Carbon Policies and ElectricUtility Rate Cases

Current and Future Issues

Dr. David Harrison, Senior Vice President

Managing the Modern Utility Rate Case

Las Vegas, February 14, 2006

1

Overview

Carbon issues already relevant in current rate cases– Examples: IRP “adders” and resource choices; IGCC proposals; purchase of carbon

credits; uncertainty analyses related to potential carbon regulations

Carbon would be much more important with a cap-and-trade program– Virtually all U.S. carbon proposals involve a cap-and-trade program

– EU ETS in Europe provides example of how this program might develop

Many issues for future rate cases– Costs: Least-cost carbon plans and future technologies (and fuel prices)

– Rates: Effects of carbon allocations key

– Trading: Price/technology risks and “prudence

– Uncertainty Analyses: Price projections for carbon/fuel/technology

– Weighted average cost of capital: effects of additional carbon/fuel volatility

Different effects of carbon policy in regulated and deregulated markets

2

Agenda

Background on NERA

International Developments and European UnionEmissions Trading Scheme (“EU ETS”)

United States Climate Change Initiatives

Rate Case Issues Related to SO2 Trading Program

Current Rate Case Issues Related to CO2

Future Rate Issues under a CO2 Cap-and-Trade Program

Conclusions and Implications

3

About NERA

NERA Economic Consulting is an international firm of economistswho provide expert advice in legal and regulatory settings

NERA economists evaluate economic issues related to highly complexbusiness and legal issues arising from:

– Antitrust, IP, energy, environment, communications, securities, labor, others

NERA experts have participated in development/evaluation of major U.S.emissions trading programs

– Acid rain trading, RECLAIM, NOx Budget/NOx SIP Call (Northeast), RegionalGreenhouse Gas Initiative (RGGI)

Current involvement in European Union Emissions Trading Scheme (EU ETS)– Studies for European Commission on initial allocation

– UK government development of NAP and subsequent policy options

– Evaluation of effects on electricity prices

– Recent confidential studies for major European electricity companies

4

NERA’s Global Presence

Sydney

TokyoNew York CityChicago Ithaca Boston

White Plains

Washington D.C.

San Francisco

Los Angeles Madrid

London

Rome

Brussels

São Paulo

Denver Philadelphia

Frankfurt

18 Offices Worldwide: Over 400 Economists, Over 500 Total Staff

Paris

5

Kyoto Protocol

– Entered into force in February 2005

– Initial compliance period (2008-’12) provides for overall reduction of 5.2% from 1990 levels

– 160 countries, representing about 60 percent of Annex I emissions

– Flexible Mechanisms to provide flexibility and lower costs

• Emissions trading (AAUs)

• Clean Development Mechanism (CDM) and Joint Implementation (JI)

European Union Emissions Trading Program (EU ETS)

– All 25 EU Member States, with over 11,000 installations representing about 40% of EUemissions

– Phase 1 (2005-’07) and Phase 2 (2008-’12) targets based upon National Allocation Plans(NAPs) of individual Member States

Other (selected) International Developments

– Asia/Pacific Partnership for Clean Development (six countries)

– “Post-Kyoto” discussions and prospects

Background on InternationalClimate Change Policies

6

EU ETS Similarities/Differences withPrior Cap-and-Trade Programs

Many Common Elements– Shift from legal-engineering to price response

– Basic architecture of a cap-and-trade program

– Allocation mostly based upon grandfathered (free) allowances

Some Differences– Allocations based upon recent emissions, not benchmarking

(heterogeneity, no prior standard)

– New entrant reserves/closure provisions (except some NOx states)

– Multiple, sequential cap, about 4% below BAU for 2005-07

– More long-term uncertainties (cap, allocations, post-2012?)

7

Steep Rise in EU ETS CO2 Pricesin 2005

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5

10

15

20

25

30

Jan-

04

Feb-0

4

Mar

-04

Apr-04

May

-04

Jun-

04

Jul-0

4

Aug-0

4

Sep-0

4

Oct

-04

Nov

-04

Dec

-04

Jan-

05

Feb-0

5

Mar

-05

Apr-05

May

-05

Jun-

05

Jul-0

5

Aug-0

5

Sep-0

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Oct

-05

Nov

-05

All

ow

an

ce

pri

ce

( !

/tC

O2

)

0

2

4

6

8

10

12

14

Vo

lum

e t

rad

ed

(M

tCO

2)

Volume traded (MtCO2) Forward price of 2005 allowances (!)

Announcement

of UK NAP

Commission

approval

of first NAPs

Official start

of trading

scheme

Announcement

of German and

Italian NAPs

Announcement

of German NAP

8

UK Electric, Gas, and CO2 PricesRisen since March

UK electricity and gas prices (forward Q4 2005), CO2 prices

Price movements reflect complex interactions among CO2, fuel (oil, gas, coal)and electricity markets

Source: Platts, PointCarbon and NERA calculations

0

15

30

45

60

75

90

Mar-05

Apr-05

May

-05

Jun-05

Jul-0

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Aug-05

Ele

ctr

icit

y /

Fu

el

Pri

ce

(!

/MW

h)

0

5

10

15

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25

30

CO

2 p

rice (!/t

CO

2)

UK Price (!/Mwh) Gas NBP (!/MWh) CO2 2005 (!/Tonne)

9

EU ETS Electricity Price EffectsBased on Deregulated Markets

Electricity prices have risen steeply in 2005,coinciding with rise in CO2 prices in EU ETS (andalso higher natural gas/fuel prices)

Price increase not matched by CO2 cost increasefor all generators (e.g., nuclear, other low emitters)

“Opportunity costs” account for substantial part ofthe added generator costs, due to free allocations

Note that “opportunity costs” would not add togenerator costs under regulated rates

10

European Policy Proposals toReduce Electricity Prices/Profits

Change allocations/ taxes on generators– Provide fewer allowances to generators

– Tax “windfall profits”

Revenue “recycling”– E.g., allowance auction to generator combined with subsidy of transmission

charges

Wholesale price regulation– (re-)regulation of markets, using residual regulatory power to limit increases

Retail price regulation– Limited rate increases with rising wholesale price

– Special “industry” tariffs

11

U.S. Climate Change Programsand Proposals

Major Federal Legislative initiatives– McCain/Lieberman, Bingaman (NCEP), Carper, Jeffords bills

– All provide cap-and-trade program for electricity generators

– Many differences in “details” (including allowance allocations)

Regional initiatives– Regional Greenhouse Gas Initiative (RGGI) in Northeast

– Western regional initiative, California initiatives

Implications: Future likely to be CO2 cap-and-trade program– Many believe question is “when” not “if” a program will be adopted

– Specific nature of the program could vary widely, particularly allocations

12

Basic Allocation Choices underCap-and-Trade Programs

Summary of basic allocation alternatives

New Entrants

Specific Data / Formula

Year Used

Metric Used

Facility Allocation

Basic Allocation Type Free

Non-updated

Updated

Auctioning

Sector, then Facility Directly to Facility

Emissions Benchmarking

Fuel Input

Product Output

Capacity

2001

2004

2002

2005

2003

Other Years

Single Year Average Max

Purchase Allowances Receive Allowances ( “Updating ”)

Actual Emissions

Benchmarking Formula

Maximum Percentage

Other

13

Additional Allocation Possibilities

Shutdown forfeitures– Linked to new entrant allocations

– Administration

– Form of “updating”

Allocations to non-emitters– E.g., “indirect emissions”, “Sky Trust”

Incorporation of existing regulations and actions– “Early action” credits

– Renewable programs, energy efficiency programs

Changes over time in allocation choices– E.g., shift in percentage of auctioned allowances

14

Background on Rate Case Treatmentof Acid Rain Trading Program

“Typical” rate case treatment of SO2 allowances and SO2 controls– Control costs (e.g., scrubbers) included in rate base.

– Zero cost for use of grandfathered (“free”) allowances to cover emissions

– Trading gains/losses used to decrease/increase fuel costs Some complications (e.g., amortization of net revenues, “below the line” actions)

– Implications: (1) electricity rates do not increase to reflect “opportunity cost” offree allowances; (2) rate case issues relate to control costs and/or allowancepurchases needed to achieve compliance with the SO2 cap

Initial concern that PUC prudence reviews may inhibit cost-effectivecontrols and cost-effective trading

– Would PUCs second guess trading activities? Add to “regulatory risks?”

– Conclusions from experience (MIT report): (1) rate treatment did not reducecost-minimizing trading: and (2) utilities generally implemented cost-effectivecontrols (scrubbers, low-sulfur coal) to minimize compliance costs

15

Differences between Prior EmissionsTrading and Carbon Trading in U.S.

No current federal carbon cap-and-trade program– But potential/likelihood of future regulations means potential impacts/risks

should be considered

Cap likely to require smaller percentage reduction for carbon than for SO2 andNOx

– SO2: roughly 34% reduction from 1990 for acid rain trading and additional 70+%for CAIR

– NOx: roughly 70% from 1990 for NOx budget/SIP Call and additional 60+% forCAIR

– CO2: reductions in 2010 relative to business as usual are 5% in McCain-Liberman and 7% in Carper (almost 30% in Jeffords)

Control technologies less important for carbon than for SO2 and NOx

– SO2 and NOx: control technologies primary means of reductions (rather thanfuel switching, demand reduction)

– CO2: alternative fuels, fuel switching, demand reduction primary means ofreductions (rather than add-on technologies)

16

Current Rate Issues Related toCarbon Emissions: Resource Plans

Integrated Resource Plans (IRP) and carbon costs– Include future CO2 prices in IRP and choice among alternative resources

E.g., PacifiCorp 2004 IRP has probability-weighted CO2 prices

CO2 values used in Company IRPs vary widely– IRPs for different years (2003 to 2005)

– Source: PacifiCorp benchmarking study

Not ModeledNevada Power Company

Not ModeledSan Diego Gas & Electric

Not ModeledSouthern California Edison

N/A (redacted)Southern Company Services

$0/tonNorthern States Power (Xcel)

$0/tonPortland General Electric

$1.50/ton (WA mandated value only)Puget Sound Energy

$4.19/ton (2008$), beginning in 2010

$8.80/ton (2008$), beginning in 2012

PacifiCorp

$10.00/ton (2004$)LG&E Energy

$12.00/ton, beginning in 2009Public Service Company of Colorado (Xcel)

$12.30/ton, beginning in 2008Idaho Power

CO2 Base Case Allowance Cost ($/ton)Company IRP

17

Current Rate Issues: ResourcePlans (cont.)

Use Carbon Costs to Choose Among Alternatives– E.g., PacifiCorp comparisons between two finalists based in part on CO2 costs

Include renewables– Many states have Renewable Portfolio Standards– Motivated in part by climate change considerations

Proposals for Integrated Gasification Combined Cycle (IGCC) “clean coal”units

– Low-carbon technology (also lower SO2, NOx, mercury)– More expensive but federal incentives (ITC, guarantees) in Energy Policy Act of 2005 as

well as possible state incentives– Examples: AEP application for 600MW IGCC project in Meigs, Ohio; PacifiCorp review

of IGCC alternatives; Cinergy feasibility study in Indiana.

Related Rate Issues– Projections of timing/levels of future carbon prices in IRP and project choices– Include renewables and other low-carbon resources– Uncertainty analyses related to carbon prices/timing in IRP and choices

18

Current Rate Issues Related toCarbon: Carbon Credit Projects

Projects to reduce carbon emissions and include costs in rates– Provide carbon reductions through carbon sequestration, use of low-

carbon technology or other means.

– Equivalent to CDM and JI projects

– Incur costs but potentially reduce future carbon liabilities

– Potential actions include specific projects, investment in carbon funds(e.g., World Bank) or purchase on exchanges (e.g., Chicago ClimateExchange)

– Example: AEP/PacifiCorp Noel Kempff project in Bolivia (reduces carbonby preventing deforestation from logging and other land uses)

Rate issues– Costs and other issues associated with projects or purchased credits

– Uncertainty regarding future value of credits

19

Future Rate Issues Related toCO2 Cap-and-Trade Program

Issues in Regulated Jurisdictions– Initial allocation will affect rates

High allocation—small effect on rates because of sale of allowances Low allocation—larger effect on rates from purchase of allowances

– Reviews of CO2-reducing investments (efficiency, fuel switching)– Review of CO2 trading activity– Effects on weighted average cost of capital– Note: Studies show national costs of meeting CO2 cap greater with cost-of-

service regulation (due to less effect on electricity rates/demand)

Issues in deregulated jurisdictions– Initial allocation generally not change price effects (exception is updating)– Price effects greater than in regulated due to “opportunity costs” (and overall

cap-and-trade program more efficient)– Potential for “re-regulation” to reduce price effects

20

Conclusions

Carbon issues are already relevant to rate cases

Emerging regional and federal carbon policies will increasethe importance of carbon issues in rate cases

Effects of carbon policies on both regulated and deregulatedutilities will depend upon many “details” of the policies thatare put in place

Contact

© Copyright 2006National Economic Research Associates, Inc.

All rights reserved.

Dr. David Harrison, Jr.

Senior Vice PresidentNERA Economic ConsultingBoston+1 617 621 2612David.Harrison@nera.com