Changes in regulatory requirements, market structures, and operational technologies have introduced complexities that traditional ratemaking approaches can’t address. Poorly designed rates lead to...
Rate-Case Mania: Lessons for a New Generation
test year. The revenue-requirement study also includes various proposed adjustments to normalize the historical costs. Normalizing adjustments modify booked costs or revenues to make them representative of the costs the utility is likely to incur in the future period when the rates will be in effect. Disputes in rate cases typically focus on issues such as whether specific booked costs were incurred prudently and for the benefit of ratepayers, whether the utility’s adjustments are proper, and whether additional normalizing adjustments should be made.
After considering the evidence and allowing, rejecting or adjusting costs accordingly, the regulatory commission will approve the utility’s revenue requirement (see “Fundamental Equation for Ratemaking” above).
The utility’s approved revenue requirement is compared with its normalized test-year revenue. The test year may be a historical year, a forecast year, or a hybrid of the two. If the revenue is less than the revenue requirement, rates must be increased to make up the deficiency. Rates may be reduced if the revenue exceeds the revenue requirement.
The utility’s capital may be borrowed (through bonds or other debt obligations), or obtained as equity from investors. The utility computes a rate base consisting of the original cost of the utility’s plant in service minus accumulated depreciation plus a working capital allowance. The commission reviews and may adjust the rate-base computation. The approved rate base is multiplied by the cost of capital the commission approves. The cost of capital is established by weighting the costs of borrowed funds at their actual interest rates, and the cost of equity at a rate the commission sets. A regulatory commission must allow equity returns that are sufficient to maintain the utility’s financial integrity and attract capital consistent with its market-risk profile.
The parties in a rate case often attempt to demonstrate the appropriate equity return through studies of the returns earned by a group of similar utilities (called comparables), or by other methods such as discounted-cash-flow analysis (DCF), or risk-premium analysis.
Only prudently incurred expenses are allowed in the definition of revenue requirements
The rate-design process determines what portion of the revenue requirement will be collected from each customer class, and through what rate form, such as a fixed customer charge or a charge that varies with usage.
Rate design begins with a cost-of-service study (COSS). The COSS assigns the costs in each accounting category in three ways in order to identify the cost causer. In this process, some costs can be assigned directly, but many costs are allocated based on a measurable ratio such as labor costs.
Disputes over rate design often focus on whether an appropriate allocation factor is used to assign the costs among functions (generation, transmission and distribution), classes of costs (customer, energy and demand), customer class (residential, commercial, agricultural and government), and time-of-use (seasonal, time of day).
Allocation of total revenue requirements by customer class is based on usage characteristics. This requires load research surveys to be carried out periodically on representative samples of customers. A variety of cost-allocation methods are available for assigning costs to customers according to patterns