How Do Regulatory Agencies Set Just and Reasonable Rates?

As discussed in the Post entitled “Why Are Electric Utilities Regulated?” virtually every state, as well as the Federal Government, has incorporated the Regulatory Compact into its utility regulatory law. That means that the utilities are required to provide service and the government is required to authorize the utility to charge Just and Reasonable rates. 

Up until the 1990s utilities’ regulated service – the service for which Just and Reasonable Rates were determined – was considered to include all three components of such service – generation, transmission and distribution.  A simple explanation of the generation, transmission and distribution functions can be found at the following You Tube video:

Beginning in the 1990s, in many parts of the country, the generation component of service began to be available on a competitive basis. The impact of this conversion to partial deregulation on the rate-setting process is discussed in more detail at the end of this Post. However, the following description of the rate-setting process applies to whatever portion of the service remains subject to regulatory ratemaking.

Just and Reasonable rates are those rates that allow the utility to recover its operating costs plus a reasonable return on its investment.  Over time this had led to the following formula that is used to determine the total revenues (referred to as the “Revenue Requirement”) that a utility will be permitted to recover over any 12 month component of the rate effective period:

So, to calculate a utility’s Revenue Requirement, the state or Federal regulatory agency must determine the following three rate components for a representative 12 month period: (1) Prudently incurred costs; (2) Reasonable rate of return; and (3) Investment in used and useful plant.  Those determinations are made in a judicial like proceeding where the utility and other interested parties can present testimony and exhibits and argue for their interpretations of the above three rate components.

Revenue Requirement        =          Prudently incurred costs of operations + (Reasonable Rate of Return x Investment in Used and Useful Plant)

Prudently Incurred Operating Costs

Operating Costs include things like labor, materials and fuels. The process begins with the operating costs taken directly from the utility’s books and records for a representative 12 month period. For rate-setting purposes the regulatory agency will adjust the raw data for the representative 12 month period to reflect any “known and measurable changes” that are going to occur during the rate effective period.  For example, for rate-setting purposes, labor costs may reflect negotiated wage increases that are going to take effect during he period in which the rates will be in effect.

Parties representing customer interests may argue for the disallowance, or exclusion, of certain operating costs that they believe were non-recurring or imprudently incurred. For example, they might argue that costs incurred by the utility to recover from an equipment outage that occurred during the representative 12 month period should not be included in rates because the outage was out-of-the ordinary and is not expected to occur again or because the outage was caused by a failure by the utility to properly maintain the equipment. 

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 rates.  Therefore, the Reasonable Rate of Return component will include the taxes paid on the return on equity component. 

The return on equity should be equal to a return that is comparable to the return on other available investments in the market that are of a similar risk to the utility. Historically, the utility and the parties representing customer interests presented extensive arguments for their preferred returns on equity for the utility. 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 for the representative 12 month period. For ratemaking purposes the actual amounts are adjusted to reflect plant that will be taken out of service and plant that will be added to service during the rate effective period. 

The Investment component was very contentious during the 1980s when large new nuclear plants came on line at a time when it did not appear that they were going to be needed to meet diminishing customer requirements. Parties representing customers argued that the investment in the new plants should not be included in rates because they were not going to be “used and useful” in providing service.

Conversion of Revenue Requirement to Rates

The Revenue Requirement, as determined above, is the total revenue that the utility is permitted to recover during any 12 month component of the rate effective period. So how is that Revenue Requirement converted to rates that customers will see on their bills?

The first thing that happens is that the Revenue Requirement is equitably allocated to each of the utility’s rate classes, typically, industrial, commercial and residential. The second thing that happens is that the portion of the Revenue Requirement allocated to each rate class is broken down into rates, typically, a customer charge, a per kW demand charge (usually only for industrial customers) and a per kWh energy charge, based on projected customer usage during a 12 month period in the rate effective period. 

Rates approved by the regulatory agency through the above described process 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 costs, return, investment and customer usage are the same as used in the rate-setting process the utility will earn the profit that was projected in that process. However, in years when any of these components are different than what was used in the rate-setting process the utility will earn more or less profit than hat which was projected.

Impact of Partial Deregulation

Where the generation component of service is available on a competitive basis the customer is considered to be buying only transmission and/or distribution service from the utility and the rate-setting process in such a case is determined by the Operating Costs, Return and Investment related to those services. The customer will then receive an invoice from the regulated services from the utility and an invoice for the competitive generation services from the generation supplier. (In some cases the utility may collect the revenues for the supplier as a separate line item on the utility invoice).

In cases where competitive generation is available but the customer elects to continue to purchase all three components from the utility the utility will purchase the generation in the competitive market and will include the cost of the generation component as a pass through charge on its invoice.

Where partial deregulation for the generation component of service has occurred the regulatory agencies have not been relieved of their obligation to ensure that electric rates are Just and Reasonable. However, where they formerly applied the above described rate-setting process to the cost of generation to ensure Just and Reasonable rates they now ensure such rates by making sure that the market for the generation component is truly competitive.

David Rosenstein worked as an attorney and consulting engineer in the electric utility industry for 40 years. When he retired he wrote a book entitled Electrifying America: From Thomas Edison to Climate Changewhich describes the evolution of the electric industry from the time Edison invented the light bulb until today. Each of his posts in this Blog describe a different aspect of electricity, the electric industry or the issues currently faced by the electric industry. 

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