagreement with Mr. Emmrich’s proposals, I commend him

for raising questions about the relationship between compensation and

performance. The Commission's general rate case proceedings, as currently

organized, are not well designed for evaluating compensation-performance

relationship comprehensively. I recommend the Commission open a generic

proceeding to address that relationship. This Part V offers thoughts on three

questions the Commission could explore.

A. How does a commission pick the quality level that defines the utility's

obligation to serve?

If compensation is for performance, the Commission must define

performance. Performance is not just about cutting cost; it is about defining the

customer experience, the supplier obligation, and the most effective ways to

carry out that supplier obligation to produce the customer experience.

In a competitive market, the required performance level is, circularly,

whatever level customers require, below which they choose to purchase nothing,


or seek a different supplier. By definition, that level is set by customer

preference and competitive alternatives. Below this quality level, the seller loses

customers; above that quality level, the seller can earn higher returns by raising

prices or attracting more customers.

Those higher returns do not last forever, however; as I have discussed

above, unless that seller's uniqueness is due to a patent, trade secret or some

other unique feature unachievable by competitors, the extra return is wiped out

over time as competitors observe, learn and improve. The result of this constant

pressure to improve is constant improvement in service quality and constant

downward pressure on prices.

These are the pressures that regulation should seek to replicate. The

Commission's task is to set a standard, and create a process for raising that

standard over time. Before accepting any incentive proposal, the Commission

should answer the following questions: For each of the major performance areas,

what levels of performance that are valued by customers are the best performing

utilities capable of accomplishing? What is the achievable state of the art, at

reasonable cost?

The SDG&E approach is subjective and self-reflecting: It computes

compensation based on improvement relative to SDG&E's own historic

performance, using its information advantage to influence the level of supra-


normal returns for its shareholders. The better approach is objective and

outward-looking: computing compensation based on the relationship of the

utility's performance to top-performing utilities, using metrics that a customer

with choice would use, just as a competitive market would do. Once the

commission sets the required quality level, i.e., normal performance, the utility

becomes obligated to perform at that level, in return for which it receives

prudent costs and a normal return. Any other approach rewards the utility for

holding back normal performance improvements, then offering them in return

for a higher return -- exactly the opposite of what a competitive market does.

Determining the quality level is not only about setting a standard, such as

"average," "above average," "excellent" or "first quartile." Quality also is defined

by innovation and creativity. The Commission should expect the utilities to

remain alert to new technologies and new service offerings, especially those that

empower customers to make efficient decisions. When those new technologies

and services are produced by competitive market companies, a consumer-

oriented utility will buy from those companies, rather than delay customer

benefits until the utility itself catches up. The utility would still earn a normal

return on its own investments, but the profit on these other services would go to

those in the market best able to serve the public. That fact itself – the utility


foregoing returns because non-utilities did the job better -- will induce the utility

to improve.

B. How might we reduce the time horizon conflicts between rate cases

and productivity investments?

A rate case deals with a limited future period. The length of that period

depends on a number of decisions, e.g. the utility's decision to file rates, a

consumer representative's decision to file complaints, and/or a commission's

decisions to initiate a rate case. Performance has different time dimensions.

Payback periods vary for new meters, for employee education, for a purchase of

in renewable energy, and for creating a new staff division relating to technology.

None of these performance time periods bears any connection to rate case time

periods. As a result, there are multiple mismatches between the period in which

rates are in effect, and the periods necessary to realize the benefits from

expenditures. There is a legitimate concern that this time period mismatch

creates a risk-reward mismatch.

Mr. Emmrich describes this problem persuasively (EXH. 46, p. HSE-14

lines 7-22):

"The frequency of rate cases has a major impact on performance incentives. The incentive impact of the rate case cycle is especially great for projects with long payback periods. Suppose, for example, that the company is subject


to a three year rate case cycle and has available a cost containment initiative with a five year payback period. Even if it begins the initiative immediately upon the conclusion of its rate case, it will incur the upfront cost of the initiative but will enjoy only two years of the benefits before the next rate case lowers rates to reflect the annual benefits. If the upfront cost of the initiative is incorporated in the initial rates the expected NPV of the initiative may be positive but may be lower than in an unregulated initiative. If the initiative is unbudgeted the expected NPV will be negative. The company is thus discouraged from pursuing opportunities that could benefit its customers. By sharing productivity gains across the GRC cycle, the utility has the incentive to invest in productivity enhancing projects on an ongoing basis instead of waiting to the next rate case cycle to begin. It is for these reasons that SDG&E proposes a productivity sharing mechanism that encourages SDG&E's management to continue to invest in long-term productivity enhancing investments that transcend the normal GRC cycle."

Similarly, see EXH. 46, p. HSE-16 lines 22-26:

"The longer the term between rate cases, the stronger the incentive to reduce costs since many productivity enhancing investments have a longer cost/benefit life than the usual three-year GRC cycle. A longer GRC term allows a longer planning cycle and to encourage the utility to undertake technology-driven investments that have long-term benefits that the traditional three-year GRC cycle provides."

Regulation should induce a company culture of continuous cost-

consciousness. Calibrating rate case scheduling with payback periods makes

sense in theory, but there are two problems in practice. The company cannot

anticipate every cost-saving expenditure at rate case time; and not every

expenditure matches neatly with a distinct rate case schedule.


The solution lies somewhere in the intersection of several factors: clear

Commission expectations, distinctions between obligatory performance and

extraordinary performance, general rate cases, and riders for specific costs. The

solution does not lie in Mr. Emmrich's proposal. Incentives for short-term cost-

cutting; returns unconnected to performance; information asymmetry; and a

culture of withholding productivity for higher shareholder rewards, do not

produce a public interest solution.

C. Do the existing multiple mechanisms for standard-setting and cost

recovery work well together?

The general rate case is only one of several places where performance and

compensation intersect. There are power purchase cases, riders and surcharges,

energy efficiency obligations, power plant performance incentives and other

measures. The Commission will want to ask whether this multiplicity of

methods, of obligations, cost recovery mechanisms and other motivators, all

intended to boost performance in different ways, is sufficiently inter-related that

all involved understand their interactions and effects. To award extra incentives

in a general rate case, disconnected from any notion of performance other than

cutting costs, will not produce this understanding.


ATTACHMENT A

Resume of Scott Hempling

Scott Hempling is the owner of Scott Hempling, Attorney at Law LLC. He recently completed 5 years as the Executive Director of the National Regulatory Research Institute. At NRRI, he was responsible for leading a staff of experts who advise 51 U.S. utility jurisdictions on all aspects of utility regulation in theelectricity, gas, telecommunications, and water industries. He has guided regulatory commissions on all phases of commission decisionmaking, including investigations, hearing procedures, deliberations, opinion writing, appellate review, legislative relations, and internal organization.

Prior to his appointment to NRRI, Mr. Hempling founded and managed a national law practice, focusing on utility regulation. Clients included state commissions and legislatures, independent power producers and marketers, investor-owned utilities, municipal power systems, ratepayer representatives, and public interest organizations.

Mr. Hempling’s research includes market structure; mergers, acquisitions, and corporate restructuring; utility diversification; revenue requirements and rate design; transmission and rate policies affecting renewable and other energy producers; methods for stimulating innovation by public utilities; and state-federal jurisdictional issues.

Mr. Hempling has appeared frequently before congressional and state legislative committees, and as a lecturer at industry conferences and training programs. Since 1988 he has taught electricity law and policy in professional seminars to thousands of students. Mr. Hempling is a member of the Bars of the District of Columbia and Maryland. In October 2007, he began a series of monthly essays on the principles of effective regulation, all posted at www.nrri.org. NRRI has published the first three years of these essays in a book entitled Preside or Lead? The Attributes and Actions of Effective Regulators.

Hempling is graduate of Yale University (B.A. cum laude in Economics and Political Science, and in Music), and Georgetown University Law Center (J.D. magna cum laude). In 2011, he was appointed an Adjunct Professor at the


Georgetown University Law Center, to teach a course on Regulation of Public Utility Monopolies.

Education

B.A. cum laude, Yale University (majors: Economics and Political Science; Music), 1978. Recipient of a Continental Grain Fellowship and a Patterson Research grant.

J.D. magna cum laude, Georgetown University Law Center, 1984. Recipient of American Jurisprudence Award for Constitutional Law; editor of Law and Policy in International Business; instructor, legal research and writing.

Professional Experience

President, Scott Hempling, Attorney at Law LLC (2011-present).Executive Director, National Regulatory Research Institute (2006-2011). Adjunct Professor, Georgetown University Law Center (2011-present).Founder and President, Law Offices of Scott Hempling, P.C. (1990-2006). Attorney, Environmental Action Foundation (1987-1990).Attorney, Spiegel and McDiarmid (1984-1987).

Past Clients

Independent Power Producers and Marketers

California Wind Energy Association, Cannon Power Company, Electric Power Supply Association, EnerTran Technology Company, National Independent Power Producers, SmartEnergy.com, U.S. Wind Force.

Investor-Owned Utilities

Madison Gas & Electric, Oklahoma Gas & Electric.

Legislative Bodies

Vermont Legislature, South Carolina Senate.


Municipal Power Systems

Connecticut Municipal Electric Energy Cooperative, Iowa Association of Municipal Utilities, City of Winter Park, Florida.

Public Interest Organizations

American Association of Retired Persons, American Public Power Association, Consumer Federation of America, Energy Foundation, Environmental Action Foundation, Illinois Citizens Utility Board, Union of Concerned Scientists.

State Commissions and Consumer Agencies

Arkansas Public Service Commission, Arizona Corporation Commission, Connecticut Department of Public Utility Control, Connecticut Office of Consumer Counsel, Delaware Public Service Commission, Hawaii Public Utilities Commission, Indiana Utility Regulatory Commission, Kansas Corporation Commission, Massachusetts Attorney General, Massachusetts Department of Public Utilities, Missouri Public Service Commission, Montana Public Service Commission, National Association of Regulatory Utility Commissioners, Nevada Consumer Advocate, Nevada Public Service Commission, New Hampshire Public Utilities Commission, New Jersey Division of Ratepayer Advocate, North Carolina Utilities Commission, Ohio Public Utilities Commission, Oklahoma Corporation Commission, Pennsylvania Office of Consumer Advocate, South Carolina Public Service Commission, Texas Office of Public Utility Counsel, Vermont Department of Public Service, Virginia State Corporation Commission, Wisconsin Attorney General.


Legislative Testimony

United States Senate

Committee on Energy and Natural Resources, May 2008 (addressing the adequacy of state and federal regulation of electric utility holding company structures)

Committee on Energy and Natural Resources, Feb. 2002 (analyzing bill to amend the Public Utility Holding Company Act) (PUHCA).

Committee on Energy and Natural Resources, May 1993 (analyzing bill to transfer PUHCA functions from SEC to FERC).

Committee on Banking and Urban Affairs, Sept. 1991 (analyzing proposed amendment to PUHCA).

Committee on Energy and Natural Resources, March 1991 (analyzing proposed amendment to PUHCA).

Committee on Energy and Natural Resources, Nov. 1989 (analyzing proposed amendment to PUHCA).

United State House of Representatives

Subcommittees on Energy and Power and Telecommunications and Finance, Commerce Committee, Oct. 1995 (regulation of public utility holding companies).

Subcommittee on Energy and Power, Energy and Commerce Committee, July 1994 (analyzing future of the electric industry).

Subcommittee on Energy and Power, Energy and Commerce Committee, May 1991 (analyzing proposed amendment to PUHCA).

Subcommittee on Environment, Energy and Natural Resources, Government Operations Committee, Oct. 1990 (assessing electric utility policies of FERC).


Appropriations Subcommittee on Commerce, Justice, State and the Judiciary, Apr. 1989 (discussing proposals to increase staff administering PUHCA).

Subcommittee on Energy and Power, Sept. 1988 (discussing "independent power producers" and PUHCA).

State Legislatures

Committee on Energy and Public Utilities, California Senate (December 1989) (discussing relationships between electric utilities and their non-regulated affiliates).

Interim Committee on Electric Restructuring, Nevada Legislature (1995-97) (discussing options for structuring the electric industry).

Committees on General Affairs, Finance, Vermont Senate (February-March 1997) (discussing options for structuring the electric industry).

Task Force to Study Retail Electric Competition, Maryland General Assembly (1997).

Electricity Restructuring Task Force, Virginia General Assembly (1999).

Judiciary Committee, South Carolina Senate (Fall 2000).

Publications and Speeches

“Regulatory Support for Renewable Energy and Carbon Reduction: Can We Resolve the Tensions Among Our Overlapping Policies and Roles?” (National Regulatory Research Institute 2011).

“Infrastructure, Market Structure, and Utility Performance: Is the Law of Regulation Ready?” (National Regulatory Research Institute 2011).

“Cost-Effective Demand Response Requires Coordinated State-Federal Actions” (National Regulatory Research Institute 2001).


“Effective Regulation: Do Today’s Regulators Have What it Takes?” in Kaiser and Heggie, Energy Law and Policy (Carswell 2011).

“Broadband's Role in Smart Grid's Success: Seven Jurisdictional Challenges” (National Regulatory Research Institute 2010).

“Certification of Regulatory Professionals” (National Regulatory Research Institute 2010).

Preside or Lead? The Attributes and Actions of Effective Regulators (National Regulatory Research Institute 2010).

Renewable Energy Prices in State-Level Feed-in Tariffs: Federal Law Constraints and Possible Solutions (lead author, with C. Elefant, K. Cory, and K. Porter), Technical Report NREL//TP-6A2-47408 (January 2010).

Pre-Approval Commitments: When And Under What Conditions Should Regulators Commit Ratepayer Dollars to Utility-Proposed Capital Projects? (NRRI 08-12 Nov. 2008) (with Scott Strauss).

“Joint Demonstration Projects: Options for Regulatory Treatment,” The Electricity Journal (June 2008).

“Corporate Structure Events Involving Regulated Utilities: The Need for a Multidisciplinary, Multijurisdictional Approach,” The Electricity Journal (Aug./Sept. 2006).

"Reassessing Retail Competition: A Chance to Modify the Mix," The Electricity Journal (Jan./Feb. 2002).

The Renewables Portfolio Standard: A Practical Guide, National Association of Regulatory Utility Commissioners (Feb. 2001) (with N. Rader).

Promoting Competitive Electricity Markets Through Community Purchasing: The Role of Municipal Aggregation, American Public Power Association (Jan. 2000) (with N. Rader).

Is Competition Here? An Evaluation of Defects in the Market for Generation(National Independent Energy Producers, Jan. 1995) (co-author).


The Regulatory Treatment of Embedded Costs Exceeding Market Prices: Transition to a Competitive Electric Generation Market (Nov. 1994) (with K. Rose and R. Burns).

"Depolarizing the Debate: Can Retail Wheeling Coexist with Integrated Resource Planning?" The Electricity Journal (Apr. 1994).

Reducing Ratepayer Risk: State Regulation of Electric Utility Expansion(American Association of Retired Persons 1993).

"'Incentives' for Purchased Power: Compensation for Risk or Reward for Inefficiency?" The Electricity Journal (Sept. 1993).

"Making Competition Work," The Electricity Journal (June 1993).

"Confusing 'Competitors' With 'Competition,'" Public Utilities Fortnightly(March 15, 1991).

"The Retail Ratepayer's Stake in Wholesale Transmission Access," Public Utilities Fortnightly (July 19, 1990).

"Preserving Fair Competition: The Case for the Public Utility Holding Company Act," The Electricity Journal (Jan./Feb. 1990).

"Opportunity Cost Pricing," Wheeling and Transmission Monthly (Oct. 1989).

"Corporate Restructuring and Consumer Risk: Is the SEC Enforcing the Public Utility Holding Company Act?" The Electricity Journal (July 1988).

"The Legal Standard of 'Prudent Utility Practices' in the Context of Joint Construction Projects," NRECA/APPA Newsletter Legal Reporting Service (Dec. 1984/Jan. 1985) (co-author).


Speaker and Lecturer

American Bar Association; Regulatory studies programs at Michigan State University, New Mexico State University and University of Idaho; CanadianAssociation of Members of Public Utility Tribunals; Canadian Association of Regulatory Utility Tribunals; Canadian Energy Law Forum; Pennsylvania Bar Institute; Louisiana Energy Bar; India Institute of Technology-Kanpur; Management Development Institute at Gurgaon, India; Independent Power Producers Association of India; American Antitrust Institute, American Association of Retired Persons; American Power Conference; American Public Power Association; American Wind Energy Association; Chicago Bar Association (Energy Section); New York Bar Association (Energy Section); Electric Power Research Institute; Electric Utility Week; Electricity Consumers Resource Council; Energy Daily; Executive Enterprises; Exnet; Federal Energy Bar Association; Harvard Electricity Policy Group; Infocast; Management Exchange; National Conference of Regulatory Attorneys; Midamerica Association of Regulatory Commissioners; Mid-Atlantic Conference of Regulatory Utility Commissioners; National Association of Regulatory Utility Commissioners; National Association of State Utility Consumer Advocates; National Independent Energy Producers; New England Conference of Public Utility Commissioners; New England Public Power Association, Southeastern Association of Regulatory Utility Commissioners; World Regulatory Forum, U.S. Department of Energy Forum on Electricity Issues.


ATTACHMENT B

Data Responses Cited in this Testimony

UCAN DR48-2

2. At page 1, you state that: "SDG&E is proposing to invest significantly in its infrastructure in the PTY period". Please provide a comparison SDG&E's investment in this rate case cycle with the investment in infrastructure in SDG&E's most recent two rate case cycles (i.e. 2007-2011 and 2005-2007) and indicate how much more money in real terms that SDG&E will be spending in this upcoming rate case cycle than in the previous ones.

SDG&E Response:We do not have the information in the format requested. Attached is our revised 5-year capital history (2005-2009 unadjusted) that was provided to DRA in July 2011. The amount of capital investment made during the rate case cycle will in large part depend on the authorized base margin that the Commission authorizes the utilities to spend to provide service to SDG&E’s and SCG’s customers.

UCAN DR48-3

3. In reference to your statement at page 2: "guaranteed productivity enhancements at levels equal to customer growth." Please provide a narrative describing why the productivity enhancements are guaranteed. Isn't it true that your proposal doesn't require such productivity but that it simply provides an economic incentive to SDG&E for such productivity.

SDG&E Response:The productivity enhancements are “guaranteed” because SDG&E will have to absorb customer growth without receiving an increase in base margin to cover that cost, therefore, the only way SDG&E can cover those costs would be to increase its productivity. There is no incentive associated with the mechanism it just means that if SDG&E is to be able to achieve its ROR then it must improve productivity to offset customer growth costs or suffer financial losses.

Documents

Evaluation of San Diego Gas and Electric Company's PTY ... › files › pdf › tty_cpuc_sdge... · My resume is attached to this testimony as ATTACHMENT A. II. INTRODUCTION AND