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 electric service. This Post explains how they establish just and reasonable electric rates.
Prior to the 1990s regulated electric service consisted of all three components of service – generation, transmission and distribution. Since the 1990s, regulated service usually consists solely of the transmission and distribution components. The following describes the process for setting just and reasonable rates for the components of service that are regulated.
The regulatory compact, implemented under state public utility acts, requires the applicable state regulatory agency to set electric rates that are just and reasonable. The process for setting just and reasonable rates starts with the following formula that determines 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 have an opportunity to present testimony and exhibits that 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 appearing in the utility’s books and records. Unless it makes adjustments the regulatory agency will use those raw costs in the formula to establish revenue requirement. However, parties participating in the ratemaking process will typically advocate adjustments to the 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 that were incurred by the utility to repair some type of non-recurring equipment outage. Only the regulated agency can sift through these arguments to arrive at the number that will be used for setting rates.
Reasonable Rate of Return
The reasonable rate of return component 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 that the utility will pay on its profit.
The cost of debt and the dividends on preferred stock are usually non-controversial. They can be taken directly from the utility’s books and records.
The return on equity is a bit more controversial. The United States Supreme Court has decided that the regulated return on equity should be equal to the 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, however, 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 in operating plant appearing in the utility’s books and records. Unless the regulatory agency makes adjustments, it will use the raw investment values in the ratemaking formula. However, once again, the parties in the ratemaking proceeding will generally advocate adjustments to these raw investment values. For example, the parties might advocate additions or subtractions for investments in facilities that are expected to be either added to, to removed from, 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 electric usage, these plants looked like they might not be needed and were referred to as “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 potential that they might not be able to earn a return on their investment in these plants many utilities cancelled plans for their construction.
Conversion of Revenue Requirement to Electric Rates
The regulatory agency uses the the revenue requirement as the total revenues 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 apply for 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 regulatory agency uses the above described ratemaking process solely to establish rates for those two regulated services.
However, even where the generation component of service has been deregulated the regulatory agencies have not been relieved of their statutory obligation to ensure that the generation component of electric rates is just and reasonable. Prior to deregulation the agencies applied the above described ratemaking process to determine just and reasonable rates for the generation component. Where the generation component of service has been deregulated they make sure that the rates for that component are just and reasonable by ensuring that the market for generation is truly competitive.
Utility invoices have also been affected by deregulation. Where the generation component has been deregulated the utility and the competitive generation supplier may each issue their own invoice to their customers. This means that customers may receive two invoices for their electric service – one from the utility for the delivery of the electricity and one from the competitive supplier for the actual electricity used. However, in some cases the utility becomes the collection agent for the generation supplier and includes the supplier’s 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. In these cases, the utility will purchase generation for those customers in the competitive market and include 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.