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In several recent utility rate cases, regulators, under pressure to contain rate increases, have disallowed a portion of a utility’s claimed employee compensation expenses, citing local economic conditions and the need for austerity. Ratepayers should of course expect that the costs that lie behind the rate remain “just and reasonable.” However, if a utility is unable to recover reasonably incurred costs through its rates, its overall costs might rise, jeopardizing its financial health, Future ratepayers might end up paying more for service. Quality of service ultimately might suffer. Moreover, management’s ability to keep the ship running might be compromised if companies are denied flexibility to adopt viable alternative compensation packages, or if certain components of employee compensation are inappropriately disallowed.

In the typical rate case, the utility offers evidence that its employee compensation costs are reasonable. If the evidence proves insufficient, regulators may choose to disallow certain requested costs. The regulator must review the evidence and consider how a cost allowance will affect rates. However, if regulators focus on specific components of employee compensation—without adequately considering the reasonableness of total costs—then the rate order might do financial harm to the utility, and, in the long term, to ratepayers.

Utilities can choose different ways to present labor costs to regulators to best support their claims of reasonableness—even as regulators, too, can and should consider a range of factors in reviewing compensation and utility revenue requirements. Here, we look at both sides of the rate-making process, and discuss some key trends in utility compensation practices.

Trends in Cost Management

A utility’s employee compensation typically comprises cash compensation—salary and incentives—and non-cash compensation, including pension and retirement plans, medical and dental care, and other benefits. The Bureau of Labor Statistics (BLS) reported that through September 2011 approximately 61 percent of employee compensation at utilities came in the form of cash wages and salaries, while the remaining 39 percent represented benefit costs. ¹ Across all industries, the costs of non-cash compensation have climbed swiftly, prompting utilities and other employers to deploy a range of strategies for managing these expenses. Examples include retirement plan restructuring; increased use of incentive-based compensation; and reductions in headcount.

First, utilities have switched employees from defined-benefit pension plans to defined-contribution pension plans, thereby shifting pension funding responsibility to employees. From 1980 through 2008, the proportion of private wage and salary workers participating in defined benefit pension plans fell from 38 percent to 20 percent. ² Over the same period, the percentage of workers covered by a defined contribution pension plan—that is, an investment account established and often subsidized by employers but owned and controlled by employees—rose from 8 percent to 31 percent.

Second, utilities have extended incentive compensation to more employees and increased the amount of total compensation at risk by implementing plans that link a portion of an employee’s compensation to his