Changes in regulatory requirements, market structures, and operational technologies have introduced complexities that traditional ratemaking approaches can’t address. Poorly designed rates lead to...
Dealing with unfunded mandates in performance-based ratemaking.
incremental activities, and only incremental activities, through a programmatic cost tracker.
By contrast, under traditional ratemaking, regulators establish rates after a review and approval of the utility’s total revenue requirement, normally based on a historical test year with some allowance for forward-looking cost changes. Under that approach, utilities typically recover their costs via a combination of base rates updated through general rate cases and separate cost trackers or adjustment mechanisms. In the past, cost trackers typically permitted utilities to recover expenses for volatile and difficult-to-predict items such as fuel and purchased power. Double recovery under traditional ratemaking is avoided largely because the costs captured by the trackers were specifically excluded from base rates.
More recently, trackers have been expanded to include other items and categories of incremental capital expenditures, such as environmental upgrades, reliability and safety expenditures, and smart grid applications. In this situation, however, the overall recovery of the costs associated with capital additions is provided through both base rates and the tracker mechanism. To prevent over- or under-recovery of costs, a clear threshold for cost recovery is established in the tracker, outside of base rates. In other words, costs in excess of a specified dollar amount included in base rates are recovered via trackers. Through a contemporaneous examination of all costs, including both increases and decreases, regulators can calculate the net change and establish rates at a just and reasonable level.
The traditional approach to cost trackers, and the recent expansion of their use, strike an appropriate balance between shareholders’ and ratepayers’ interests. The utility isn’t guaranteed full recovery of any given cost, nor is it guaranteed a specific profit. Earning the authorized return on equity continues to depend upon the utility’s prudent management and efficient operation.
Rate Plans and Incentives
Regulators in many states have established performance-based, multi-year rate plans that often contain earnings-sharing mechanisms. In many cases, such plans freeze or limit rates for several years. In doing so, they sever the link between a utility’s traditional revenue requirement and its actual rates. Specifically, a utility that agrees to a rate freeze has essentially limited its ability to seek base rate increases for a defined period in exchange for being able to retain some or all of the benefit of any cost reductions or productivity gains achieved during that period, depending on the mechanics of the earnings sharing mechanism. This type of incentive mechanism seeks to provide a utility with the opportunity to earn greater rewards in exchange for the assumption of greater risk.
Importantly, under any multi-year rate plan, there must be recognition that utilities often incur expenses related to regulatory, judicial, or legislative mandates that couldn’t reasonably have been anticipated when the rate plan was developed. These types of costs, referred to as “programmatic” or “exogenous” costs, warrant special treatment because they fall outside of the control of utility management and would undermine the utility’s ability to earn a reasonable return on equity if rate recovery weren’t permitted, outside of the multi-year rate plan. As a result, multi-year rate plans often include specific cost recovery mechanisms