Northwest Energy Review Transition Board
Proposal for a Bonneville
Contingent Cost Recovery Mechanism
(TB 98-15)
NOTE: Written comments on this proposal can be accepted at the Power Planning Council Office until close of business, September 4, 1998.
For the past three months, the Transition Board has listened carefully to the comments of various interests on the staff’s "strawman" and the Board’s own draft proposals for a contingent cost recovery mechanism or, as it is frequently called, a "stranded cost" mechanism for Bonneville.
We have modified our initial proposal significantly in response to public comment. The following section on contingent cost recovery is a revised proposal on which we seek further public comment. It is our intent to reach a final decision on our recommendations for contingent cost recovery by mid-September. Written comment can be accepted until the close of business September 4, 1998.
Because Bonneville is constrained legally and by the realities of a competitive wholesale power market, it can effectively only charge rates that are the lower of its costs or market price. Its rates can exceed market prices only for relatively short periods, i.e. within a rate period, before it risks losing customers. The Board believes that, under most circumstances, the probability of Bonneville being unable to recover its costs and the magnitude of those unrecovered costs are relatively small. Perceptions of Bonneville’s future financial condition have generally been improving over recent months. Under some expectations about future market conditions, it is likely that Bonneville’s customers would see substantial benefits relative to purchasing from the wholesale power market, even if Bonneville is called upon to bear additional costs for salmon mitigation or other reasons. There are, however, possible combinations of market conditions and additional costs where Bonneville would be unable to fully recover its costs. It also appears that if Bonneville is to experience cost recovery problems, those problems probably occur in the 2007 – 2012 time frame when it is more likely to be subjected to larger costs and/or reductions in power production as a result of salmon mitigation measures.
Effective cost management can reduce the likelihood that Bonneville could not recover its costs. Also, traditional risk management tools, like building and maintaining adequate financial reserves, can completely or substantially mitigate cost under-recovery under some conditions. However, as a federal agency, Bonneville does not have stockholders who knowingly accepted the risk of losses or who stand to benefit when market prices exceed costs. Congress and the Administration need confidence that, under an acceptable range of conditions, the U.S. Treasury will not be called upon to absorb long-term losses. Consequently, a contingent cost recovery mechanism is essential if a "Northwest Chapter" of federal restructuring legislation is to be received favorably.
In developing this proposal, the Transition Board is attempting to satisfy the following objectives:
• To the greatest extent possible, the mechanism should align the incidence of future benefits and future risks;
• The mechanism should not disadvantage those who subscribe for Bonneville power relative to their alternative of purchasing on the market;
• The mechanism should minimize and bound the uncertainty to which purchasers of Bonneville power are subject;
• The mechanism should provide incentives for Bonneville to control its costs;
• The mechanism should not allow Bonneville to use its monopoly power in transmission to recover power system costs if power subscribers are paying significantly less than market prices.
• To the extent possible given market conditions and Bonneville’s costs, Bonneville should ensure an adequate level of reserves entering the subsequent rate period (2007—2012). This level of reserves should take into account the risk of costs Bonneville may have to bear during that period.
Recommendation
To achieve the above objectives, the Transition Board proposes a staged contingent cost recovery mechanism. The proposed mechanism has four stages of progressively more aggressive actions. The second, third and fourth stages are triggered by projected levels of reserves. The trigger for the fourth stage is a forecast reserve level that implies a high probability of deferral of Treasury repayment absent remedial action. The relationship of the different trigger levels, and some important considerations in setting them, are discussed after the description of the four stages.
Discussion
The Transition Board, by proposing a staged mechanism based on projected reserve levels, intends to avoid, if possible, the necessity of implementation of more aggressive subsequent stages or, at least, to make them as minimal as possible while maintaining a high probability of Treasury repayment.
Recommendation
Any revenue insufficiency will first be addressed through application of 4(h)(10)(c) credits to the extent possible, and the use of financial reserves, including any unused borrowing authority.
Discussion
This recommendation is, in effect, an endorsement of current policy. Where credits and/or reserves are available, they should be used to the fullest extent possible to avoid the necessity of subsequent actions that might impair Bonneville’s ability to fulfill its obligations or require that it impose additional costs on others.
Recommendation
Bonneville will project its end-of-fiscal-year financial reserves periodically during its operating year, but, at a minimum, each July and in the event of a development that could substantially affect these reserves. If the end-of-fiscal-year projected reserves drop below the first trigger level, Bonneville will identify proposed cost reductions consistent with meeting its obligations and hold a public hearing to present them. Bonneville will hear public comments on the proposed reductions, weigh the comments, decide which reductions to implement and implement them as quickly as possible.
Discussion
The Transition Board believes that effective cost control is an essential element of contingent cost recovery and should be initiated in time to minimize the extent to which subsequent stages must be implemented.
Recommendation
If the projected end-of-fiscal-year reserves are below the first trigger level, the administrator should implement a capped rate adjustment mechanism for Bonneville’s power rates for the next fiscal year of the rate period. This mechanism would raise subscriber rates to the lower of:
1. The level necessary to restore reserves to the level necessary to assure the desired level of Treasury repayment, taking into account the effects of any cost reductions implemented in Stage 2, or
2. A predetermined market cap.
If feasible, the cap would be set by the New York Mercantile Exchange (NYMEX) futures market at the California-Oregon border (COB, appropriately adjusted for delivery point and product character), over the year following imposition of the rate adjustment. Currently, this futures market more than 4-5 months out is "thin." That is, few futures contracts are traded in later months, so the credibility of futures prices as a market projection over a whole year is uncertain. Expanded participation in this market over time may remedy this problem. If, by the time of potential application, the futures market over a span of a year is judged to be sufficiently deep to represent a true market, the futures market should be used. If not, the cap would be set by the margin between actual prices in the past year’s spot market and Bonneville’s monthly prices in the same period, appropriately adjusted for delivery point and product character.
Discussion
The Transition Board believes that establishing a market cap based on a forward looking market index is preferable in that it reflects the prices at which customers could purchase power over the coming year and is less subject to weather-related variability. However, unless the futures market is sufficiently deep, the index might not be reliable. If that is judged to be the case, a mechanism using actual spot market prices over the past year would be an acceptable substitute. The intent in either case is to allow customers to know the limits of their exposure on a year-ahead basis.
Recommendation
If, after implementation of the first three stages, projected reserve levels are at or below a second, lower trigger level that implies a high probability of Treasury deferral, Stage 4 would be implemented. In this stage, the recovery of any remaining unrecovered costs necessary to restore reserves to the level required to assure the desired probability of treasury repayment would be accomplished through a mechanism and allocation methodology adopted by the Federal Energy Regulatory Commission. Recovery by this mechanism would be limited to $100 million in any year, up to a cumulative total of $600 million. Legislation will direct the FERC to promptly carry out a proceeding to design and adopt the mechanism and allocation methodology so that it may be implemented without delay if the need arises.
Discussion
The region has been unable to reach a reasonable level of agreement on this stage of contingent cost recovery. Consequently, the Transition Board proposes that the Federal Energy Regulatory Commission be directed to developed an appropriate methodology. The FERC is experienced in these issues and is equipped to deal with them. It is essential that FERC develop its methodology in advance of an actual triggering event so that the mechanism can be implemented quickly enough to have the desired effect. The duration of this stage of the recovery mechanism would be 15 years – a period long enough to take Bonneville to the point that Supply System debt will have been largely paid off.
Recommendation
A target reserve level should be established for the last year of the initial rate period which takes into account anticipated costs during the 2007—2012 period. Both the trigger levels in the final years of the initial rate period should be selected to achieve the end of period reserve level after making the last year’s Treasury payment.
Discussion
It appears that if Bonneville is going to experience cost recovery problems, those problems are more likely to occur in the 2007 – 2012 period. This is when Bonneville is more likely to be subject to larger costs/and or reductions in power production capability as a result of salmon mitigation measures. The intent of this recommendation is to ensure that Bonneville has reserves entering into that period that take into account the risks of higher costs during that period.
Recommendation
Our proposal is to implement Stage 2 measures coincident with Stage 3 and then implement Stage 4. This means that the first trigger must be at a higher level of projected reserves than the second trigger. The margin between trigger levels should be sufficient to allow each stage’s effects a chance to make implementation of the next stage unnecessary. The coordination among the target level of reserves and trigger levels for contingent cost recovery stages will require a significant analytical effort. Bonneville has performed these analyses in the past and should set these levels as part of the rate case to accomplish these goals.
Discussion
The overall probability of making Bonneville’s payment to the Treasury is affected by a number of variables under Bonneville’s control. Bonneville calculates the probability of making its Treasury payment taking into account net revenues for risk included in their basic power rates, together with any contingent cost recovery mechanisms like cost reductions and rate adjustment. The target level of reserves is that end-of-year level that yields an acceptably high probability of making all of the Treasury payments during the five-year rate period. The trigger levels are those levels of reserves that trigger those mechanisms. The trigger levels would typically be set below the target levels because random variability in water conditions and markets could have a reasonable probability of restoring reserves to the target level without resorting to other mechanisms.
The target level of reserves and the levels of projected reserves used as triggers for cost control, power rate adjustments and the last stage of contingent cost recovery can vary but these levels must be coordinated to meet a given level of confidence of making the Treasury payment. Raising the net revenues for risk in power rates, other things equal, would allow lower triggers for the stages of contingent cost recovery while maintaining the same probability of Treasury payment. Conversely, for a given target level, lowering the trigger level for one mechanism would require raising the trigger levels for other mechanisms.