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New Situation, Same Solution: Electric Utility Ratemaking

image credit: Catalyst Consulting LLC

Electric utilities face increasing pressure to achieve financial targets.  The current pandemic in the U.S. further compounds the problem that utilities have seen coming for several years. Slowing demand growth, changes in wholesale markets, new environmental constraints and growing consumer interest in distributed generation and renewables are driving changes to the way electric utilities incur costs.  But the pandemic does not change the remedy.  Electric utilities must review their costs and customer rates to ensure that the rates reflect these dynamic cost drivers.  To do this, utilities should frequently perform rate reviews, by determining revenue requirements, conducting cost of service studies, and reviewing rate design. 

Revenue Requirements

The first step of any electric utility rate analysis is to determine the amount of revenue that the customer rates must generate annually.  Utilities are entitled to recover their prudently incurred costs and to earn a reasonable return on their investments, so the revenue requirement should include annual expenses, for purchased power, O&M, depreciation, taxes and other costs.  This includes pro forma adjustments to capture any costs expected when rates will be in effect. It must also include a total margin that will allow the utility to achieve the target debt service coverage or other objective financial metric. This allows the utility to pay the interest on long term debt and prepare for contingencies related to weather events, consumption changes, or variations in wholesale power supply costs.  In this way the revenue requirement best represents the total annual revenue that the utility must produce in order to meet or exceed its financial goals.   

Under the current pandemic circumstances, utilities may ultimately adjust the revenue requirement to account in some way for the costs of suspended disconnections and waived late payment charges.  At this juncture both utilities and regulators are actively considering possible solutions to this challenge.

Cost of Service Study (“COSS”)

The COSS is used to determine the cost to provide service to customers, both in total and by individual rate class.  The COSS is an effective tool for assessing whether each rate class is paying its fair share of total costs and for designing rates that fairly assign costs to each rate class.  The electric utility should prepare a COSS using standard methods that have been established by industry experts, accepted by regulators, and/or approved by the courts – even if the electric utility is not subject to state jurisdiction. These methods must determine as accurately as possible what it costs for the electric utility to serve each class of customers.

The first step is to Functionalize all of the utility’s costs into major functional groups, e.g. production, transmission or distribution.  This answers the question, to what function does a particular cost relate?  The second step is to Classify all functionalized costs as related to energy, demand, or the number of customers.  This answers the question, how does the particular cost vary?  The third step is to Allocate the functionalized, classified costs to the rate classes.  This answers the question, which customers cause the utility to incur the particular cost?  The COSS can then be used to show the actual per-unit costs to serve each rate class, separated or unbundled into demand, energy, and customer components. Those actual costs can then be adjusted to reflect the target revenue requirement, so that unbundled, cost-based rates for each rate class may be calculated.  These unbundled, cost-based rates provide essential guidance for designing rates that are fair, just and reasonable.

Rate Design

The Revenue Requirement shows whether an overall rate increase is needed.  The unbundled, cost-based rates from the COSS show which rate classes are subsidizing or being subsidized by other rate classes, and provide guidance on how the particular rate schedules should be adjusted.   When the cost-based rates are unbundled by component – including purchased power demand, purchased power energy, transmission demand (if applicable), distribution demand, and distribution customer – the utility can assess whether the existing charges (customer charge, energy charge, and demand charge where applicable) send the appropriate price signals to consumers, or whether revisions are needed to correct that and/or to afford the utility sufficient protection against revenue erosion. 

Significant rate changes can be difficult to adopt in a short period of time.  The ratemaking principle of gradualism is applied when electric utilities adjust rates in smaller increments over time to avoid dramatic rate increases all at once.

Utility margins should be included in fixed charges whenever possible, so that variations in weather or conservation do not adversely impact utility margins.  Typical rate designs are referred to as Two-Part Rates (comprised of per-customer and energy charges) and Three-Part Rates (comprised of customer, energy, and demand charges).

The rate design should (a) allow the electric utility to secure the target revenue requirement, (b) align with the wholesale power rate structure, (c) minimize subsidies within and between rate classes, (d) encourage efficient usage, and (e) properly charge and credit consumers with distributed generation resources.  The rates must also be understandable, be stable, and avoid undue discrimination.  If a consumer causes the utility to incur a particular cost, the consumer should pay that cost.  Rates designed on the basis of unbundled, cost-based rates are an effective way to achieve all of these objectives.

Conclusion

In the current pandemic, and during periods of any rapid change, it is especially important for electric utilities to review their rate structure, to ensure continued financial stability while also addressing the changing economic and social interests of the community they serve.  Electric utilities must be flexible, because there is no one perfect rate design – conditions change, and corresponding changes to the rate structure may be warranted.  Utilities must also be alert, and continue to monitor emerging trends, customer interests, best practices of other utilities, and the associated impact of all of these dynamic elements on the future financials of the utility.  In this way the electric utility will remain best positioned to manage and indeed thrive in whatever environment the future brings.

John Wolfram's picture

Thank John for the Post!

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Discussions

Matt Chester's picture
Matt Chester on May 20, 2020 10:28 pm GMT

n the current pandemic, and during periods of any rapid change, it is especially important for electric utilities to review their rate structure, to ensure continued financial stability while also addressing the changing economic and social interests of the community they serve.

The last part has rarely been more evident as it has now. Customers always push back on rate increases, especially when it's hard to tangibly gauge what they're getting out of the it-- will the post COVID world have these ratemaking cases seen differently by the customers? 

Richard Ford's picture
Richard Ford on May 31, 2020 12:15 am GMT

John made some good points.  How should we apply them?  What about "avoid undue discrimination?"  When my wife died and my distribution price per kWh went up 44%, I thought that was undue discrimintion against widowers.  (Because the fixed charge stayed the same while I did half as much laundry, cooking, dishes, etc.)

Send "appropriate price signals to consumers" should not mean "You had better not install LED lights or solar panels, or your price per kWh will go up."

"Include margins in fixed charges?"  I disagree.  Every company in the world has to have a profit margin to stay in business.  Every company that does not have a monopoly includes a markup in each unit of product sold.

"Gradualism?"  Try coming to a public rate hearing and explaining to a little old lady in a small apartment why she should continue paying twice as much per kWh so that people with big houses can gradually get used to paying the same price that she does.  Connecticutt made the right decision on gradualism when the legislature ordered that the fixed charge for residential customers be cut about in half. 

 

 

 

John Wolfram's picture
John Wolfram on Jun 9, 2020 3:32 pm GMT

Thanks for the comments.  How to apply the points in any situation is usually the difficult part.  Because ratemaking involves averaging – simply by virtue of grouping consumers into rate classes, if not in other ways – there will always be some degree of inequity, and thus subsidization, between and among consumers.  Perhaps this is where the “undue” qualifier comes in to play.  Also, there are many examples of companies including margins in fixed costs – including subscription services, tickets for theatre or sporting events, memberships, and more.  Most of these are not natural monopolies that actively encourage customers to consume less of what they sell. Gas utilities face criticism for adding any margins on the gas commodity or variable charge during cold winters, and thus are encouraged to include any margins (which they have a legal right to attempt to earn) in the fixed charges.   There are always many sides to rate design, particularly the treatment of capacity costs.  Bonbright said it well in his classic “Principles of Public Utility Rates” when he said “Of all of the many problems of rate making that are bedeviled by unresolved disputes about issues of fairness, the one that deserves first rank for frustration is that concerned with the apportionment among different classes of consumers of the demand costs or capacity costs... Here, notions of ‘fair apportionment’ are almost sure to conflict with economists’ convictions as to the relevant cost allocations.”

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