The Regulatory Compact is the system in which state utility regulators define a reasonable rate of return for a utility and then structure a system that allows the utility the opportunity to earn that return. In exchange, the utility serves customers within a given jurisdiction. Traditional cost recovery methods no longer work well. The utility industry can no longer afford to build needed infrastructure and wait to recover those costs later, sometimes many years down the road.

This is rapidly becoming a crisis as the industry is called upon to address an increasingly complex and expensive range of capital investments to replace aging infrastructure, expand existing infrastructure and meet environmental issues such as climate change. These investments carry increased risks and uncertainty and do not work well under a regulatory system built on price stability, long lag times to recover costs, and readily available and affordable capital.

Although the economic crisis has not caused the problem, it has made it worse by depriving us of financing options and needed flexibility. We are working with legislators and regulators to develop new regulatory models that will help meet these challenges. Faster cost recovery would reduce the cost and risk of many projects and would allow us to do more with fewer resources.

If you were to view alternative regulatory models as a continuum, at one end would be a system in which all costs of service are included in a single charge-per-kWh of consumption, with no adjustments outside of a general rate case. Utility revenues would be subject to intense volatility as customer usage varied. At the other end would be a decoupled rate structure in which virtually all costs of service are considered fixed and rolled into a flat user fee. Revenues in this case would be highly predictable but offer no flexibility to the benefit of either the utility or the consumer. Along the continuum are a host of rate-making tools. Among those garnering the most attention are:

• Future test years: Forecasted expenditures are used to calculate revenue requirements, with true-up to actual expenditures. This already is in use in Georgia and Connecticut.
• Construction Work In Progress (CWIP): Financing costs are placed into the rate base during construction. Virginia routinely awards CWIP in rates. Few other states do it automatically, although many state commissions are authorized to consider it on a case-by-case basis.
• Riders/trackers: These tools are tariff adders that track specific categories of costs between rate cases. Most states allow them for fuel and purchased power costs (fuel adjustment clauses). Virginia has an Environmental and Reliability Rider, and West Virginia has an Expanded Net Energy Cost rider.
• Formula rates: Automatic revised tariffs based on formulae or indices without extended regulatory proceedings. These include performance-based rates. SWEPCO has formula rates in Louisiana. The Federal Energy Regulatory Commission (FERC) and Massachusetts follow formula rates, and legislation is pending in New Jersey.