Cost Allocation and Rate Design


Regulators allocate the costs of power plants, transmission lines, and other joint and common expenses among the rate classes (i.e., residential, commercial, and industrial users). The way in which such costs are allocated can make a significant difference in a customer group’s electricity rates. If costs are not appropriately assigned, the result is a cross subsidy between rate classes.

Rate design refers to the way end-user rates are structured to recover utility costs; the design is often the final step in a rate case. Rate design is a complex process. Regulators attempt to balance multiple objectives, including utility cost recovery, mitigation of rate shock, equity among customers, economic efficiency, and energy efficiency. Typically, rates include a monthly fixed customer charge and a rate for each unit of usage. In a tiered or inclining block rate structure the usage rate increases with greater consumption in each pre-determined tier or block, for example, 0-500 kWh, 501-100 kWh.

In some states, utilities have proposed the following changes in rate design that could significantly affect residential customers, particularly if revenue recovery is shifted from volumetric rates to fixed charges:

  • High fixed charges—utilities increasingly are seeking to recover more of their costs through fixed customer charges that all users pay, while deemphasizing charges that vary based on usage (i.e., volumetric charges). To the extent that this occurs, it shifts the burden of paying for these costs away from customers who use more electricity or gas and thus toward those who use less. Straight fixed- variable rate design (SFV) rates allow utilities to recover nearly all fixed costs through fixed monthly charges, having the effect of substantially increasing the monthly fixed fees while lowering usage charges.
  • Demand charges—few utilities today impose demand charges on residential customers, but more and more are considering them. A demand charge is typically based on the highest average usage within a given month over a certain time period. Using a lot of power over a short time period results in a higher demand charge than steady usage. The theory is demand charges create an incentive to reduce peak usage. However, it is difficult for residential consumers to both understand and control their peak usage—they cannot, for example, stop their refrigerator or air conditioner from cycling on at the same time other appliances are in use. In addition, their peak usage period may not be the same as the utility’s peak.
  • Trackers—another trend in rate design involves the use of new cost-recovery surcharges or “trackers.” Trackers adjust rates between rate cases based on actual increases or decreases in certain utility costs. The danger they pose for consumers is that such adjustments tend to limit regulators’ ability to scrutinize and evaluate costs. This design also may lessen the utility’s incentive to control its costs between rate cases.
  • Decoupling (see this chapter’s section Energy Efficiency Programs)
  • Time-variant rates (see this chapter’s section Time-Varying Rates and Demand Response)

Cost Allocation and Rate Design: Policy

Equitable cost allocation

In this policy: FederalState

Regulators should devise cost-allocation methods that appropriately assign the cost of power plants, transmission, distribution, and other expenses to those customers responsible for the costs and expenses. Such methods should be consistent with universal service and affordability goals and should not unfairly shift costs to residential customers.

Equitable rate design

In this policy: State

Regulators should ensure that residential rate design minimizes flat, fixed charges and fees. They should not adopt high fixed charges, straight fixed-variable rate design, or demand charges for residential customers.