As regulators weight rate hike for Appalachian Power, years of legislative intervention have complicated the task

On Friday, after nearly a week of hearings that involved thousands of pages of filings from parties ranging from Attorney General Mark Herring’s office to the Virginia Poverty Law Center, Virginia regulators began deliberations about whether Appalachian Power should be able to raise its electric rates to increase its revenues by roughly $65 million.

All over the country, public utility commissions are regularly charged with such decisions, trusted by state governments to strike the correct balance between the interests of utilities that must raise capital to build and maintain some of the nation’s most fundamental infrastructure and the interests of the customers who pay the bills. 

But for Virginia’s State Corporation Commission, the always complex task is complicated by six years of extensive tinkering with the state’s system of utility regulation by a General Assembly that has long maintained cozy relations with its dominant electric utilities. 

Thanks to a controversial rate freeze passed by the General Assembly in 2015 and a reworking of the state’s review system in 2018, Appalachian Power’s rates haven’t been reviewed by regulators since 2014. 

Since then, much has changed. The federal Clean Power Plan that was the spur for the rate freeze never went into effect. Virginia’s Grid Transformation and Security Act of 2018 transformed the biennial review system into a triennial one while also giving the electric utilities broad leeway to reinvest their over-earnings in capital projects. And the 2020 Virginia Clean Economy Act committed the state to hundreds of millions of dollars in new investments in renewable energy.

Even as legislative priorities have changed, bills for Appalachian customers have risen. Data from the State Corporation Commission’s annual report on electric utilities shows that since 2007, the average monthly Appalachian Power bill for a residential customer has risen almost 64 percent, from roughly $67 in July 2007 to $109 in July 2020. Most of those increases occurred between 2007, when the state reclaimed oversight of its electric utilities after a brief attempt at deregulation, and the 2015 rate freeze. 

‘Single-issue intervention by the legislature’

This year, Appalachian is asking regulators to raise customer rates by about 6.5 percent while increasing investors’ rate of return from the current level of 9.42 percent to 9.9 percent. 

A subsidiary of American Electric Power, the utility provides electric service to more than half a million customers primarily in Southwest Virginia. Its territory is geographically challenging and on the whole both more sparsely populated and less affluent than that controlled by Dominion in the central, eastern and northern portions of the state. 

The company today is both healthy and financially secure, utility lawyers and executives assured the State Corporation Commission during hearings last week in Richmond. But without a “modest” rate increase, they contended, that stability could be upended.

If regulators fail to increase rates and lower the company’s authorized return on equity, “we will not have even a remote possibility of recovering our cost of service, which puts the health of the company at risk,” wrote Appalachian President and Chief Operating Office Christopher Beam in testimony to the SCC Aug. 28. 

At hearings in Richmond last week, Appalachian Power attorney Noelle Coates said such an outcome would be “punitive,” “unfair,” “inexplicable” and “not good regulatory or public policy.” 

Other participants in the case disagree. SCC staff and the Office of the Attorney General, among others, have advocated that not only should rates not be increased but that the new return on equity should be set at a little over 8.7 percent. There they diverge: SCC staff believe that for the overall triennial period, Appalachian Power has in the final accounting overearned by only about $4.6 million. The Attorney General’s Office, however, thinks the overearnings are far more significant, amounting to more than $36 million and necessitating customer refunds. (Unaudited commission reports from prior years indicated Appalachian overearned by about $33 million in 2017-2018.)

“Over the last decade, capital costs have come down, interest rates have come down, so utilities’ earned returns are above the returns to investors required,” Penn State University Professor of Finance J. Randall Woolridge testified for the Attorney General’s Office during hearings in Richmond Sept. 15. And Appalachian has “access to capital,” he added. “They have very good credit ratings.” 

The regulatory compact

Utility regulation is structured according to what’s known as the “regulatory compact.” The idea of the compact is that the state grants the utility a monopoly over a particular service — electricity, water, gas, etc. — and in return has the right to regulate the utility’s earnings. Under traditional ratemaking, utilities have the right to recoup their costs as well as earn a certain amount of revenue above the break-even level (the return on equity) as a way to attract investors for the large-scale capital projects they carry out.

The question of whether rates should be raised, however, isn’t just a matter of trying to project the future or investor behavior. Virginia legislators — who can and do accept big campaign contributions from utilities — have laid out over the past 13 years an increasingly complicated framework for determining when rate increases can and cannot occur. The most recent revision of the system sets reviews of rates every three years, with Appalachian’s current case covering the triennial review period of 2017 to 2019.

At the core of the review is an “earnings band” that governs the SCC’s ratemaking decisions. According to statute, if an electric utility’s base rate earnings fall within a 0.7 percent range of its authorized rate of return, customer electric rates cannot change. If the earnings are above the upper limit of that band, the commission must return 70 percent of the overearnings to customers, with shareholders allowed to keep the remaining 30 percent. If the earnings are below the bottom of the band, the SCC must order a rate increase. (The law outlines no situations in which regulators must order a rate decrease.)

If this all sounds very complicated, it is. It’s also unusual: an August 2020 report commissioned by the Virginia Poverty Law Center, which is also opposing Appalachian’s proposed rate hike, found that no other comparable state has an earnings band or a mechanism for sharing overearnings set solely by the legislature. 

 “The distinguishing characteristic of Virginia’s ratemaking framework is the single-issue intervention by the legislature into a process that would customarily be deliberative, interactive and comprehensive,” the report found. 

These “isolated requirements established by the legislature” are “anomalous” in the United States, the authors concluded. That is “precisely because they are established by the legislature outside of administrative process that includes the opportunities to present evidence, question assumptions and generally conform to norms established by administrative law proceedings.”

This “alternative regulatory plan,” as Judge Judith Jagdmann characterized the code section that outlines it, presents complications. SCC staff, who believe that Appalachian Power’s overearnings only amount to about $4.6 million, project that its revenues will fall short by almost $50 million over the next three years. But because staff’s estimate of the company’s overearnings falls within the earnings band, if the commission accepts its view, the utility wouldn’t be entitled to receive a rate increase even if it knew it wouldn’t earn enough over the coming years.

“Are utilities in the position where they’re going to be winners sometimes and losers sometimes with this code section, and where the commission’s hands are tied?” Jagdmann asked the case’s participants Thursday.

Effectively, most said, yes. 

“Sometimes the law requires rates designed to produce a revenue sufficiency and sometimes the law requires rates designed to produce a revenue deficiency,” said Will Reisinger, an attorney representing the Virginia Poverty Law Center. 

Will Cleveland, an attorney with the Southern Environmental Law Center representing environmental nonprofit Appalachian Voices, however, cautioned that for electric utilities, “the code is more likely to create a winner rather than create a loser.”

Statute “may perversely prevent a rate increase going forward simply because past revenues were sufficient to cover past costs,” he told the commission earlier in the week. “But (it) is equally if not more perverse in the opposite direction. It prevents the commission from lowering rates on a going-forward basis even when past revenues dramatically exceeded past costs.”

At least at first glance, the numbers seem to bear out his assertion. Regulators in the last rate case conducted in 2014 found that Appalachian had overearned by about $24 million and that ratepayers were entitled to about $6 million in refunds. Nevertheless, law in place at the time said rates couldn’t be cut unless regulators found the utility had overearned in two consecutive reviews. Unaudited data reported by the SCC would later show Appalachian overearned in both 2015 and 2016, but the rate freeze enacted by the General Assembly in 2015 prevented the next review from ever occurring. The company’s application for the current rate review also shows it overearning in 2017 and 2018, as do SCC reports. Still, the company contends that it actually underearned over the overall triennial period and is entitled to raise customer rates. 

An $88 million question mark

How Appalachian reached that conclusion lies in another provision of a law passed by the General Assembly in 2018 under the Grid Transformation and Security Act. This sweeping legislation not only did away with the rate freeze but significantly altered the existing system of regulation and narrowed the SCC’s authority to oversee electric utility earnings.  

Among its many changes was an amendment to a crucial section of the law known as Section A8 that lays out the terms of the triennial reviews. Previously, utilities had been allowed to fully recover costs associated with the early closure of plants only if they made their retirement determination prior to Dec. 31, 2012. In 2018, however, the General Assembly deleted the language related to the December 2012 deadline, vastly expanding the ability of utilities to recoup costs from customers related to early retirements.

That small change has allowed Appalachian to argue in the current case that it has the right to recover the remaining costs of eight coal units it closed in 2014 and 2015 during the 2017-2019 triennial period — despite the fact that the closures predate the review period by several years. 

Amounting to about $88 million, those costs are sufficiently large to drive down not only Appalachian’s 2019 earnings but also its earnings for the entire triennial period below the bottom limit of the earnings band. That outcome would trigger a mandatory rate increase. 

Appalachian has defended its $88 million earnings adjustment as a right afforded the company according to “the plain and unambiguous language of the code,” as attorney Coates told the commission last week. 

“We did actually make the retirements in 2015,” American Electric Power accounting manager Wayne Allen told Judge Jehmal Hudson during hearings Sept. 15. “Those assets remained on our books pending future recovery, and per the provisions of the law, management deemed those assets to be recovered during this triennial period.”

Still, other participants in the case say it isn’t so simple. The Attorney General’s Office and the Virginia Poverty Law Center have argued that House Bill 528 passed during the 2020 session, which restores the right of the SCC to determine amortization periods for prematurely retired plants, trumps the Grid Transformation and Security Act provision that gave that power to the utilities themselves. 

“The company’s position seems to be, ‘Look, we recorded it on our books, they were audited, so the commission has no discretion whatsoever in reviewing this adjustment,’” said Ralph Smith, a consultant testifying for the Attorney General’s Office on Sept. 16. But after legal research, he said, “we do believe the commission has discretion, and apparently the staff does too.”

SCC staff also oppose the wholesale writeoff of $88 million during the triennial period, albeit with a different rationale. They say that the coal plant retirements, which the utility decided to do in 2011, were normal rather than early and therefore Appalachian doesn’t have the right to fully recover those costs through the $88 million earnings adjustment it wants to make. 

“These were older units that by 2011 had already been in service 50 or 60 years,” said Sean Welsh, a utility accountant with the SCC, during the Sept. 17 hearing. During the 2014 rate review, he said, “they were treated as normal retirements at the end of their useful lives.”

The lost years

Underpinning much of the debate in Richmond last week was the nagging question: What should be done about Appalachian’s earnings in 2015 and 2016, when the rate freeze was in place? 

Had the rate freeze not been enacted by the legislature and the normal 2016 biennial review occurred, Assistant Attorney General Mitch Burton said Sept. 17 during a cross-examination of SCC accountant Welsh, “we wouldn’t be here in this position today.”

Welsh agreed: “This case would look different if the 2016 biennial had happened.”

But while the Grid Transformation and Security Act made no provision for a review of the company’s earnings during those years, even explicitly leaving in place language from the rate freeze bill that declared “no biennial reviews … shall be conducted at any time by the Commission” for Appalachian Power during the freeze, the Attorney General’s Office has argued those years’ earnings are relevant to the case and can be taken into account by the SCC in determining overall earnings. 

“We’re asking the commission to review its history and to recognize that the commission basically had no authority over Appalachian’s earnings reviews or over depreciation rate setting or for prospective ratemaking during this period when their reviews were suspended by the legislature and to factor this into its decision of what’s reasonable in the current case and what’s in the best interest of ratepayers,” Smith told Appalachian attorney James Bacha Sept. 16. 

Appalachian attorney Coates said “the law precludes the commission from looking at the costs in 2015 and 2016.”

Another wave of legislative solutions?

As the commission moves into the deliberation phase of the rate case, which according to statute must be decided by Nov. 30, conversations continue in Richmond about whether yet another reworking of the regulatory system is in order. 

The 2020 General Assembly session saw a rash of challenges to the existing framework of regulation, particularly from newly ascendant Democrats eager to reduce what they see as the undue influence of Dominion and Appalachian in the statehouse. 

One of the most dramatic was the Fair Energy Bills Act, sponsored by the bipartisan team of Del. Jay Jones, D-Norfolk, and Del. Lee Ware, R-Powhatan. This measure, which died in a Democrat-controlled committee, would have gotten rid of the unique system of regulation that governs Virginia’s electric utilities. Ware has said he intends to continue his efforts next session. 

Several times during Appalachian Power’s rate hearings in Richmond last week, opponents of the rate increase indicated they would welcome legislative action to restore to the SCC more of the authority it traditionally enjoyed. 

“I personally think the law should allow the commission to set going-forward rates, either by raising them or cutting them, based on going-forward costs, but that is not what (the code) provides,” Cleveland of the Southern Environmental Law Center said during his opening argument in a discussion of the SCC staff’s calculation that Appalachian Power would be short some $50 million in revenues over the next three years. 

But “the solution to APCo’s problem here isn’t” the $88 million earnings adjustment related to the retired plants, he concluded. “The solution is to lobby the General Assembly to restore the commission’s unfettered ratemaking authority. And to be honest, we would welcome their partnership in such an endeavor.”

Burton, of the Office of the Attorney General, took a similar tack.

“If the company wishes to return to a traditional cost-of-service model for ratemaking, it is free to take its complaints about the commission’s limited discretion to the proper venue that can consider such statutory changes,” he said.