United States
Environmental Protection
Agency
Air and
Radiation
(6204-J)
EPA 430/R-94/009
May 1994
EPA Cleaning the Air at Least Cost:
PUC Options for Treatment of SO? Allowances
Headquarters Repository
USEPAWestBldg
1301 Constitution Avenue N.W.
Room 3340
Washington, DC 20004
Recycled/Recyclable
Primed on paper that contains
at least 50% recycled fiber
ACID
RAIN
PROGRAM
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Contents
Acknowledgments iii
Executive Summary v
1. The Need for Regulatory Guidance 1
2. Integrated Resource Planning, Compliance Planning and Allowance Trading 2
3. Accounting v. Ratemaking and the FERC Rules 2
a. Allowance Accounting 2
b. Valuation of Allowances 3
4. Beneficial Allowance Ownership, Risks and Rewards 5
5. Allowance Ratemaking Treatment Mechanisms and Procedures 5
a. Option A - Traditional Ratemaking 6
b. Option B - Modest Incentives .7
c. Option C - Market-Value Incentives 8
d. Other Proposals 9
6. Summary 9
Endnotes 10
Appendix A: Policy Statement and Rules For Trading and Ratemaking Treatment of
Clean Air Act S02 Allowances - Version I (Traditional Ratemaking) ..A-1
Appendix B: Policy Statement and Rules For Trading and Ratemaking Treatment of
Clean Air Act S02 Allowances - Version II (Modest Incentives) B-1
Page i
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Page ii
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Acknowledgments
This report was written by Barry D. Solomon at the Acid Rain Division of EPA. Valuable
comments on the paper and the model ratemaking treatment rules were received from
Dwight Alpern, Joe Kruger, Renee Rico, Brian McLean and Rick Morgan of EPA, Douglas
Bohi of Resources for the Future, Mike Gildea and Ken Under of the Edison Electric
Institute, Professor Paul Joskow of MIT, Klaus Lambeck of the Public Utilities
Commission of Ohio, Ken Rose of the National Regulatory Research Institute, Mike Walsh
of the Chicago Board of Trade, and Eliot Wessler of the Federal Energy Regulatory
Commission. The views and opinions expressed herein do not necessarily represent the
opinions or policies of the outside reviewers or their respective organizations. An
abbreviated version of this report was published in Fortnightly.
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Page iv
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Executive Summary
The sulfur dioxide (SO2) emission allowance trading system, authorized under the Acid Rain
Program of the Clean Air Act Amendments of 1990, is expected to save the nation $ 1 to 2 billion
or more per year over the cost of traditional command and control regulation of acid rain
emissions. One of the major barriers to active trading of allowances, however, has been
regulatory uncertainty. To date, only 9 State Public Utility Commissions (PUCs) have issued
formal guidance on the ratemaking treatment of S02 emission allowances. The Federal Energy
Regulatory Commission has issued rules on the accounting treatment of emission allowances,
but similarly has not addressed their rate treatment. '
This report will suggest options for PUCs to consider for guiding electric utilities on allowance
trading and rate treatment. After discussing how the Integrated Resource Planning (IRP) process
can be easily amended to address allowance trading as part of a least-cost compliance plan, the
report suggests options in several areas. These include valuation of allowances, allocation of
allowance ownership rights, risks and benefits, allowance cost recovery mechanisms and
proceedings, prudence review of allowance transactions, and treatment of allowance reserves
and pools. For many of these areas, three classes of options-are possible: traditional ratemaking •
and modest and complex incentive approaches to treatment of emission allowances. -It is hoped
that discussion of these options will assist States in the process of developing their own emission
allowance guidance that best fits their own circumstances.
This report also includes technical appendixes with two alternative model regulations for
ratemaking treatment of allowances that may be used or adapted by States. A PUC, in adopting
a ratemaking treatment for allowances, might also find it useful to consider language in this report
for a preamble to State regulation of S02 allowances.
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Page vi
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Cleaning the Air at Least Cost:
PUC Options for Treatment of SO2 Allowances
1. The Need for Regulatory
Guidance
The Acid Rain Program of the Clean Air Act
Amendments of 1990, (CAAA) authorized the
U.S. Environmental Protection Agency (EPA) to
create an innovative 'system of tradeable sulfur
dioxide emission allowances for affected electric
utilities. EPA issued most of its implementing
rules and regulations in early 1993.n This system
is unique in that it requires a partnership between
the EPA, electric utilities, the Federal Energy
Regulatory Commission (FERC), State Public Util-
ity Commissions {PUCs), and State air pollution
control agencies for successful least-cost imple-
mentation and compliance with SO2 reduction
requirements.
As of April 1994, only nine PUCs have addressed
the trading and ratemaking treatment of emission
allowances. Four States, Ohio, Pennsylvania,
Wisconsin, and Iowa, have issued generic
ratemaking guidance. Four additional States,
Indiana, West Virginia, Maryland and Connecti-
cut, have given guidance on allowances through
the issuance of orders in specific cases. Addition-
ally, New York has issued interim guidance. This
dearth of PUC guidance' is especially troubling
because Phase I acid rain compliance deadlines
begin next year. Uncertainty-over PUC treatment
of allowances has been cited by regulators, many
utilities and others as a hindrance to the full
development of an efficient national market in
allowances and realization of full economic ben-
efits to consumers.2
Since emission allowances are a new and unique
commodity with no exact model or-precedent,
State PUCs need to provide guidance to electric
utilities in order to minimize regulatory uncertainty
about rate and accounting treatment of allow-
ances and acceptable acid rain compliance options
or plans.3 The novelty of the allowance trading
system makes it likely that some changes in
regulatory procedures and decisions will have to
be made. Guidance is needed from PUCs instead
of from EPA because Section 403{f) of the CAAA
appropriately preserves State and FERC jurisdic-
tion over electric utility regulation. Moreover,
PUCs are in the best position to determine what
are the best compliance plans for"their investor-
owned utilities. If more guidance is not issued, the
large cost savings expected from the Acid Rain
Program as compared with command-and-control
regulation, perhaps more than $2 billion a year,
may not be realized.
Regulatory guidance should be issued as soon as
possible irrespective of the compliance exposure
in a particular State1. For example, utilities in the
21 Eastern states that must meet acid rain com-
pliance deadlines for Phase I (which begins in
1995) may have the greatest urgency for consid-
eration of allowance trading among their compli-
ance options. Yet Phase II utilities, whose com-
pliance requirements begin in 2000, are currently
making strategic planning decisions. These utili-
ties may have tremendous financial opportunities
in the allowance trading market. For example, the
currently traded price of an allowance is low,
perhaps under $200, and utilities that project a
need for additional allowances in Phase II can take
advantage of the low prices by buying allowances
today and banking them for future use. On the
opposite side, many states have utilities with
surplus allowances because of earlier State acid
rain laws or strict State Implementation Plans or
visibility requirements under the CAAA (e.g.,
.many Western utilities are in this position4).These
utilities can benefit ratepayers and possibly share-
holders by participating now -in the allowance
market.
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PUC Guidance Options
2. Integrated Resource Planning,
Compliance Planning and Allowance
Trading
The formal acid rain compliance plan requirements"
are detailed in EPA's Acid Rain Permits rule that
was promulgated on January 11,1993B. These
requirements are very streamlined compared to
past air pollution compliance planning require-
ments. In Phase I, the EPA is the permitting
authority, and in Phase If the State air agency will
generally issue the acid rain permits. State PUCs
may well find it useful to require affected utilities
to submit for review more detailed acid rain
compliance plans than the plans submitted to EPA
for pBrmit issuance. -Many-States have already
done so. Guidance on plan development and
implementation by the PUCs in coordination with
State air agencies would be helpful and jn the best
interest of least-cost compliance.
Good acid rain compliance planning should have
many of the same features of, and should be
integrated with, a well-designed integrated re-
source plan (IRP) or planning process.6 Some of
these features are:
• The plan should be system-wide and compre-
hensive.
• The plan should be transparent with clearly
documented assumptions.
• The plan should consider a reasonably large
number of scenarios and compliance options
or portfolios (e.g., low and high-sulfur coal
prices, gas prices and availability,-cost and
availability of renewable energy • generation
and independent power production, scrubbing
and allowance trading costs, early retirement
and life extension of power plants).
• The plan should consider risk and uncertainty
of the compliance options.
• The plan should encourage flexibility to re-
spond to changing market conditions.
• The plan should consider the modularity of the
compliance options, i.e., the ability of the
options to be implemented incrementally.
• The plan should consider the potential for
•energy efficiency-in a least-cost compliance
strategy (i.e., EPA's Conservation and Re-
—*•- newabterEnergy Resetva-aHowanceSt-ceduced-
utilization of Phase I units, and system-wide
emissions reduction through energy conserva-
tion).
Allowance trading deserves particular attention
from PUCs in an'IRP or compliance plan because
it is a newer and less familiar option. A good
resource or compliance planning process is gener-
ally well suited to accommodate allowance trading
and should consider all aspects, i.e., the purchase,
sale, freeing-up (through over-control of high-SO2
emitting units), and banking of allowances and
allowance futures and options. In general, a utility
with low direct SO2 reduction costs will find it
profitable to over-control and sell excess allow-
ances, while a utility with high S02 reduction costs
will find it more cost-effective to purchase allow-
ances on the market.
3. Accounting v. Ratemaking and
the FERC Rules
a. Allowance Accounting
It is the general practice in the field of utility
regulation for the accounting treatment of costs to
flow from the ratemaking treatment of those costs
or transactions. This follows from the historical
flexibility of utility accounting practices. . -Soon-
after passage of the CAAA, several observers
speculated on the accounting treatment of emis-
sion allowances through the use of existing ac-
counts.7 The FERC, however, has largely pre-
empted this approach through the promulgation of
new accounting rules for emission allowances.
The FERC issued final rules in March 1993 that
revise their Uniform Systems of Accounts (USof A)
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PUC Guidance Options
to include allowances under the CAAA.8 The
FERC issued its allowance accounting rutes before
its ratemaktng rules apparently because Jtforesaw
the need for uniform changes in its-accounting
-procedures, while being less -certain of what
changes might be required in ratemaking.8 In the
rules, the FERC does not prescribe the ratemaking
treatment of allowances-under 4ts jurisdiction -or
that of any state PUC, i.e., the rules are intended
to be "rate neutral".
There is some concern, however, that PUCs may
look to generally accepted accounting principles
(GAAP) as reflected in the USofA to provide a
frame work for ratemaking treatment out of conve-
nience and unintentionally bias compliance choices.
In particular, until cost recovery procedures for
allowances are universally adopted by the FERC
and the States, there will be.uncertainty about the.
cost recovery mechanism, timing, valuation, and
PUC scrutiny, of allowance market transactions.
These concerns underscore the need for all Com-
missions to adopt allowance ratemaking proce-
dures.
The FERC accounting rules amend the USof A to
create new accounts for allowances in Balance
Sheets, Operation and Maintenance Expense; and
Income Statements. This is accomplished by
classifying the initial allowances as inventory and
anticipating the creation of regulatory assets and
liabilities to result from allowance rate actions of
electric regulatory commissions. In addition, the
rules designate several other existing accounts for
additional allowance classifications, transactions,
or penalties. These new accounts are summarized
in Table A.
b. Valuation of Allowances
GAAP require that an asset be booked at the lower
amount of acquisition cost or the market value.
The allowances allocated to utilities by EPA, either
the basic allowance allocations or various bonus
allowances, are issued at no direct cost and thus
these allowances must be booked by the utility at
zero cost. Valuation of allowances is also dis-
cussed in the FERC rules, which address several
other situations that can occur besides that of
allocated or bonus allowances. These include
. allowance .auctions' and other unbundled.-market
transactions; utility affiliate allowance transfers,
.allowances acquired through exchanges,-and
bundled fuel or power pool purchases.
The FERC-rules -recjwe-that ailowaoces-shaU be
valued generally at historical cost, i.e., the amount
of cash or its equivalent paid to acquire an
allowance. A weighted average cost method
would then be used for determining the cost of
allowances issued from a utility's inventory. Thus
the zero-value allowances, once traded, would be
valued, like allowances sold through an auction, at
their most recent purchase price. The FERC rules
similarly require that allowances received in ex-
changes shall be valued based on the inventory
value of the allowances traded. If a utility
exchanges one set of allowances plus "boot"
(monetary consideration) for another set of allow-
ances, the value of the acquired allowances would
be the sum of the inventory cost of the allowances
traded and the boot paid.
Allowance trades between utility affiliate compa-
nies would be valued at the fair market value. The
FERC reversed its- proposed -ruter-which would
have valued such transactions-at the initial inven-
tory cost. This change in valuation method was
made in the interest of system-wide least cost
compliance planning, i.e., so that affiliate allow-
ance trades would not be discouraged and the
number of accurate allowance market price sig-
nals would be increased. This, in turn, will
facilitate the development of the allowance mar-
ket. Allowances acquired in a bundled purchase
with fuel or power, or through a purchase stream
over time, would also be valued at their fair market
rate at the time of purchase. If fair market value
cannot be determined for an allowance stream, a
discounted present value approach based on the
interest rate for ten-year U.S. Government bonds
will be used. The FERC's fair market valuation of
allowances transferred between utilities engaged
in wholesale power sales surmounts the ratemaking
problem of allocated allowances having zero value,
since under most regulatory embedded cost-
based formula rates incremental charges are not
recoverable from ratepayers.
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Q)
CO
CD
. , . ',- _..(i. ' ' '"- ;':.';;. Table A ._•/ • iO^/Aj?'''r';':;?V^:|J'^> >;"v^'r'
' '• .'; .'..' -' •« FERG ALLOWANCE ACCOUNTING/G/WEGOWES .'.^'"-^L/'/^sSC ^H-^-
Account #
158.1
158.2
509
426.3
124
254
182.3
421
426.5
186
253
407.4
407.3
411.8
411.9
Name of Account
Allowance Inventory
Allowances Withheld
Operation and
Maintenance Expense
Penalties
Other Investments
Other Regulatory Liabilities
Other Regulatory Assets
Miscellaneous Nonoperating
Income
Other Deductions
Miscellaneous Deferred
Debits
Other Deferred Credits
Regulatory Credits
Regulatory Debits
Gains from Disposition of
Allowances
Losses from Disposition of
Allowances
Comments
Main account for allowances owned by utility.
Records costs of allowances.
Account is credited when allowances are used.
Covers allowances withheld by EPA for annual allowance auctions.
Once allowances are purchased in auctions, costs of allowances are transferred to the Allowance
Inventory account (#1 58.1 ).
• Account debited when allowances are used.
• Debits are concurrent with monthly S02 emissions.
• Charges for excess emissions penalties.
• Accounts for allowances acquired for speculative purposes.
• Accounts for gains from general (nonspeculative) allowance trades by credit, or deferral when
there is regulatory uncertainty.
• Accounts for losses from general (nonspeculative) allowance trades.
t
• Below the line account for gains from speculative allowance trades.
• Below the line account for losses from speculative allowance trades.
• Non-speculative futures/options contracts.
• Used to hedge against unfavorable price changes.
• Non-speculative futures/options contracts.
• Used to hedge against unfavorable price changes.
• Credits for allowance gains on income statement (regulatory assets).
• Debits for allowance losses on income statement (regulatory liabilities).
• Credits for allowance gains on income statement (non-regulatory assets).
• Debits for allowance losses on income statement (non-regulatory liabilities).
"O
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OL.
at
to
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PUC Guidance Options
4. Beneficial Allowance Ownership,
Risks and Rewards
The principal factor that should determine whether
the ratepayers or utility shareholders receive any?.•-
available gains or losses from allowance trading is..
who "owns" the traded allowances. While the
legal title and ownership of the allowances rests
with the utilities, the "beneficial" ownership of the
allowances will typically lie with the ratepayers if
the risk and reward or penalty from allowance
trading is symmetrical.10 The initial allowance
allocation by the EPA to the electric utilities is
based on fuel consumption and S02 emission
levels of generating units, for which the underlying
•costs (e.g.; fuel, operating costs, depreciation,
etc.) is normally paid for by ratepayers. In some
cases. States have imposed earlier or more strin-
gent air pollution control limits that result in
compliance by their utilities with the emission
reductions required under EPA's Acid Rain Pro-
gram before the deadlines in the CAAA. In these
cases, the allowances will also have been usually
"paid for" by the ratepayers.
State PUCs have used a "burdens and benefits" or
"risk and rewards" test in determining how to treat
a financial gain from the sale of utility property.
This test uses three criteria: who financed the
investment in the asset, who actually owned the
asset, and who bore the risk of any decline in the
asset's value?11 The application of this test by
PUCs confirms that they have long treated
ratepayers as the beneficial owners of utility
property.12
Under what conditions might the beneficial own-
ership of allowances lie with the shareholders?
This could occur with below-the-line'or specula- "
tive allowance transactions, or. with allowances
associated with newer power plants that are not
fully depreciated or amortized. In addition, share-
holders might have beneficial ownership of allow-
ances if power plant capital or compliance costs
are not in the utility's rate base and construction
work in progress expenses were not collected
from the ratepayers, e.g., because of a disallow-
ance of imprudently incurred compliance costs.
In most cases, the allowances that a utility
beneficially owns will be a small share of its total
allowance inventory, normally much less than
20%. This will be the case because most PUCs
will undoubtedly discourage or disallow specula-
tive allowance transactions (as opposed to allow-
ance price hedging) for ratemaking purposes, and
-prudence disallowances are likely to* be. faretor of
small .financial consequence. In addition, most of
the allowances allocated to utilities are for older,
fully depreciated power plants, at least during
Phase I (1995-1999), and scrubber retrofits will
normally be fully recoverable in rate base.
Even if a utility has little or no beneficial ownership
rights to its emission allowances, there may be
circumstances under which an incentive for en-
gaging in allowance trading is called for, as long as
the symmetry between risk and reward or penalty
is still preserved. For example, in the current early
stage of development of the allowance market,
price and supply data may be scarce or unreliable.
While most of the 30 + initial allowance trades
have occurred at a low price, most utilities have
not yet entered the market. The circumstances
where incentives for trading may be useful will be
explored in the next section.
5. Allowance Ratemaking Treatment
Mechanisms and Procedures
This section will discuss three alternative ap-
proaches to ratemaking treatment of emission
allowances. These options are based on several
existing PUC ratemaking treatments and utility
proposals,-among other sources.13 They-can be
distinguished by the degree to which a special
incentive is believed to be required or fair in order
to optimally use the allowance market as part of
a least-cost compliance strategy. These options,
in reality, should be conceptualized as points along
a continuum of a greater range of ratemaking
options, and only serve to illustrate the major
features of the different approaches. A PUC, in
adopting a rate treatment for allowances, might
consider the discussion that follows, along with
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PUC Guidance Options
elements of earlier sections, for inclusion in a
preamble to State regulations concerning rate-
making treatment of allowances. • >-~ - •
a. Option A - Traditional Ratemaking
Traditional ratemaking treatment of emission al-
lowances would use a cost of service approach.
This option would utilize existing ratemaking pro-
cedures and presumes that utilities already have
sufficient incentive to use and trade for emission
allowances when it is cost-effective to do so.
These incentives arise from a utility's obligation to
serve its ratepayers at the lowest reasonable cost
and from regulatory lag.14 In many states this
incentive is strengthened by risk-based, inte-
grated resource planning (IRP) requirements, which
can >be extended to acid-rain compliance planning
and competitive challenges under the Energy
Policy Act of 1992. Thus, under this option,
existing PUC mechanisms such as IRP reviews,
fuel adjustment clauses, rate-of-return profit regu-
lation, and ex post prudence review are viewed as
adequate checks and balances to achieve least-
cost compliance and economic use of the allow-
OPTION A - TRADITIONAL RATEMAKING
> .Example
Ohio - Issued guidelines through a generic
order dated March 25, 1993 to encourage all
Ohio utilities to engage in economically justi-
fied allowance trading and apply to EPA for
allowances from the Conservation and Re-
newable Energy Reserve. This includes reL
quirements for an allowance trading report
that describes trading ^pJans, -allowance re-
serves, and banks, and possibly participation
in allowance pools, futures, and options mar-
kets. Revenues and expenses from allow-
ance transactions will.be re vie wed ^n the
annual Electric Fuel Clause proceeding, and
flowed through to ratepayers on an energy*
basis, except for below-the-linetransactions.
Incentive treatment of allowances may ,be
considered in the future on a case-by-case
basis. -,- " -
ance market. This section summarizes possible
features of a traditional ratemaking approach to
the-treatment of SO2 allowances. Appendix-A
contains model language for a policy statement
and regulations based on this type of option.
This option would recognize in rate base the
historical cost of holding allowances in the allow-
ance inventory. A close analogy can be made
between allowance inventory and fuel inventory,
since generally the rate of allowance use will be a
direct' function of the rate of fuel use and the
resulting S02 emissions (as measured by the
Continuous Emissions Monitoring System) at a
fossil fuel power plant. Once an allowance is used
by a utility as part of its energy-related power
production activity, its cost may be recoverable as
an operation and maintenance expense in the
same period. This expense would be recovered in
most states through a fuel adjustment clause,
energy cost rate, or a similar provision. Gains as
well as losses (e.g. through allowance trading)
would be similarly flowed through to ratepayers.
Traditional ratemaking allows for a reserve in a
utility's fuel inventory and would also allow for a
small allowance operating reserve as a contin-
gency against unforeseen circumstances or emer-
gencies -socrr-as -power--outages and -adverse
weather. Similarly, a utility may bank allowances
for future use if this action is part of an overall
compliance strategy. Allowances that are held
(banked) for future use could be recovered through
Allowance for Funds Used During Construction
(AFUDC),including any carrying charge accrual.
An alternative would be to allow carrying charge
accrual to be recovered through a fuel clause.
While the PUC will establish the general rate
treatment for allowance reserves and banks, this
does not assure that it will find prudent a particular
- level of reserves or banks held by the •utility%—The-
proper level of the reserve or bank will vary
depending on a utility's particular operating situ-
ation, and the case for its level should be made by
the company. The pooling of allowances between
utilities provides a mechanism for lowering the
number of allowances that would need to be
reserved or banked. A utility may pursue allow-
ance pooling but would not be required to do so.
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PUC Guidance Options
b. Option B - Modest Incentives
There may be circumstances under-which a spe--
cial incentive may be called for in order to encour-
age a utility to engage in cost-effective allowance
trading. Advocates of this type of option contend
that utilities 'will be asked to bear non-traditional
risks in using the allowance market. These
advocates argue that some utilities will be unwill-
ing to take these risks because the experience of
regulatory disallowances in the 1980s has created
a highly risk averse and capital averse industry.
Thus, according to this view, modest incentive
mechanisms should be crafted so that ratepayers
and shareholders each benefit from favorable
allowance transactions, and accrue costs from
unfavorable transactions, in direct proportion to
the actual risks taken. Such an incentive could
also help jump-start the allowance market and
thereby increase the level of cost-effective trading
and cost savings for consumers. This section
summarizes possible features of a modest incen-
tive ratemaking approach-to treatment of SO2
allowances. Appendix B contains model language
for a policy statement and regulations based on
this type of option.
The State PUC may determine that it is in the
ratepayers' best interest if the utility has a special
incentive to search out the-allowance market and
to engage in beneficial trading, particularly in the
early stage of market development. In this case,
the PUC could set the shareholders' share of gains
and losses from allowance trading equal to the
utility's allowed percentage rate of return on
equity. The logic behind this analog is that while
in financial markets a utility requires a reasonable
rate of return in order to attract capital investment
in the company, a utility needs a small share of
potential gains from allowance trading in order to
attract it to participate in this'still 'relatively un-
known market. This could be designed in the same
manner as a shared savings incentive that is used
in many States to encourage utilities.to cost-
effectively invest in energy efficiency programs.
Admittedly the chosen percentage split may be
arbitrary although it could be adjusted or phased
out over time as trading experience is gained and
market circumstances change.
When an allowance transaction occurs,- the
ratepayers' share of the allowances would be used
to determine what portion of the gains or losses
are flowed through .to them, again by a fuel
adjustment clause, energy cost rate, or similar
provision. The remaining minority share of the
gains or losses is retained by the company. As
with the traditional ratemaking treatment, the
modest incentive-ratemaking treatment does not
obviate the need for ex post prudence review by
the PUC.
There are other situations whereby an allowance
trading incentive could be established by design or
by default. These could include npn rate-based,
below-the-line or speculative allowance transac-
tions, allowances associated.with a newer power
plant that is not fully depreciated, or a disallow-
ance of imprudently incurred compliance costs
that earned or freed-up allowances. .The simplest
of these cases may be the class of circumstances
under which below-the-line transactions are.re-
corded. For example, a utility may decide to
establish an unregulated subsidiary to speculate in
the market with allowances beyond its EPA allo-
cation. In this case, a PUC could allow this activity
as long as it is separated from the rate base.
OPTION B - MODEST INCENTIVES
Example^ i • "
"*,•-'' , i ;f
Connecticut - Issued a decision dated March
'4, 1993 on a petition by the United Illuminat-
ing Company , ( ,.
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PUC Guidance Options
Similarly, if a utility has a power plant or scrubber
that has not been fully depreciated and amortized,
it may request that all or a portion of the remaining
costs be taken off the books along.-with, the
allowances, to be funded by the shareholders
'without carrying charge deferral. Finally, if a utility
suffers prudence disallowances associated with
compliance expenditures (including nuclear power
plant investment), any earned or-surplus allow- •
ances associated with these costs should be
regarded as beneficially owned by the utility to do
with as it best sees fit. In each of these cases,
there would be a direct incentive for the company
to more vigorously trade allowances in order to
increase the potential benefit to its stockholders.
Under the modest incentives option a utility could
be encouraged to enter into and trade in an
allowance pool with other utilities (perhaps in
different regions of the nation) in order to minimize
the number of allowances it needs to reserve or
bank. A "carrot" for encouraging allowance
pooling could be for a PUC to allocate utility
shareholders a slightly higher share of any gains
from allowances sold into an allowance pool (with
symmetrical treatment for losses), while a "stick"
approach would be for the PUC to give greater
scrutiny to the level of allowance reserves and
banks.
c. Option C - Market-Value Incentives
A third option for the rate treatment of allowances
presumes that traditional ratemaking treatment of
compliance costs has a bias in favor of scrubbing
or fuel-switching, depending on the jurisdiction.
This problem may be compounded by the valua-
tion of allocated allowances at zero and the capital
gains tax on the sale of such allowances (as
discussed later). Thus, it can be argued that a
more radical departure from traditional rate-of-
return regulation is called for, one that utilizes a
market-based incentive consistent with the mar-
ket orientation of the allowance trading system.
The promising precedence for a market-based
incentive mechanism for allowances can be de-
rived from shared-savings programs-forrenergy
conservation, power plant or scrubber perfor-
mance standards and price-cap utility regulation.
The market-value incentives approach for allow-
ances has been advocated by Rose of the National
-,Regulatory ResearcrMnstitute1?, although similar
proposals have been adopted or made by others
'such as-'Southem Indiana Gas & Electric Co^PSI,
and the-Chicago Board of Trade. The idea-of this
option is to create-a strong incentive for a utility
to minimizeits-SO^ reduction costs. This meoha-
nism would be designed -to reward a utility for
good performance within its control and to penal-
ize it for poor performance within its control. This
incentive could increase a utility's interest in
adopting innovative and cost-effective emissions
reduction options, more so than under Options A
and B.
An essential feature of this option is the establish-
ment of a benchmark price of allowances, which
would create a standard against which a utility's
compliance costs are measured. If the company's
compliance costs per-ton of SO2 reduced are less
than the benchmark price, it would retain a share
of the difference between its actual compliance
costs and what the costs would have been at the
benchmark rate. Any excess allowances could be
sold by the utility. If its per-ton compliance costs
exceed the benchmark price, the utility would be
OPTION C - MARKET-VALUE INCENTIVES
" \ * * ' Example "'^ - ^ ' ; -;.
Indiana - Issued a decision dated October 14,.
1992 on a petition by Southern Indiana Gas
=and Electric Company (SIGECO) to preapprove
its Clean Air Act Compliance. Plan, .which
focuses on retrofitting the Culley Units No. 2
and 3 with scrubbers. Per this agreement,,
r«4he, Indiana <- Utility- Regulatory ^Commission -
set« a market benchmark-price of-$365 "at'-
which any safes by SIGECO of EPA extension ::
allowances would be credited to ratepayers ;
on an energy basis. Consequently, if the sale
price is different from $365 per allowance;
the difference in revenues would be debited/
or credited below-the-line for shareholders.
Jhe decision also ordfirs.SIGECO^to bank.at_
least 10% of its allocated allowances in
Phase I. i .",,- ,' •• " • :'' '.-. -' ,
Page 8
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PUC Guidance Options
given rate recovery of either compliance costs
based on the benchmark rate, or a predetermined
•portion • of the • difference*~between-vtne* -actual -
compliance costs and compliance costs based on
the benchmark rate. Cost recovery would occur
periodically based on such a formula without the
ratebasing of assets.
Two problems with this approach, whichTmake it
controversial, are the need for accurate determina-
tion of a utility's compliance costs and a bench-
mark allowance price. A third concern is that this
option may result in large gains or losses assumed
entirely by the utility. While the compliance costs
can be reviewed in an IRP process, compliance
planning, preapproval, rate case or related pro-
ceedings, they may be subject to extensive debate
and alternative assumptions. A solution could be
:to base the utilityfsvcompliance cost recovery only
on the benchmark price. Predetermination of a
benchmark allowance price, however, especially
in the early years of the market, may prove to be
even more vexing. The best method might be to
base the price on the fair market value of allow-
ances, to the extent that it is known. That price,
however, may initially change frequently, and a
PUC would have to post the price in advance and
apply it objectively. The price could be periodically
adjusted to respond to a changing market, al-
though frequent-price adjustment would make
compliance planning difficult.
d. Other Proposals
Some advocates of ratemaking incentives for
allowance trading have argued that changes in the
tax code are necessary to encourage allowance
trades.16 Proponents of this proposal contend that
a potential hindrance to allowance-trading has
been created by the Internal Revenue System (IRS)
decision to tax the proceeds or capital gains from
the sale of initially allocated allowances (with a
historical cost of zero), typically at a 34% corpo-
rate income tax rate.17 The objection to this
income taxation is that it fails to recognize the
linkage between the allowance sale and any future
costs necessitated by the-transaction, e.g.-the
cost of a scrubber or the future purchase of
replacement allowances. Consequently, the sale
of any allocated allowances may be discouraged.
The proposed solution to this disincentive would
be to use an investment tax credit mechanism,
.-whereby a utility.could choose to deduct the
revenue from-a sale-of allocated allowances from
the asset value, for rate purposes, of its invest-
ment in scrubbers or similar technology related to
the sale.18 Alternately, a utility could reduce the
• 'depreciation amount in-its cost-of service for the
~ emissions abatement property by an amount equal
to such proceeds. This proposal assumes that the
gain from the allowance sale is less than the
utility's basis in emissions abatement property,
and may not be applicable to other compliance
options.
The proposed mechanism would allow gains from
allowance sales to be gradually passed onto
ratepayers using the amortization methods ap-
plied to the investment tax credit. And since it
would not increase the utility's income tax burden,
the proposal would remove the potential disincen-
tive to sell allocated allowances. .
EPA has not taken a position on this issue..
Moreover, because the proposed solution would
require either new federal tax law or a ruling by the
IRS, it is not now applicable to PUC allowance
ratemaking decisions.
6. Summary
It is urgent for the PUCs to issue policy guidance
for electric utilities on the ratemaking treatment of
sulfur dioxide emission allowances and acid rain
compliance planning in order to reduce regulatory
v_ uncertainty .and maximize4he economic benefits
of the allowance system. As of this writing, only
nine Commissions have done so. Those that
provide such guidance remove a key impediment
for their utilities to pursue least-cost compliance
with the CAAA and minimize rate impacts for their
customers. A well-designed integrated resource
'planning process provides a logical place in which
. to integrate compliance planning, including allow-
ance trading. The FERC issued major allowance
accounting rules in early 1993 that can provide a
reference point for ratemaking treatment without
Page 9
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PUC Guidance Options
prescribing it. These rules also require allowances
to be valued generally at historical cost. Excep-
tions to the valuation rule will occur for allowance
trades among utility affiliates and for bundled fuel
and power pool purchases. In these cases the
-allowances should be valued generally at the fair
market value.
While utilities retain the legal title-and-owrrership-
of allowances, their "beneficial" ownership will
typically lie with the ratepayers. This factor
provides the basis for ratepayers to generally
receive any rate gains or losses from allowance
trades. Traditional ratemaking treatment pre-
sumes that a utility already has sufficient incentive
to trade allowances and would flow gains or losses
to ratepayers through a fuel clause or similar
provision. Incentive ratemaking could set aside a
share of trading gains or losses for shareholders,
create a market-value incentive or permit below-
the-line allowance trading.
Endnotes
1. Federal Register, Vol. 58, No. 6, January 11,1993,
pp. 3590-3766; Federal Register, March 23, 1993,
Vol. 58, No. 54, pp. 15634-15717.
2. Resolution to Encourage States to Enunciate Policies
on Treatment of Allowance Transactions, Adopted at
the NARUC 1993 Summer Committee Meetings, San
Francisco.
3.B.D. Solomon and K.Rose, "Making a Market f or SO2
Emissions Trading", The Electricity Journal, Vol. 5, No.
6 (July 1992), pp. 58-66.
4. C.V. Mathai, "Phase II Allowance Allocations and an
Assessment of the Allowance Market in the West", Air
& Waste, Vol. 43 (June 1993), pp. 839-844.
5. 40 CFR Part 72.
6. Mitchell's comprehensive 1992 survey of State IRP
programs found that an increasing number of them
have good IRP, especially Wisconsin and some in the
West and Northeast. See C. Mitchell, "Integrated
Resource Planning Survey: Where the States Stand".
The Electricity Journal, Vol. 5, No. 4 (May 1992), pp.
10-15. See also E. Hirst, "Data and Analysis Needed
to Prepare an Electric-Utility Integrated Resource Plan",
Oak Ridge, National Laboratory, Oak Ridge,. TN, for
suggestions about how to integrate IRP with acid rain
compliance planning; and S. Brick, "Analysis of Utility
Acid Rain Compliance Plans: A Discussion of Issues arid
Methods", pp. 75-90 in K. Rose and R.E. Burns, eds.i
Regulatory Policy Issues and the Clean Air Act: Issues
and Papers from the State Implementation Workshops.
"Columbus, 'OHrNRRI 93--»rf inal Report to the ti:S.
EPA, July 1993.
7. See, for example, B.D. Solomon and S. Brick, " State
Regulatory Issues in Acid Rain Compliance". The
Electricity Journal, Vol. 5, No. 2 (March 1992), pp. 20-
27.
8. Federal Register, Vol. 58, No. 65, April 7,1993, pp.
17982-18007.
9. K. Rose and R.E. Burns, "A Need to Act: The FERC,
the State Commissions, and the Clean Air Act", Public
Utilities Fortnightly (December 1, 1992), pp. 19-21.
10. K. Rose, R.E. Burns, et al., Public Utility Commis-
sion Implementation of the Clean Air Act's Allowance
Trading Program. Columbus, OH: National Regulatory
Research Institute, NRRI 92-6, May 1992, pp. 145*
155.
11. D. Sponseller, "Accounting for Gains on the Sale
Of Utility Property", Public'Utilities-Fortnightly (May 16,
1985), pp. 49-52.
12. Note 11, op. cit., p. 150.
13. See, for example, The Keystone Center, State
Regulation of Allowance Trading: Final Consensus
Report of a Keystone Policy Dialogue. Keystone, CO:
The Keystone Center, November 1993; K. Rose, A.S.
Taylorand M. Harunuzzaman, Regulatory Treatment of
Electric Utility Clean Air Act Compliance Strategies,
Costs, and Emission Allowances. Columbus, OH:
National Regulatory Research Institute, NRRI 93-16,
December 1993; Braine, B., Mann, C. and Button, A.,
Utility Ratemaking Options for SO2 Emissions Allow-
ances. Fairfax, VA: ICF Resources, Prepared for Edison
Electric Institute, January 1994.
14. L. Chalstrom, "Allowance Trading - No Need for
States to Reinvent the Regulatory Wheel", The Electric-
ity Journal, Vol. 6, No. 8 (October 1993), pp. 70-75.
15. K. Rose, "Regulatory Treatment of Allowances and
Compliance Costs", pp. 117-140 in K. Rose and R.E.
Burns, eds., op. cit.
Page 10
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PUC Guidance Options
16. ICF Resources, "Analysis of a Proposal for Tax
Treatment of S02 Allowance Sales Revenue", prepared
for Allegheny Power System, August 1992.
17. Internal Revenue Service, "Revenue Procedure 92-
91, Regarding Income Tax Consequences of Air Emis-
sion Allowance Program Established by Clean Air Act
" 'Amendments of 1990", Internal Revenue Bulletin 1992--
46, November 16, 1992.
18. A similar incentive proposal has been offered-by
D.R. Bohiand D. Burtraw, "Avoiding Regulatory Gridlock
in the Acid Rain Program", Journal of Policy Analysis
and Management, Vol. 10 (1991), pp. 676-684; D.R.
Bohi and D. Burtraw, "Regulatory Aspects of Emissions
Trading: Economic and Environmental Goals", The
Electricity Journal, Vol. 4, No. 10 (December 1990),
pp. 47-55.
Page 11
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PUC Guidance Options
Page 12
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Appendix A
Policy Statement and Rules For Trading and Ratemaking
Treatment of Clean Air Act SO2 Allowances - Version I
(Traditional Ratemaking)
1.01 General Policy.
1.02 Definitions.
1.03 Regulatory Oversight of Compliance Plans
and Emission Allowance Trading.
(a) Acid Rain Compliance Plans.
(b) Conservation and Renewable Energy
Reserve Allowances.
(c) Auctioned Allowances.
(d) Allowance Pools.
(e) Allowance Market Speculation.
1.04 Allowance Accounting.
(a) Accounting Treatment.
(b) Valuation. .
1.05 Ratemaking Treatment of Emission Allow-
ances. -
' (a) Valuation.
(b) Ratemaking Treatment.
(c) Fuel Adjustment Clause Rate
Treatment.
(d) Allowance Reserves.
(e) Banked Allowances.
. . (f) 'Allowance Futures and Options
Contracts.
1.06 Public Information and Confidentiality.
1 .'07 Prudence of Compliance Plans and Allow-
ance Transactions.
1.01 General Policy.
The Commission expects the electric utilities of
this State to engage actively in cost-effective
allowance trading as part of a least-cost Acid Rain
Compliance Plan to meet their requirements under
Title IV of the Clean Air Act {CAA Title IV) to
reduce sulfur dioxide emissions. Allowance trad-
ing has the potential to lower significantly the cost
of complying with the CAA Title IV by increasing
the flexibility of electric utilities to develop a
compliance plan, from a broader range of compli-
ance options and to lower the costs of methods of
emissions reduction, such as fuel switching, flue
gas desulfurization, and energy conservation.
Recognizing that the development of a liquid
market for allowance trading ,is therefore in the
ratepayers' interest, the Commission promulgates
these rules in order to reduce regulatory uncer-
tainty regarding its policy toward allowance trad-
ing and the ratemaking treatment of allowances.
The regulatory treatment of allowances, as set
forth in these rules, will be based on traditional
Commission mechanisms and procedures.
1-02 -Definitions.
The following words and terms, when used in this
rule, shall have the following meanings:
Acid Rain Compliance Plans - A utility plan to meet
its requirements under CAA Title IV to limit or
reduce emissions of sulfur dioxide and nitrogen
oxides at affected units.
Affected Unit - A utility boiler or combustion
turbine that is subject to a sulfur dioxide emission
limitation under CAA Title IV.
Allocated Allowances - Allowances allocated by
the. U.S. Environmental Protection Agency (EPA)
at no cost to affected units under CAA Title IV,
either through annual allocations as set forth in 40
CFR 73.10, Tables 2 and 3, or through allocations
based on the use of specified compliance options
(e.g., substitution plan, Phase I extension plan,
reduced utilization plan, energy conservation, re-
newable energy generation, or repowering plan)
under 40 CFR parts 72 and 73.
-------
Appendix A
Allowance - An authorization under CAA Title (V
to emit one ton of sulfur dioxide during or after a
specified calendar year.
Allowance Futures Contract * An agreement be-
tween-a futures exchange clearinghouse and
traders to-buy or sell an allowance on a specified
future date at a specified price. < - •-.-• "-.
Allowance Options Contract - A contract that
conveys the right, but not the obligation, to buy
or sell an allowance at a certain price for a limited
time. Only the seller of the option is obligated to
perform and only if the buyer exercises the option.
Allowance Pool - A voluntary agreement between
two or more utilities or other organizations to
divide up an allocation of allowances among the
pool •members,.Abased,on.mutually, agreed upon
conditions.
Allowance Reserves - Allowances held in reserve
for non-speculative, short term use for contingen-
cies or emergencies, such as unusual weather or
forced plant outages.
Auc|ign Allowances - Allowances acquired or sold
through the EPA's annual allowance auctions, or
through auctions held by another organization.
Banked Allowances - Allowances held in reserve
for non-speculative, future use.
Below-the-line - Revenues and expenses that are
not associated with utility operations and that are
not used to set rates.
Boot - Something acquired or forfeited to equalize
an exchange, usually monetary consideration.
Conservation and Renewable Energy Reserve - A
reserve of 300,000 total allowances -that "are1
allocated under 40 CFR 73, subpart F on a first
come, first-served basis by the EPA to an electric
utility for avoided SO2 emissions associated with
qualified energy conservation measures or renew-
able energy generation that is implemented before
the utility's Acid Rain compliance deadline.
Excess Emissions - Any emissions of sulfur diox-
ide in a year in excess of an affected unit's
allowances that can be used under 40 CFR part 73
to authorize that year's emissions.
.•Fair Marketr-yalue - The amount at-which an-
., allowance could reasonably be sold in a transact
? tion between;a willing buyer.and a willing.seller,
other than in a forced or liquidation sale.
Historical Cost - The amount of cash or Its
equivalent, if any, paid to acquire an allowance.
Integrated Resource Plan - A resource plan pre-
pared by the electric utility and reviewed by the
Commission that attempts to evaluate supply-side
and demand-side utility resource options on an
equal basis, while accounting for risk and uncer-
tainty. ,
Speculation - The use of the allowance market
including futures contracts or options to profit
from expectations of future price changes.
Weighted Average Unit Cost of Inventoried Allow-
ances - The total.historical cost of the allowances
that are in inventory at the end of the month and
are eligible for use in the given year divided by the
total number of allowances that are in inventory at
the end of the month and eligible for use in the
given year.
1.03 Regulatory Oversight of Compliance Plans
and Emission Allowance Trading.
(a) Acid Rain Compliance Plans - No later than on
June 1, 1994, each utility shall file with the
Commission an Acid Rain Compliance Plan that
details its.plans for reducing emissions of sulfur
dioxide and nitrogen oxides as required under CAA
•••Title'lV. The-Plan shall include the plan submitted
to the EPA and relevant portions of the Integrated
Resource Plan (IRP) and contain additional infor-
mation concerning all actions involving allow-
ances (e.g., participation in the allowance trading
market, use of allowance pools, futures and
options contracts, actual allowance contracts and
Page A-2
-------
Appendix A
contract offers, plans for participation in allow-
ance auctions and to apply for allowances from
the EPA's Conservation and Renewable -'Energy-
Reserve, etc). Revisions to this Plan shall be filed
annually with the Commission by June 1 in
subsequent years.
(b) Conservation and Renewable Energy Reserve
Allowances - To the extent a utility is eligible, each
utility shall apply to the EPA for Conservation and
Renewable Energy Reserve allowances, based on
any energy conservation and renewable energy
programs that are included in its IRP, for any
energy savings from energy conservation and
renewable energy generation that are achieved on
or after January 1,1992 but before its compliance
deadline. Additionally, each utility shall determine
the extent to which these programs can be cost-
effectively expanded ..and .new ones instituted
based on the test described in the IRP Order. In
making such determination, the utility shall take
account of the benefit of the market value of
allowances that may be awarded by the EPA, as
well as the value of allowances that may be saved
through any energy conservation and renewable
energy generation. Until the Conservation and
Renewable Energy Reserve is depleted, each util-
ity shall notify the Commission on an annual basis
when it is ready to apply for these allowances so
that the Commission can verify previous years'
energy savings and certify whether each utility's
application meets the requirements of the appli-
cable EPA regulations. If a utility.believes that it
is currently ineligible to apply for these allowances
because the Commission has not met the require-
ments under 40 CFR 73, subpart F for net income
neutrality and least-cost planning, the utility should
recommend to the Commission a mechanism or
mechanisms that would make it eligible.
(c) Auction Allowances - Each utility-should par-
ticipate in the March 1995 auction of allowances
that will be sponsored by the EPA and in subse-
quent ones sponsored by the EPA and by other
organizations where such participation is prudent.
In particular, each utility should compare the
expected price of allowances in such auctions
with the utility's internal costs of compliance, with
the expected price at which allowances could be
sold or acquired by other means, and with the
value to the utility of retaining allowances in an
allowance bank or reserve.
(d) Allowance Pools - The Commission recognizes
that allowance -pooling arrangements that are
consistent--wtth CAAiTitle IV may be appropriate
and can help minimize the number and cost of
allowances that a utility will need to reserve or
bank. Each utility may propose to the Commission
its voluntary participation in an -allowance pool
with other utilities or other organizations, either
outside of or within the regional power pool or
electric reliability council, as part of its Acid Rain
Compliance Plan under paragraph (a) of this
section.
(e) Allowance Market Speculation - It is the
Commission's policy that the expenses and rev-
enues from speculative allowance transactions
should not be reflected in a utility's rates. If a
utility plans to speculate in the allowance market,
it is required to give advance notification- to the
Commission along with details of the types of
transactions and a method for insuring that ex-
penses and revenues associated with such trans-
actions remain below-the-line. •
1.04 Allowance Accounting.
(a) Accounting Treatment - The Commission
adopts the Federal Energy Regulatory Commis-
sions Balance Sheet and Income Statement ac-
counting practices to record allowances held,
allowances transacted, and allowance penalties.
These accounts are:
(i) Account 158.1 - For Allowance Inven-
tory.
(ii) Account 158.2 - For Allowances With-
held by the EPA.
(iii) Account 509 - For debiting of Operation
and Maintenance Expense when allow-
ance are used.
Page A-3
-------
Appendix A
(iv) Account 426.3 - For booking of excess
emissions penalties below-the-line when
a utility does not hold enough allow-
ances to cover its annual emissions of
sulfur dioxide.
(v) Account 124 -Other Investments, for
allowances acquired for speculative pur-
poses by a utility.
(vi) Account 254 - Other Regulatory Liabili-
ties, to account "for gains from non-
speculative allowance trades.
(vii) Account 182.3 - Other Regulatory As-
sets, to account for losses from non-
speculative allowance trades.
(viii) Account 421 - Miscellaneous
Nonoperating Income, to account for
gains from the trading of allowances
held for speculative purposes.
(ix) Account 426.5 - Other Deductions, to
account for losses from the trading of
allowances held for speculative purposes.
(x) Account 186 - Miscellaneous Deferred
Debits, to account for the costs of non-
speculative, commodity exchange-traded
allowance futures or options contracts.
(xi) Account 253 - Other Deferred Credits,
to account for the benefits of non-
speculative, commodity exchange-traded
allowance futures or options contracts.
(xii) Account 407.4 - Regulatory Credits, to
account for a gain on a regulatory asset,
on the-Jncome Statement. ~,
(xiii) Account 407.3 - Regulatory-Debits, to
account for a loss'on a regulatoryliabil- -
ity, on the Income Statement.
(xiv) Account 411.8- Gains from Disposition
of Allowances, to account.for.a gain
other than on a regulatory asset, on the
Income Statement.
(xv) Account 411.9 - Losses from Disposi-
tion of Allowances, to account for a loss
other than on a regulatory liability, on the
Income Statement.
(b) Valuation - Each allowance shall be valued
generally at historical cost,, which.for allocated
allowances and Conservation and Rene wabieHEn-r
ergy -Reserve allowances from the EPA equals
zero. Inventoried allowances shall be valued at
their weighted average unit cost. In calculating
the weighted average cost, only allowances that
are eligible for use during the current year shall be
included in the calculation. Allowances received
in exchanges shall be valued based on the inven-
tory value of the allowances traded. If a utility
exchanges one set of allowances plus boot for
another set of allowances, the value of the
allowances shall be the sum of the inventory cost
of the allowances traded and the boot paid.
Allowances acquired in a bundled purchase with
fuel or power, through a purchase stream over
time, or acquired from an affiliate company shall
be valued at the fair market value at the time of
purchase. If the fair market value cannot be
determined for an allowance stream, a discounted
present value approach based on the interest rate
for ten-year U.S. Government bonds shall be used.
When allowances are'used t>y a "utility, their
expense shall be recognized monthly.
1.05 Ratemakina Treatment of Emission
Allowances.
(a) Valuation - Allowances and non-affiliate allow-
ance trades shall be valued for ratemaking pur-
poses as defined in Section 1.04(b). Allowances
traded by a utility to a holding company or an
unregulated affiliate subsidiary, company, shall be
.valued at the higher of historical cost.and fair
market value. .Allowances traded by an unregu-
lated affiliate subsidiary company or holding com-
pany to a utility shall be valued at the lesser of the
historical cost and fair market value.
(b) Ratemaking Treatment - The allowance inven-
tory shall be treated the same way as fuel inven-
tory for ratemaking purposes and will be included
Page A-4
-------
Appendix A
in rate base consistent with the Commission's
practice for operating inventory items. Allow-
ances in inventory will earn a return, in the same
way as other rate base investments, equal to the
allowed rate of return on rate base.
(c) Fuel Adjustment Clause Rate Treatment -
Electric utilities shalt charge allowances
-------
Appendix A
actions implementing the Acid Rain Compliance
Plan shall be determined by the Commission in
ratemaking and other proceedings, as appropriate.
A determination of the prudence and reasonable-
ness of an allowance transaction or of actions
implementing the Acid Rain Compliance Plan will
be based on a retrospective, factual review using
the information available at the time the transac-
tion or action was undertaken. If a utility is not
taking all reasonable actions to minimize its costs
(including allowance costs) in the context of its
Acid Rain Compliance Plan, the Commission will
not allow the utility to recover from its ratepayers
costs in excess of what would be or would have
been incurred under prudent and reasonable poli-
cies and practices. If any such costs recovered by
a utility from its ratepayers through the Fuel
Adjustment Clause under Section 1.05(c) are
found to be imprudent by the Commission, these
costs shall by refunded with interest to the
ratepayers through the Fuel Adjustment Clause.
Page A:6
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Appendix B
Policy Statement and Rules For Trading and Ratemaking
Treatment of Clean Air Act S02 Allowances - Version II
(Modest Incentives)
1.01 General Policy.
1.02 Definitions.
1.03 Regulatory Oversight of Compliance Plans
and Emission Allowance Trading.
{a) Acid Rain Compliance Plans.
(b) Conservation and Renewable Energy
Reserve Allowances.
(c) Auctioned Allowances.
(d) Allowance Pools.
(e) Allowance Market Speculation.
1.04 Allowance Accounting.
(a) Accounting Treatment.
(b) Valuation.
1-05 Ratemakino. Treatment of Emission Allow-
ances.
(a) Valuation.
. (b) Ratemaking Treatment.
(c) Fuel Adjustment Clause Rate
Treatment.
(d) Allowance Reserves.
(e) Banked Allowances.
(f) Allowance Futures and Options
Contracts.
1.06 Public Information and Confidentiality.
1.07 Prudence of Compliance Plans and Allow-
ance Transactions.
1.01 General Policy.
The Commission expects the electric utilities of
this State to engage actively in cost-effective
allowance trading as part of a least-cost Acid Rain
Compliance Plan to meet their requirements under
Title IV of the Clean Air Act (CAA Title IV) to
reduce sulfur dioxide emissions. Allowance trad-
ing has the potential to lower significantly the cost
of complying with the CAA Title IV by increasing
the flexibility of electric utilities to develop a
compliance plan from a broader range of compli-
ance options and to lower the costs of methods of
emissions reduction, such as fuel switching, flue
gas desulfurization, and energy conservation.
Recognizing that 'the development of a liquid
market for allowance trading is therefore in the
ratepayers' interest, the Commission promulgates
these rules in order to reduce regulatory uncer-
tainty regarding its policy toward allowance trad-
ing and the ratemaking treatment of allowances.
The regulatory treatment of allowances, as set
forth in these rules, will be based on modest
incentives that are designed to encourage directly
each utility to engage in allowance trading, by
rewarding the utility for good performance and
commensurately penalizing it for poor perfor-
mance.
1.02 Definitions.
The following words and terms, when used in this
rule, shall have the following meanings:
Acid Rain Compliance Plans - A utility plan to meet
its requirements under CAA Title IV to limit or
reduce emissions of sulfur dioxide and nitrogen
oxides at affected units.
Affected Unit - A utility boiler or combustion
turbine that is subject to a sulfur dioxide emission
limitation under the CAA Title IV.
Allocated Allowances - Allowances allocated by
the U.S. Environmental Protection Agency (EPA)
at no cost to affected units under CAA Title IV,
either through annual allocations as set forth in 40
CFR 73.10, Tables 2 and 3, or through allocations
based on the use of specified compliance options
-------
Appendix B
(e.g., substitution plan, Phase I extension plan,
reduced utilization plan, energy conservation, re-
newable energy generation, or repowering plan)
under 40 CFR parts 72 and 73.
Allowance - An authorization under CAA Title IV
to emit one ton of sulfur dioxide during-or after a
specified calendar year.
Allowance Futures Contract -An agreement be-
tween a futures exchange clearinghouse and
traders to buy or sell an allowance on a specified
future date at a specified price.
Allowance Options Contract - A contract that
conveys the right, but not the obligation, to buy
or sell an allowance at a certain price for a limited
time. Only the seller of the option is obligated to
perform and only if the buyer exercises the option.
Allowance Pool - A voluntary agreement between
two or more utilities or other organizations to
divide up an allocation of allowances among the
pool members, based on mutually agreed upon
conditions.
Allowance Reserves - Allowances held in reserve
for non-speculative, short term use for contingen-
cies or emergencies, such as unusual weather or
forced plant outages.
Auction Allowances - Allowances acquired or sold
through the EPA's annual allowance auctions or
through auctions held by another organization.
Banked Allowances - Allowances held in reserve
for non-speculative, future use.
Below-the-line - Revenues and expenses that are
not associated with utility operations and that are
not used to set rates.
Boot - Something acquired or forfeited to equalize
an exchange, usually monetary consideration.
Conservation and Renewable Energy Reserve - A
reserve of 300,000 total allowances that are
allocated, under 40 CFR 73, subpart F, on a first
come, first-served basis by the EPA to an electric
utility for avoided S02 emissions associated with
qualified energy conservation measures or renew-
able energy generation that is implemented before
the utility's Acid Rain compliance deadline.
Excess Emissions - Any emissions of sulfur dioxj
ide in a year in excess of an affected unit's
allowances that can be used under 40 CFR 73 to
-authorize that year's emissions. ••-•:—:
Fair Market Value - The amount at which an
allowance could reasonably be sold in a transac-
tion between a willing buyer and a willing seller,
other than in a forced or liquidation sale.
Historical Cost - The amount->of cash or its
equivalent, if any, paid to acquire an allowance.
Integrated Resource Plan - A resource plan pre-
pared by the electric utility and reviewed by the
Commission that attempts to evaluate supply-side
and demand-side utility resource options on an
equal basis, while accounting for risk and uncer-
tainty.
Marginal Allowance Cost - The cost to an indi-
vidual electric utility of acquiring an additional
allowance from the allowance trading market,
inclusive of broker fees, and including auction
allowances.
Speculation - The use of the allowance market
including futures contracts or options to profit
from expectations of future price changes.
Weighted Average Unit Cost of Inventoried Allow-
ances - The total historical cost of the allowances
that are in inventory at the end of the month and
are eligible for use in the given year divided by the
total number of allowances that are in inventory at
the end of the month and are eligible for use in the
given year.
1.03 Regulatory Oversight of Compliance Plans
and Emission Allowance Trading.
(a) Acid Rain Compliance Plans - No later than on
June 1, 1994, each utility shall file with the
Commission an Acid Rain Compliance Plan that
details its plans for reducing emissions of sulfur
dioxide and nitrogen oxides as required under CAA
Title IV. The Plan shall include the plan submitted
Page B-2
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Appendix B
to the EPA and relevant portions of the Integrated
Resource Plan (IRP) and contain additional infor-
mation concerning all actions involving allow-
ances (e.g., participation in the allowance trading
market, use of allowance pools, futures and
options contracts, actual allowance contracts and
''contract offers, plans for participation in allow-
ance auctions and to apply for allowances from
the EPA's Conservation and Renewable Energy
Reserve, etc). Revisions to this Plan shall be filed
annually with the Commission by June 1 in
subsequent years.
(b) Conservation and Renewable Energy Reserve
Allowances - To the extent a utility is eligible, each
utility shall apply to the EPA for Conservation and
Renewable Energy Reserve allowances, based on
any energy conservation and renewable energy
programs that .are .included, in its IRP, for any
energy savings from energy conservation and
renewable energy generation that are achieved on
or after January 1,1992 but before its compliance
deadline. Additionally, each utility shall determine
the extent to which these programs can be cost-
effectively expanded and' new ones, instituted
based on the test described in the IRP Order. In
making such determination, the utility shall take
account of the benefit of the market value of
allowances that may be awarded by the EPA, as.
well as the value of allowances that may be saved
through any energy conservation and renewable
energy generation. Until the Conservation and
Renewable Energy Reserve is depleted, each util-
ity shall notify the Commission on an annual basis
when it is ready to apply for these allowances so
that the Commission can verify previous years'
energy savings and certify whether each utility's
application meets the requirements of the appli-
cable EPA regulations. If a utility believes that it
is currently ineligible to apply for these allowances
because the Commission has not met the require-,
ments under 40 CFR 73, subpart F-.f or -net income
neutrality and least-cost planning, the utility should
recommend to the Commission a mechanism or
mechanisms that would make it eligible.
(c) Auction Allowances - Each utility should par-
ticipate in the March 1995 auction of allowances
that will be sponsored by the EPA and in subse-
quent ones sponsored by the EPA and by other
organizations where such participation is prudent.
In particular, each utility should compare the
expected price of allowances in such auctions
with the utility's internal costs of compliance, with
the expected price at which allowances could be
sold or acquired by other means, and with the
value to the utility of retaining allowances in an
allowance bank or reserve. --- .-*•
(d) Allowance Pools - The Commission recognizes
that allowance pooling arrangements that are
consistent with CAA Title IV may be appropriate
and can help to minimize the number and cost of
allowances that a utility will need to reserve or
bank. Each utility may propose to the Commission
its voluntary participation in an allowance pool
with other utilities or other organizations, either
outside of or within the regional power pool or
electric reliability council, as part of its Acid Rain
Compliance Plan under paragraph (a) of this'
section. A utility that enters an allowance pool and
sells allowances shall retain a share of profit (the
positive difference between the sale price and the
weighted average unit cost, described in Section
1.05), and the equivalent share of any loss. This
share of profit or loss to be retained by the utility
shareholders shall equal 11 percent.
(e) Allowance Market Speculation - It is the
Commission's policy that the .expenses ahd.rev-
enues from speculative allowance transactions
shall not be reflected in a utility's rates. If a utility
plans to speculate in the allowance market, it is
required to give advance notification to the Com-
mission along with details of the types of transac-
tions and a method for insuring that expenses and
revenues associated with such transactions re-
main below-the-line. An example of speculative
allowance transactions would be those conducted
by an unregulated subsidiary of a utility that are
funded from below-the-line sources. In this
situation, the subsidiary may be permitted to
retain any profits or required to assume any losses
from such transactions.
1.04 Allowance Accounting.
(a) Accounting Treatment - The Commission
adopts the Federal Energy Regulatory Commis-
sions Balance Sheet and Income Statement ac-
counting practices to record allowances held,
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Appendix B
allowances transacted, and allowance penalties.
These accounts are:
»
(i) Account 158.1 - For Allowance Inven-
tory.
(ii) Account 158.2 - For Allowances With-
held by the EPA.
(iii) Account 509 - For debiting of Operation
and Maintenance Expense when allow-
ance are used.
(iv) Account 426.3 - For booking of excess
emissions penalties below-the-line when
a utility does not hold enough allow-
ances to cover its annual emissions of
'sulfur dioxide.
(v) Account 124 - Other Investments, for
allowances acquired for speculative pur-
poses by a utility.
(vi) Account 254 - Other Regulatory Liabili-
ties, to account for gains from non-
speculative allowance trades.
(vii) Account 182.3 - Other Regulatory As-
sets, to account for losses from non-
speculative allowance trades.
(viii) Account 421 - Miscellaneous
Nonoperating Income, to account for
gains from the trading of allowances
held for speculative purposes.
(ix) Account 426.5 - Other Deductions, to
account for losses from the trading of
allowances held for speculative purposes.
(x) -Account 186 -'Miscellaneous-Deferred
Debits, to account for the costs of non- •
speculative, commodity exchange-traded
allowance futures or options contracts.
(xi> Account 253 - Other Deferred Credits,
to account for the benefits of non-
speculative, commodity exchange-traded
allowance futures or options contracts.
(xii) Account 407.4 - Regulatory Credits, to
account for a gain on a regulatory asset,
on the Income Statement.
(xiii) Account 407.3 - Regulatory Debits, to
account for a loss on a regulatory liabil-
ity, on the Income Statement.
(xiv) Account 411.8 - Gains from Disposition
of Allowances, to account for a gain
other than on a regulatory asset, on the
Income Statement.
(xv) Account 411.9 - Losses from Disposi-
tion of Allowances, to account for a loss
other than on a regulatory liability, on the
Income Statement.
(b) Valuation - Each allowance shall be valued
generally at historical cost, which for allocated
allowances and Conservation and Renewable En-
ergy Reserve allowances from the EPA equals
zero. Inventoried allowances shall be valued at
their weighted average unit cost. In calculating
the weighted average cost, only allowances that
are eligible for use during the current year shall be
included in the calculation. Allowances received
in-exchanges shall be valued based on the inven-
tory value of-the allowances traded.-- If a utility-
exchanges one set of allowances plus boot for
another set of allowances, the value of the
allowances shall be the sum of the inventory cost
of the allowances traded and the boot paid.
Allowances acquired in a bundled purchase with
fuel or power, through a purchase stream over
time, or acquired from an affiliate company shall
be valued at the fair market value at the time of
purchase. If the fair market value cannot be
determined for an allowance stream, a discounted
present value approach based on the interest rate
f or ten-year U.-S. Government bonds shall be use€k-
When allowances are used by a utility, their
expense shall be recognized monthly.
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Appendix B
1.05 Ratemaking Treatment of Emission
Allowances.
(a) Valuation - Allowances and allowance trades
shall be valued for ratemaking purposes as defined
in Section 1.04(b). If the fair market value cannot
• be determined, the utility shall value allowances in •
the applicable circumstances as discussed in,
Section 1.04(b) at the marginal allowance cost.
(b) Ratemaking Treatment - The allowance inven-
tory shall be treated in the same way as fuel
inventory for ratemaking purposes and will be
included in rate base consistent with the
Commission's practice for operating inventory
items. Allowances in inventory will earn a return
in the same way as other rate base investments,
equal to the allowed rate of return on rate base.
(c) Fuel Adjustment Clause Rate Treatment -
Electric utilities shall charge allowances (including
fractional amounts) to expense in the month
during which related sulfur dioxide emissions
occur. Expensed allowances shall be recovered
through the utility's fuel adjustment clause. Prof-
its or losses on allowance transactions (the differ-
ence between the transaction price or fair market
value, in the case of bundled or affiliate transac-
tions, and the weighted average unit cost of
inventoried allowances that are involved in the
utility's transaction) shall be flowed through to
ratepayers in the fuel adjustment clause on an
energy (kWh) basis at a rate equal to 90 percent.
The utility shall thereby retain 10 percent of the
profits, and assume 10 percent of the losses, from
such transactions, subject to prudence review.
The exact amount of the profit and loss to be
assumed by the utility company and the basis for
the continuation of this mechanism will be re-
viewed by the Commission periodically, as appro-
priate.
(d) Allowance Reserves - Each utility shall deter-
mine in .its Acid Rain Compliance Plan under
Section i .03{a) the appropriate level of allowance
reserves to include in its allowance inventory,
which shall be no greater than the average emis-
sions level for three weeks (6.250 percent) of
sulfur dioxide that is expected for the year. The
actual level of allowance reserves should be based
on the probability of forced outages, adverse
weather conditions, fuel quality variability, vari-
ability in electric load growth, and other .factors.
(e) Banked Allowances - Each utility shall.deter-
.mine in its Acid Rain .Compliance Plan-under
Section 1..O3(a) the appropriate .level of banked
allowances to hold for future use, based on the
expected conditions in the allowance trading
market and factors internal to the company as
specified in its IRP (e.g., plant retirements, load
growth, etc.). The expense of banked allowances
shall be recovered through Allowance for Funds
Used During Construction, including any carrying
charge accrual.
(f) Allowance Futures and Options Contracts -
The Commission recognizes that allowance fu-
tures and options contracts offer electric utilities
a means of price hedging to minimize the risks of.
limited availability and unfavorable allowance price
fluctuations. Profits and losses in the allowance
futures and options markets will be treated in the
same way as profits and losses on other allowance
transactions, although these may include any
costs and .credits-(including, carrying costs} in-
curred to open, maintain and close the futures and
options hedging position. • To ensure such treat-
ment, each utility should describe its strategy for
using allowance futures and options in its Acid
Rain Compliance Plan under Section 1.03{a). The
costs or revenues from hedging transactions shall
be deferred and the amounts included in allowance
inventories when the applicable allowances are
acquired, sold, or otherwise disposed of.
1.06 Public information and Confidentiality.
It is the general practice of the Commission to treat
information submitted to the Commission con-
cerning allowance trading, the Acid Rain Compli-
ance Plan, and the IRP as public information. .For
good cause, each utility may file for confidential
treatment of certain proprietary information, which
may be examined by the Commission, Commis-
sion staff, an Administrative Law Judge, or the
Consumer Advocate under a protective order or
Page B-5
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Appendix B
seal. Examples of information that may be
considered confidential by the Commission in-
clude trade secrets, a utility strategy for allowance
contract negotiations, marketing analyses, and
private technical or financial work products or
papers.' The burden of. proof for establishing a
basis for confidentiality will be on the utility
making the request.
1.07 Prudence of Compliance Plans and
Allowance Transactions.
None of the provisions of these rules constitute or
imply a Commission finding of prudence and
reasonableness concerning a utility's actual or
potential allowance transactions or actions imple-
menting the Acid Rain Compliance Plan, although
there-is a presumption of.prudence. The prudence
and reasonableness of such transactions and of
actions implementing the Acid Rain Compliance
Plan shall be determined by the Commission in
ratemaking and other proceedings, as appropriate.
A determination of the prudence and reasonable-
ness of an allowance transaction or of actions
implementing the Acid Rain Compliance Plan will
be based on a retrospective, factual review using
the information available at the time the transac-
tion or action was undertaken. If a utility is not
taking all reasonable actions to minimize its costs
(including allowance costs) and to acquire Conser-
vation and Renewable Energy Reserve allowances
in the context of its Acid Rain Compliance Plan, the
Commission will not allow the utility to recover
from its ratepayers allowance costs in excess of
what would be or would have been incurred under
prudent and reasonable policies and practices. If
any such costs recovered by a utility from its
ratepayers through the Fuel Adjustment Clause
under Section 1.05(c) are found to be imprudent
by the Commission,.these costs shall by refunded
with interest to the ratepayers through the Fuel
Adjustment Clause.
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