One of the most important regulatory proceedings for a utility is the general rate case or GRC. It is in this proceeding that rates and revenue requirements are set for a period of time. The results have strong impact on the potential earnings for an investor-owned utility. The general concept of ratemaking is that monopoly entities are entitled to charge rates that will allow them to cover their costs of service, plus a reasonable rate of return (or profit) on capital invested by shareholders to build the necessary facilities to provide the service. The process of setting rates requires determining a revenue requirement that includes all the revenue the utility needs to collect to cover costs and make a reasonable return, and then translating that revenue requirement into specific rates for specific customers. This process is outlined below. A similar process is used to set rates for non-profit utilities such as municipal utilities and co-ops except that there is no line item for return on equity.
Determining the Authorized Rate of Return
The first step in the ratemaking process is a determination of the utility’s authorized rate of return. This is set by the regulatory commission, sometimes as part of the rate case and other times in a separate proceeding called a cost of capital proceeding. The regulators look at the current investment marketplace and determine how much return investors must be offered to ensure they invest in utility stocks as opposed to other investment opportunities. The regulators also estimate the utility’s cost of borrowing money. Separate rates of return will be set for debt and for equity, which is the money invested by stockholders. Regulators may also determine an approved debt/equity ratio. The debt cost, return on equity, and the debt/equity ratio combine to determine the utility’s overall rate of return.
The second step is to forecast how much gas and/or electricity customers will use over the rate case period. This information is important because it will determine the amount of capital and expense dollars that will be required to provide reliable service and the revenue that the utility will collect. Forecasts are made using historical usage data, expected growth or decline in population and business activities and other societal trends. The forecast will be broken down by customer class so that costs and revenues can be determined on a per class basis.
Determining a Revenue Requirement
A revenue requirement is defined as the total amount of money a utility must collect from customers to pay all operating and capital costs, including its return on investment. The revenue requirement is determined by forecasting expenses (operating and maintenance, administrative and taxes other than income taxes), depreciation, and income taxes for a rate cycle, and then adding to that the return on rate base plus any approved amounts (positive or negative) outstanding in any balancing accounts. The rate base is the depreciated value of all the capital facilities the utility has constructed in order to provide services to its customers plus working capital. The return on equity multiplied by the equity portion of the rate base (the percentage financed through shareholder investment) is the primary component of profit for a utility.
In some states, utility earnings are protected by use of a balancing account. A balancing account is an accounting mechanism that keeps track of the difference between the revenue requirement and the actual revenues obtained or expenses incurred. Any differences covered by the balancing account are added to or subtracted from future revenue requirements, thus insulating the utility and its customers from risks of revenue or expense deviations. Typical items covered by balancing accounts for utilities include expenses such as gas purchase costs or expenses due to unforeseen circumstances, and, in some states, revenue fluctuations due to increased or decreased weather-related usage. The use of balancing accounts to stabilize revenues associated with weather conditions is called weather normalization.
Here is an example of a revenue requirement:
Allocating Revenue to Customer Classes
Once an overall revenue requirement for a service is established, it must then be determined what portion will be paid by each class of customer. This process is called revenue allocation. The general concept is that revenue should be allocated based on the costs required to serve a class of customers. Various allocation methods are used in different situations. The simplest method allocates costs based on usage. While simple, this approach is not necessarily an accurate way of assigning costs. Since many of the costs of a gas or electric system are fixed, actual costs caused by customers are more likely to be based on the maximum demand that a customer puts on the system, and not on the amount of gas or electricity used.
Thus, a more common — though more complex — method is to allocate costs based on the estimated cost of service to each customer category (cost-of-service). This allocation can take into account demand-based costs as well as usage-based costs. An even more complex method (equal proportionate marginal costs or EPMC) allocates costs based on the marginal cost of serving each customer category. The marginal cost methodology looks at the cost of serving one additional increment in each class, rather than using the average cost as is done in the cost-of-service methodology. Actual determination of revenue allocation can be complex and is commonly one of the most highly contested issues in regulatory proceedings.
Here is an example of revenue allocation:
Determining Rate Design
Once a revenue requirement has been determined and allocated to the various customer classes, the rates that each customer class will pay are determined in the rate design phase of the proceeding. But before actual rates can be set, the rate structure must be determined. Rates are structured in any number of ways, but typically they are divided into three distinct components:
- Customer charge — A per-customer charge in $/month, independent of usage.
- Reservation or demand charge — A charge in $/kW/month (for electric) or $/therm or Mcf/month (for gas) based on contract quantity or the maximum demand incurred within a specific timeframe.
- Usage or variable charge — A charge based on actual usage in kWh (for electric) or therms of Mcf (for gas).
Allocating Revenue to Charge Types
Once the rate structure is set, another allocation must occur. This is the allocation within a customer class that determines how much revenue will be applied to customer charges, demand charges, and usage charges. Once this has been done, we now know how much revenue the utility is expected to collect from each charge type within each customer class.
Here is an example of allocating the class revenue allocation to charge types:
Determining the Rate
Finally, the rates for each customer type are calculated by dividing the allocated revenue by the appropriate forecasted factor. For instance, a residential customer class that is allocated $1 million per month to customer charges and has 100,000 customers forecasted, would have a monthly customer charge of $1 million divided by 100,000 customers, which equals $10 per customer per month.
Here is an example of determining the rate for an industrial class:
GRC proceedings may occur at a regular interval such as every three or four years, or may occur whenever initiated by a utility filing or a request by the regulatory agency with jurisdiction over the utility. Proceedings typically take a long time, in some cases more than one year.
Here is the typical process for a GRC proceeding: