The Process for Determining Regulated Electric Rates
The Post entitled What is an Electric Utility? explains why regulatory agencies establish just and reasonable electric rates for regulated service. This Post explains how they establish just and reasonable electric rates.
Prior to the 1990s regulated electric service consisted of generation, transmission and distribution. Since the 1990s, regulated service usually consists solely of transmission and distribution. The following description of the ratemaking process applies to that portion of the service that remains regulated.
Just and reasonable rates allow the utility to recover its operating costs plus a reasonable return on its investment. Regulatory agencies use the following formula to determine the total utility revenue for a 12 month period (referred to as the revenue requirement):
Revenue Requirement = Prudently incurred costs of operations + (Reasonable Rate of Return x Investment in Used and Useful Plant)
Therefore, to establish a utility’s revenue requirement, the regulatory agency must first determine the following three rate components:
- Prudently incurred costs;
- Reasonable rate of return; and
- Investment in used and useful plant.
The regulatory agency makes its determinations in a judicial-like proceeding. In that proceeding the utility and other interested parties present testimony and exhibits to support their respective interpretations of the above three rate components.
Prudently Incurred Operating Costs
Operating costs include things like labor, materials and fuels. The starting point for determining this component is the raw operating costs taken directly from the utility’s books and records. Unless adjusted, those raw costs will be used in the formula to establish revenue requirement. However, parties typically advocate numerous adjustment to that raw data.
For example, the utility might argue that the raw labor costs should be increased to reflect a negotiated wage increase that is going to take effect during the rate effective period. And customers might argue that the raw labor costs should be decreased to exclude costs incurred to recover from an non-recurring equipment outage.
Reasonable Rate of Return
The reasonable rate of return is a weighted average of the utility’s cost of capital. It includes the interest rate on the utility’s long term bonds, the dividends on any preferred stock, the interest rate on any short term debt and a return on outstanding equity.
The return on equity is the profit component of the utility’s revenue requirement. Therefore, the return on equity component includes an adder for the taxes owed on the profit.
The cost of debt and the dividends on preferred stock are usually non-controversial and can be taken directly from the utility’s books and records.
The return on equity is more controversial. The United State Supreme Court has decided that the regulated return on equity should be equal to return a return on investments that have risks that are comparable to the utility’s. Historically, the utility and the other parties presented extensive arguments for their preferred returns on equity. In recent years regulatory agencies have found ways to reduce the contentiousness of this issue.
Investment in Used and Useful Plant
As with the operating cost component, the investment component starts with net investment for operating plant taken from the utility’s books and records. Unless adjusted, the raw investment values will be used to establish electric rates. However, once again, the parties will generally advocate adjustments to these raw investment values. For example, the parties will advocate additions or disallowances for investments in facilities that are expected to be either added to, to taken out of, service during the rate effective period.
The Investment component was very contentious during the 1980s when large new nuclear plants were under construction and about to come on line. Because of diminishing customer energy usage, these plants looked like they might become “excess capacity”. Parties representing customers argued that the investment in the new plants should be excluded from rates because they were not going to be “used and useful” in providing service. Because of the threat of exclusion of this investment the utilities cancelled plans for many off the planned nuclear plants.
Conversion of Revenue Requirement to Electric Rates
For ratemaking purposes, the regulatory agency uses the the revenue requirement as the total revenue that the utility may recover during any 12 month period. So how is that revenue requirement converted to the electric rates that a customer will see on his bill?
First, the regulatory agency will allocate the revenue requirement equitably among each of its rate classes, typically, industrial, commercial and residential. This is sometimes referred to as “dividing the revenue pie”.
Second, the regulatory agency will use projected customer usage for a 12 month period to convert each rate class’ share of the revenue requirement into electric rate components for that class. The components are, typically, a customer charge, a per-kW demand charge (usually only for industrial customers) and a per-kWh energy charge.
Electric rates approved by the regulatory agency will remain in effect until the regulatory agency changes the rates again. This could be for one year or it could be for many years. During the years that the rates are in effect, if the operating costs, return, investment and customer usage are the same as used in the ratemaking process the utility will earn the profit that was projected in that process.
However, in years when any of these components are different, the utility will earn more or less profit than that which was projected. If the changes reducing profits are sustained the utility will seek a rate increase. If the changes increasing profits are sustained the regulatory agency or its customers may seek to reduce the rates.
Impact of Partial Deregulation on Electric Rates
Where the generation component of service is available on a competitive basis the customer is considered to be buying only transmission and distribution service from its utility. In that case the ratemaking process focuses solely on operating costs, return and investment related to those regulated services.
However, even where the generation component of service has been deregulated the regulatory agencies have not been relieved of their obligation to ensure that the generation component of electric rates is just and reasonable. Where the agencies formerly applied the above described ratemaking process to determine reasonable rates for the generation component they now meet the just and reasonable requirement for the generation component by using their authority to ensure that the market for generation is truly competitive.
Utility invoices have also been affected by deregulation. In the partially deregulated environment the utility and the competitive generation supplier generally will each issue their own invoice to their customers. However, in some cases the utility is required to collect the generation supplier’s charges and will include those charges as a separate line item on its invoice to its customers.
Even when given the option to purchase competitive generation services, some customers wish to continue purchasing generation from their utility. To serve those customers the utility purchases generation in the competitive market and includes the cost of that generation component as a pass through charge on its invoice.
Additional information on electricity pricing can be found at the U.S. Energy Information Administration publication entitled Electricity Explained: Factors Affecting Electricity Prices.
I. David Rosenstein worked as a consulting engineer and attorney in the electric industry for 40 years. At various times during his career he worked for utility customers, Rural Electric Cooperatives, traditional investor owned regulated utilities and deregulated power generation companies. Each of his posts in this blog describes a different aspect of the past, present or future of the electric industry.