How a utility makes money under cost-of-service

Using traditional cost-of-service methodology, the majority of earnings are determined by the rate of return on equity the commission authorizes multiplied by the value of assets in the equity portion of the rate base. Because earnings are dependent upon the value of the rate base, utilities have been incentivized to invest in more facilities, thereby increasing their potential earnings. To protect the customer from paying for unnecessary facilities, regulators require prior approval of major facility additions as well as reasonableness reviews of expenditures.

Earnings Portion of Revenue Requirement = (Authorized Rate of Return on Equity) X (Equity Portion of Rate Base)

Under cost-of-service regulation, a utility can increase earnings in four ways:

  1. Increase rate base.
  2. Increase the commission-approved rate of return on rate base.
  3. In some cases, hold expenses below the forecast used to set rates.
  4. In some cases, increase sales beyond forecasted loads.

The last two strategies work if expenses and/or revenues are not subject to balancing accounts. So if a utility is able to get regulators to approve a certain expense threshold and then subsequently beats that threshold, it gets to keep as profit any remaining expense dollars. And if the utility has not been “decoupled” and achieves more sales than forecast when the rates were set, the utility gets excess revenues to increase profits.

It is important to keep in mind that authorized rates of return are not guaranteed by regulators. Utilities can fall short of authorized returns in many ways. Areas of risk include:

  • Disallowances on money already spent — If regulators believe that utilities have failed to act prudently in spending money, the money spent can be disallowed, meaning that the utility is not allowed to include the expenditures in its revenue requirement.
  • Expenses that are not balancing account protected — In this case, exceeding forecasted expenses would result in lower returns.
  • Absence of balancing account protection for revenue fluctuations due to weather or other drops in sales — This means that should an electric utility’s service area experience a cooler than usual summer, thus resulting in lower power usage for air conditioning, revenues will be reduced. A similar effect would occur for a gas utility during a warm winter with low heating loads. If there is no balancing account protection then the utility will fall short of earnings projections (conversely, if its sales due to weather are greater than projected, earnings may increase).