HomeMy WebLinkAboutINS-12-065 - Gas Rates Redesign - Delivery & TransportationREPORT TO:Finance & Corporate Services Committee
DATE OF MEETING:
October 15, 2012
SUBMITTED BY: Walter J. Malcolm, Director of Utilities, x4538
PREPARED BY:
Jim Gruenbauer, Manager, Regulatory Affairs & Supply,
x4255
WARD(S) INVOLVED:
All
DATE OF REPORT:
October 10, 2012
REPORT NO.:
INS-12-065
SUBJECT:
Gas Rates Redesign – Delivery & Transportation
RECOMMENDATION:
For Information Only.
Note: The changes in the methods used to set gas rates as described in this report are
intended to align with principles adopted by regulatory authorities such as the Ontario Energy
Board (OEB). Any implementation of these rate design changes is subject to approval by
Council. This will occur in its pending reviews of the annual operating budget and subsequent
proposals to change gas rates. Due to the technical nature of this report, a Glossary of Terms
and Market Schematic are attached.
EXECUTIVE SUMMARY:
Effective November 1, 2012, Kitchener Utilities (KU) will no longer hold any TransCanada
Pipelines Limited (TCPL) long haul contracts to transport gas from Alberta to Ontario.
Accordingly, the rate for gas transportation approved by Council should no longer be based on
TCPL tolls. Similar to the supply of gas, the transportation of gas must be operated on a not-
for-profit basis to align with OEB approved rate-making principles. The surplus of gas
transportation revenues over costs on a planned basis must be eliminated. This will reduce the
regulatory risk of the OEB asserting direct control over KU gas rates and significantly and
permanently reducing the annual utility earnings and dividends to the City.
Under a modified cost of service approach to rate-setting, KU’s local gas delivery rates must
increase. This will preserve overall utility revenues and fully recover KU costs of service,
including earnings and a fixed dividend to the City. This adjustment in gas delivery rates will
drive earnings that are at the upper limit for comparable utilities whose rates are regulated by
authorities such as the OEB. Further increases to KU utility earnings and dividends are not
considered defensible. However, over time, the portion of gas delivery revenues derived from
fixed charges should increase to match and fully recover KU largely fixed costs of service
(including profit for reinvestment and a fixed dividend). This will reduce seasonal weather-
related revenue risk. These changes can be phased-in with corresponding decreases in the
variable delivery charges to yield neutral annual customer bill impacts from the rate redesign.
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BACKGROUND:
Current Rate Design - Overview
Under current Provincial legislation, the gas rates of KU are not regulated by the OEB, but set
by City Council. For more than a decade, the gas rates for transportation and delivery as
approved by Council and charged by KU have been based on the regulated rates of other
utilities. The gas transportation rate is currently based on the National Energy Board (NEB)
approved toll for long haul firm transportation from Alberta to Ontario on the TCPL system. Gas
delivery rates are currently based on the OEB approved rates for Union Gas Limited (UGL) in
the Southern Ontario Area, which is adjacent to Kitchener.
An important rate-making principle to which the City has adhered over the years is that there
should be no ongoing cross-subsidization between the services provided by KU to its
customers. In an increasingly competitive marketplace, this principle levels the playing field for
participants. It has also been supported by the City’s external auditors and reflected in the
presentation of segmented utility financial information to demonstrate to readers that operating
cross-subsidies do not exist.
While using the regulated rates of other utilities have served Kitchener and its ratepayers well in
the past, they have become less relevant due to major changes in the gas market. In addition,
in a challenging and ever-changing municipal funding environment, there is an increased need
for budget transparency, and stable revenues and sustainable earnings from KU as a strategic
City enterprise. The need for earnings stability has raised questions about the continued use
and relative merits of the regulated rates of other utilities to set the gas rates for transportation
and delivery services to KU’s customers.
REPORT:
Gas Transportation
In the late 1990’s, when KU began to actively manage its own gas commodity purchases, all of
the gas supply was transported from Alberta to Ontario on the TCPL system. At that time, the
TCPL toll was $ 0.936 per GJ (3.529 cents per m3). The current approved interim long haul toll
for TCPL is $ 2.243 per GJ (8.465 cents per m3). This toll has increased by about 90% over the
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past several years due to declining volumes shipped on the TCPL system. As TCPL tolls have
increased sharply overtime relative to cheaper alternatives, KU has reduced its contracted
levels of long haul transportation with TCPL. Please refer to Figure 1 below.
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The approved final long haul toll for 2009 was $ 1.19 per GJ (4.491 cents per m3). TCPL requested an
interim toll for 2012 of $ 2.45 per GJ (9.246 cents per m3) which was denied by the NEB.
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FIGURE 1 – TCPL Contracts Held by KU & Approved Tolls
Effective November 1, 2012, KU will no longer hold any long haul transportation contracts with
TCPL. Gas supplies sourced in Western Canada will be transported to Ontario using far less
expensive purchased services from KU’s diversified portfolio of approved suppliers.
The rate currently charged to KU customers for transportation of gas is 6.182 cents per m3.
This rate has been held constant since July 1, 2010 to avoid the subsequent sharp increases in
the TCPL toll as noted above. The rate has been more than sufficient to recover the underlying
average cost of transportation.
The surplus between KU’s gas transportation revenues (based on TCPL tolls) and costs (based
on declining levels of TCPL contracts) has been significant and generally trending higher to its
current level of about $ 4 million annually. This trend, in fact, is opposite to expectations when
Council approved the use of the approved TCPL toll to set KU transportation rate and KU was
empowered to seek lower cost alternatives to TCPL. It was initially expected that the surplus
(“transportation benefit”) would diminish over time as TCPL tolls and alternative means of
transporting gas to Ontario became more competitive. Instead, TCPL tolls have become
increasingly uncompetitive over time. It is no longer relevant or appropriate to use the TCPL toll
to set the KU gas transportation rate.
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Indeed, the ongoing generation and retention of a surplus between gas transportation revenues
and costs is contrary to the legacy rate-setting methodology approved by the OEB. The
transportation of gas from supply sources to Ontario is treated on a “pass-through” basis for
OEB rate-regulated utilities, similar to the commodity purchase and resale of gas. The average
forecast cost of transportation is recovered in rates, with subsequent adjustments to “true-up”
any differences between amounts collected in rates and actual costs incurred. Transportation of
gas is thereby operated on a break-even / flow-through basis.
In order to reduce the regulatory risk of the OEB asserting direct control over KU rates, KU must
adopt a similar “pass through” approach to set its gas transportation rate. Failure to do so runs
the risk of a significant and permanently imposed reduction in KU annual utility earnings and
dividends to the City. However, this approach is subject to making offsetting adjustments to
local gas delivery rates that are necessary to preserve overall utility revenues and to stabilize
earnings, as discussed further in the following section.
Gas Delivery
With Council’s approval, KU adopted the customer rate classifications and gas delivery rates for
UGL as regularly reviewed and approved by the OEB. This approach provided comparable
rates with municipalities adjacent to Kitchener served by UGL such as Waterloo and
Cambridge. It also provided a form of indirect (and therefore less costly or burdensome)
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regulation by the OEB of KU’s gas delivery rates.
While comparable in principle and theory, in structure and practice, KU is quite different from
UGL. Both utilities are monopoly distributors of natural gas in their service areas. However, KU
is municipally-owned. Its customers also own the utility. This is not the case for UGL, a much
larger gas utility, which is privately owned by a foreign corporate shareholder (Spectra Energy).
Moreover, UGL is an integrated gas utility, with assets that provide gas storage, transmission
and distribution services to customers in Ontario and beyond. Importantly, by virtue of its
corporate ownership structure, UGL has ready access to broad financial markets to fund its
operating and capital programs that maintain and expand its utility system. KU’s access to
capital is constrained by the City’s municipal finance and budget framework. These structural
attributes drive significant differences in the costs incurred by each utility to provide service. In
textbook terms, KU does not enjoy the “economies of scale and scope” that UGL does.
KU does enjoy some cost advantages due to its municipal ownership within the current
legislative framework. These advantages relate primarily to income and property taxes,
regulatory oversight and financial reporting. However, the City’s past practice with municipally
owned enterprises has been to include a notional value of property and income taxes in their
cost structure to maintain a level playing field for other market participants.
UGL’s rates for gas supply, transportation and delivery are regulated by the OEB. UGL’s profit
comes from the delivery of gas to customers, not from the commodity purchase and resale of
gas or the transportation of gas from supply sources to Ontario. Gas delivery rates are based
on an OEB approved “cost of service” methodology applied to UGL’s forecast of operations for
the upcoming year. Utility cost of service includes all annual operating, maintenance, general
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It is noteworthy that, prior to 1998 when KU “unbundled” its gas rates into separate services and began
to actively manage its own gas commodity purchases, the gas rates charged to KU customers were
identical to those approved by the OEB for UGL.
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and administrative expenses, and earnings to fund capital expenditures and provide an allowed
return on debt and equity (profit including dividend) to the shareholder. The allowed return is
strictly based on a formula with no discretion in how it applies. This approach to setting gas
delivery rates for UGL has been used by the OEB for many years.
Under a modified cost of service approach to rate-setting, KU’s gas delivery rates must
increase. This will preserve overall utility revenues and fully recover KU costs of service,
including earnings and a fixed dividend to the City as a municipal enterprise. However, this
adjustment in gas delivery rates will drive earnings that are at the upper limit for comparable
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utilities whose rates are regulated by authorities such as the OEB. Further increases to KU
utility earnings and dividends are not considered defensible.
Similar to UGL, the costs incurred by KU to provide monopoly delivery service to KU customers
are largely fixed, especially for the upcoming budget year (due to collective bargaining
agreements for labour and other service contracts that are necessary for utility operations).
However, the monthly and seasonal gas volumes delivered to customers are heavily influenced
by weather due to the predominance of gas use for space heating purposes. This variability
and volumetric weather risk impacts KU more so than UGL. This is due to KU’s relative lack of
sizable non-seasonal industrial gas use to balance the seasonal swings in residential and
commercial gas use.
In order to predictably recover KU’s fixed costs of service (including profit for reinvestment and a
fixed dividend to the City), KU budgeted delivery revenues from fixed charges should be closely
matched. This will reduce seasonal weather-related revenue risk. The prudent rate-making
principle of matching fixed costs of service (including the municipal funding requirements of KU)
with fixed revenues will stabilize and sustain utility revenues and earnings. Changes to fixed
charges can be phased-in with corresponding decreases in the variable delivery charges to
yield relatively neutral annual customer bill impacts from the rate redesign.
ALIGNMENT WITH CITY OF KITCHENER STRATEGIC PLAN:
Theme: Financial Management
Strategic Direction: Ensure responsible use of public funds within a supportive policy
framework.
The rates charged to customers in Kitchener for the transportation and delivery of natural gas
should transparently recover the full costs incurred by Utilities Division. The methodology used
to set Kitchener’s rates should be fairly consistent with the utility cost of service methodology
approved by regulatory bodies such as the OEB, while adhering to the municipal finance and
budget framework in which Utilities Division must operate.
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The rate of return is calculated based on a modified cost of service model with the notional value of
income and property taxes added to the utility dividend consistent with the basis of calculation for the
dividend from the City’s golf enterprise, to ensure a “level playing field” with private sector competitors.
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FINANCIAL IMPLICATIONS:
For 2013, changes in rates to align with appropriate rate-making principles are designed to be
neutral for KU’s system gas customers. These represent the large majority of customers served
by KU. Direct purchase customers of KU (mostly commercial and industrial) would face an
increase in delivery rates in the range of 6% to 22%. Further rate changes will be implemented
carefully to minimize any large unfavourable impacts on annual customer bills. Any increase in
delivery rates, if and as subsequently approved and implemented, would impact only a portion
(typically less than one-third) of the total annual bill for commercial and industrial customers.
UGL currently has an application before the OEB to increase its gas delivery rates, effective
January 1, 2013. If approved, its comparable delivery rates would increase by about 5% to
13%. If KU continues its legacy rate-making approach to adopt UGL’s OEB-approved delivery
rates, then this increase would presumably apply to customers in Kitchener in 2013. In other
words, there would be little difference in the gas delivery rates charged to most KU customers in
2013 as a result of the change in rate-making approach as set out in this report.
The charts below display the neutral impact of the changes in rates to align with appropriate
rate-making principles for an average residential system gas customer of KU in 2013.
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COMMUNITY ENGAGEMENT:
Public notice of the implementation of gas rate changes will be provided through local media
prior to any approval by Council as per normal practice.
CONCLUSION:
While using the regulated rates of other utilities to set KU gas rates have served Kitchener and
its ratepayers well in the past, there is a compelling need for change. It makes little or no sense
to continue to use the TCPL toll to set KU’s gas transportation rate when KU no longer holds
any contracts with TCPL to transport gas from Alberta to Ontario. Moreover, use of the TCPL
toll to set the KU transportation rate generates excess revenue, which cannot be supported by
rate-making principles used by regulatory authorities such as the OEB. To continue to generate
excess revenue from gas transportation risks the OEB asserting direct control over KU gas
rates. This may significantly and permanently reduce KU overall utility earnings and dividends
to the detriment of the City and ratepayers.
The rate design for gas transportation and delivery should be changed to reduce regulatory and
financial risks in a measured way that also recognizes the dual role of KU as a utility and a
strategically beneficial municipal enterprise. Rate design changes can be phased-in and
managed carefully to yield relatively neutral annual bill impacts for most customers.
ACKNOWLEDGED BY: Jim Witmer, Interim Deputy CAO, Infrastructure Services
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Report to Finance Committee – Gas Rates Redesign
Glossary of Key Terms
Cost of Service:
The total annual costs incurred by a utility, which must be
recovered in its rates. It is also referred to as revenue requirement, which
includes cost of goods sold, operating, maintenance and administration
expenses,depreciation and amortization expense, property, capital and income
tax expenses, and cost of capital. Cost of capital includes interest on debt and
allowed return on investment (return on rate base – see below) to shareholders.
Direct Purchase Customers:
End use customers of the gas utility that arrange
for gas supply and transportation at their own cost and risk. The utility only
provides gas delivery service to these customers.
Fixed Costs:
Certain costs which in the aggregate do not vary in amount
regardless of the quantity of gas sold or transported.
Fixed Revenues / Charges:
The fixed revenue generated from daily or monthly
fixed charges for maintaining secure delivery of natural gas to end use locations.
Gas Delivery:
The provision of gas to customers at their home or business as
required (on demand) on an hourly, daily, seasonal, and annual basis.
Gas Storage:
Gas is often stored underground inside depleted gas producing
reservoirs, salt domes, or in tanks as liquefied natural gas. The gas is injected in
times of low customer demand and withdrawn when demand picks up. Storage
helps the utility to economically balance the varying daily, monthly, and seasonal
swings in gas demand by customers with more stable receipts of gas supplies
from transportation pipelines.
Gas Supply Rate:
The rate charged to system gas customers (see below) for
natural gas commodity, fuel, and administration.
Gas Transportation Rate:
The rate charged to system gas customers (see
below) for bringing natural gas to Ontario from producing basins in Alberta.
Long Haul Transportation:
On the TCPL Canadian Mainline system (see
below), this refers to transportation of gas from Alberta to Ontario.
National Energy Board (NEB):
The Canadian federal regulatory body, which
oversees inter-provincial natural gas policy and regulates the rates of
transmission pipelines.
Ontario Energy Board (OEB):
A provincial regulatory tribunal, which regulates
the natural gas and electricity distribution utilities, pipelines, and marketers in
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Ontario. The OEB also provides advice on energy matters referred to it by the
Government of Ontario.
Rate Base:
Utility rate base is comprised of the aggregate of plant and
equipment at historical cost less accumulated depreciation plus an allowance for
working capital. For rate-making purposes using a cost of service approach, this
values the utility’s fixed assets needed to provide service at net book value.
Rate of Return:
In setting rates, the regulatory authority tries to strike a balance
between the prices to be paid by customers and the rate of return which
shareholders of the utility are allowed to earn on their equity investment.
System Gas Customers:
End use customers that receive gas supply and
transportation from the utility, in addition to delivery services.
TransCanada Pipelines Limited (TCPL):
It owns and operates a system of
natural gas pipelines, which carries gas through Alberta, Saskatchewan,
Manitoba, Ontario, and Quebec.
Transportation Benefit:
The positive surplus between Kitchener Utilities (KU)
gas transportation revenues (based on TCPL tolls) and costs (based on declining
levels of TCPL contracts).
Union Gas Limited (UGL):
A major Canadian natural gas storage,
transmission, and distribution company based in Chatham-Kent, Ontario. KU
contracts with UGL for storage and transportation services inside Ontario.
Variable Revenues:
Revenue generated from volumetric quantities as actually
delivered or used and billed to customers.
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