Cost-of-service ratemaking sets rates based on forecasted costs of providing service plus an authorized “reasonable” rate of return on the equity invested by shareholders to build the capital facilities necessary to provide service. Under ratemaking theory, the authorized return should balance the interests of ratepayers and shareholders: The rate should be just high enough to attract needed capital to maintain service reliability but no higher since anything above that level would provide shareholders with a profit level above what is necessary (and force ratepayers to pay more than they should for service).
Rates of return are set by regulators after testimony by interested parties and analysis by regulatory staff. They vary based generally on the return on alternate investments such as bonds and other conservative business options, perceived risk associated with a specific company, and the regulatory climate in a specific locale. In some cases, rates of return can be set by a pre-determined formula, often using a 30-year Treasury index average and then adding a risk premium. For the first six months of 2019, authorized rates of return in the U.S. averaged 9.66% for electric utilities and 9.33% for gas utilities.