Public Service Company of Colorado (PSCo), a subsidiary of Xcel Energy, awaits final ruling by the Colorado Public Utilities Commission (CPUC) on whether its proposed future test year will be adopted in its gas rate case, Docket No. 12AL-1268G. It doesn’t look good for PSCo. The ALJ’s recommended decision rejected the proposed future test year and adopted a historic test year. The CPUC upheld the ALJ’s ruling in December 2013. The CPUC then denied applications for rehearing, reargument and reconsideration on January 29, 2014 and mailed the decision on February 10, 2014.

The fight for a future test year provides an interesting and topical subject given the state of the utility industry. Multiple articles have been written about the need for infrastructure investment and development and the “utility death spiral”.

The future test year could be central to stimulating utilities to invest in infrastructure and shoring up their finances. While PSCo fights an uphill battle to get its future test year adopted, Indiana-American Water Company filed a future test year rate case with the Indiana Utility Regulatory Commission (IURC) for Indiana-American’s water utility properties in late January. Indiana-American became the first utility to file a future test year rate case under Senate Enrolled Act 560 from the 2013 legislative session in Indiana (SEA 560 made significant changes to Indiana’s utility laws, and this article deals only with the allowance of future test years). SEA 560 provides utilities with the option to select a historic, future or hybrid test year. Indiana-American chose to file a future test year case.

What is a test year, let alone a future test year?

A test year provides the baseline of a utility’s operations when setting rates. The test year consists of a 12-month period used to evaluate the subject utility’s cost of rendering service. Rate-setting typically involves three kinds of test years: historic, future and hybrid. Some state regulatory schemes limit the types of test years that a utility may use.

For historic test years, the parties propose adjustments to the test year figures based on fixed, known and measureable changes to the test year data that also occur within 12 months from the end of the historic test year. One prominent example is labor costs. Typically, salaries and wages increase from a historic test year, and the test year salaries and wages expense will be adjusted upwards for fixed, known and measureable changes within the 12 month period after the end of the historic test year.

Forecasting the utility’s revenues, expenses and rate base form the basis of future test years. The forecast typically involves the utility’s budgeting and planning data. Not all states allow future test years in their utility regulation.

Hybrid test years represent a combination of historic test year and future test year.

Why a future test year?

Based on the examples cited above, utilities prefer a future test year. Many benefits accrue to the utility when choosing a future test year.

The future test year narrows regulatory lag (and ideally eliminates it completely). Regulatory lag has several definitions but in essence, it represents the delay experienced by the utility while waiting for new rates to be implemented. A historic test year exacerbates the problem of regulatory lag. By the time new rates receive regulatory approval, those rates could be based on data that is two years old or more. The future test year attempts to reduce regulatory lag.

The future test year places more risk on the utility’s customers by shifting some of the risk from the utility to the ratepayers. Inflation risk, system growth risk, and other risks amalgamate to form the risk profile faced by a utility.

Periods of high inflation make future test years more desirable because the regulatory lag will be greater. Likewise, if system growth slows, regulatory lag exacerbates under-recovery because system growth cannot make up for revenues lost by regulatory lag. In these situations, future test years attempt to provide the utility with greater ability to recover the costs of providing service. Historic test years during periods of low inflation and high system growth reduce the risk of under-recovery.

Future test years accelerate cost recovery, which is why utilities prefer future test years. As recognized earlier, many articles describe the crushing need for investment in infrastructure. Future test years offer a mechanism to accelerate cost recovery and to prompt utilities to invest in infrastructure.

The future of future test years

Historic test years still represent the most common test years in a utility rate case. Easy to understand and based on actual results, historic test years provide a sense of certainty when setting rates. In this era of stagnant demand and significant infrastructure needs, future test years may become more common as a mechanism to encourage infrastructure investment and to stabilize utility finances. Moody’s recently recognized that the “implementation of … a future test-year” procedure in New Mexico favorably impacts the financial outlook of utilities. The author believes more legislation similar to Indiana’s SEA 560 might be enacted in other states as state legislatures deal with the need for investment in utility infrastructure. Its time might not be now, but the future test year appears to have a future.