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Rate-Case Mania: Lessons for a New Generation

Fortnightly Magazine - February 2006

distribution segments of the business, the single supplier model still was judged to be the best one, since both segments were characterized by declining average cost curves. However, in these segments there were calls for light-handed regulation based on simpler concepts tied to the notion of incentive regulation.

In practice, incentive regulation has not proven to be as light-handed as originally conceived. Since the X and Z factors did not stay constant over time, they had to be periodically adjusted based on whether the utility was accruing much larger gains than anticipated (or losing much more money than anticipated). In the original power cost recovery formulation, the utility was allowed to keep any gains beyond the specified level. However, it became politically difficult to do that.

Complex formulas were developed for deciding how to “split” the gains (or losses) if the utility exceeded (or fell short of) its performance on the various indexes. Some argued that all gains should be given to the customers. But if that were to be done, it would eliminate any incentive for the utility to make those improvements in the future. 2 In some situations, the commissions agreed to share the gains between the utility and its customers on a sliding-scale basis, but in practice forced the utility to give all the gains to the customer. This has created the well-known problem of reneging on “regulatory commitment.” 3

While no perfect solutions have been found, it would be fair to say that the international trend in regulation has been to move away from heavy-handed regulation to light-handed regulation. This generally has meant moving away from cost-based tariffs to performance-based tariffs and ultimately to market-based tariffs.

Cost-Of-Service, Regulation-Based Tariffs

In a nutshell, the goal of utility ratemaking is to set future rates that allow a utility to collect enough revenue in the period when the rates are in effect to cover the utility’s costs and an adequate, but not excessive, return on investment. The process of setting tariffs consists of two major steps. The first step is called ratemaking and involves a determination of revenue requirements. The second step is called rate design and involves the allocation of revenue requirements into functions (generation, transmission, and distribution), class of service (residential, commercial, government, agricultural, and industrial), voltage level (primary, secondary, and tertiary), category (demand, energy, and customer) and time-of-use (seasonal, time-of-day).

With the exception of fuel surcharges, rates are not intended to recover specific expenses incurred in the past. Instead, an approved revenue requirement estimates a utility’s expenses and required return for the period during which the rates will be in effect. Rates then are set to cover the revenue requirement. The approved rates must allow the utility an opportunity to collect enough revenue to cover its expenses and return on investment but the regulatory process does not provide any guarantees of financial success to the utility.

Revenue Requirement

The utility ratemaking process starts when a utility files a revenue-requirement study based on costs and revenue recorded in the utility’s books in a historical or forecast period called the