Utility Economics, Cost of Service, and Ratemaking
This domain tests how a regulated utility converts its investment and expenses into a revenue requirement, and how that requirement is apportioned among customer classes and translated into tariff designs.
Rate base and revenue requirement
- Rate base generally equals plant in service plus an allowance for working capital and materials and supplies, plus construction work in progress only where the commission allows it, minus accumulated depreciation, minus accumulated deferred income taxes, minus contributions in aid of construction.
- The used-and-useful test and the prudent investment standard determine what enters rate base.
- Revenue requirement = operating and maintenance expense + book depreciation + taxes other than income + income tax + (rate base x rate of return). The allowed rate of return is a weighted average of embedded debt cost and allowed return on equity at the approved capital structure.
Cost of service
- Three steps: functionalize (production, transmission, distribution, customer), classify (demand, energy, customer), then allocate to classes.
- Demand allocation methods include coincident peak (1CP or 12CP), average and excess demand, and minimum-system demand. The choice moves cost between high-load-factor and low-load-factor classes and is the most contested issue in a rate case.
Rate design
- Objectives: revenue sufficiency, fairness, efficiency, stability, and simplicity.
- Tools: fixed customer charge, energy charge, demand charge, inclining or declining blocks, time-of-use periods, and real-time pricing. Straight-fixed-variable designs reduce cross-subsidy but weaken conservation signals.
- Embedded cost sets the revenue target; marginal cost informs the structure and is capped by the revenue requirement.
Worked example
Rate base of 500 million dollars, allowed return 7.5%, O&M 60 million, book depreciation 25 million, taxes other than income 10 million, income tax 12 million. Return = 500 x 0.075 = 37.5 million. Revenue requirement = 37.5 + 60 + 25 + 10 + 12 = 144.5 million. If class sales are 1,000 GWh, the average rate is 14.45 cents per kWh before any rate-design adjustment such as a higher fixed charge.
Traps that cost marks
- Including CWIP in rate base when the commission has not authorized it.
- Double-counting depreciation by expensing it and deducting it from rate base twice.
- Using the book depreciation rate where the commission has ordered a different remaining-life or depreciation study.
- Allocating all production plant to energy and none to demand.
- Presenting marginal cost as the revenue requirement rather than as the design signal.