Energy Rates

Ratemaking is the formal regulatory process used to set rates, or prices, for public utilities that provide energy services to most Americans. (A similar process exists for water and sewer service.) Approved rates determine what investments the utility can make and what programs and services will be delivered. The ratemaking process directly affects energy bills and the quality of service received.

Traditional vs. alternative ratemaking: Traditionally, before allowing utilities to change rates or make new investments, regulators require a rate case review. During this process, they analyze evidence to determine how much revenue the utility needs to recover its costs and earn a reasonable profit. Based on the required revenue from this analysis, regulators set rates. Once these rates are established, they remain in place until a new rate case is filed and approved. In a traditional rate case, all of a utility’s costs and revenues are examined. This comprehensive review determines fair rates based on evidence and public participation in the process.

Alternative ratemaking refers to mechanisms that allow rates to be adjusted automatically or outside a full rate review. Multi-year rate plans are one form of alternative ratemaking. They allow for automatic rate changes in the years between full rate reviews based on predetermined and approved factors.

Cost trackers are another form of alternative ratemaking. Trackers enable utilities to recover specific costs outside of rate cases. They adjust rates between rate cases based on increases or decreases in certain utility costs. Often, trackers limit regulators’ ability to evaluate costs or consider new revenue opportunities. As a result, consumers may pay too much for their energy, leading to consumer harm. This design may also lessen the utility’s incentive to control its costs between rate cases. Decoupling, which guarantees a utility a certain amount of revenue between rate cases regardless of energy usage, is another example of alternative ratemaking (see also Consumer Protections in Energy-Efficiency Programs).

Among the criticisms of alternative ratemaking are the following:

• Lack of financial oversight: Alternative ratemaking undermines the comprehensive review of utility costs and revenues. Investment decisions may not be prudent. Consumers may not always pay just and reasonable rates.
• Incentives to cut costs and harm consumers: When earnings are protected in a multi-year rate plan, utilities have incentives to cut costs related to reliability or customer service in ways that have adverse effects on consumers.
• Revenue maximization over service improvement: Utilities pursue strategies to maximize their revenues under alternative ratemaking mechanisms rather than through actual improvements in overall service and reliability.
• Questionable rate case cost savings: Although the number of rate cases may be reduced, the cost of tracking, monitoring, and evaluating alternative mechanisms may offset those savings.

Appropriate cost allocation is a critical issue in the ratemaking process. This refers to how regulators divide costs among the customer classes: residential, commercial, and industrial. If costs are not assigned fairly, at least one customer class will pay more than its fair share.

Rate design:  This refers to how rates are structured to recover the approved revenues within each rate class. Each customer class (residential, commercial, and industrial) must contribute to the overall revenues approved in the rate case. The amount each customer class must recover, and the design of the rates themselves, can be contentious. Historically, the rate design for residential customers has consisted of a modest monthly fixed customer charge and a fixed rate for each unit of usage.

Policymakers are increasingly considering “alternative rate designs” for residential customers. These alternatives may provide incentives for customers to use less energy, shift their energy usage from peak hours to off-peak hours, or reflect seasonal costs. Peak hours refer to times of day when generation of electricity or natural gas is most expensive. Usually, these are hours when residential customers use the most energy for cooling in warmer climates and home heating in colder climates. These changes in rate design can have significant bill impacts on some customers, harming their ability to afford an essential energy service. Examples include:

• High fixed charges: Some utilities have increased fixed monthly charges and lowered usage-based fees. This structure increases bills for households with lower usage and decreases bills for those with high usage. It can be harmful for older adults on fixed incomes.
• Demand-response programs: These programs use incentives and technology to reduce energy usage during more expensive peak hours and shift demand to off-peak hours (see also Rate Programs to Shift or Decrease Energy Use).
• Time-of-use rates: This rate design charges customers more for their usage during certain peak hours to reduce energy usage and shift demand to off-peak hours (see also Time-Varying Rates and Demand Response).
• Demand charges: These reflect the highest usage in a given month. Using a lot of power over a short period results in a higher demand charge than using the same amount of energy with steady usage. The goal is to create an incentive to reduce peak usage. However, many customers do not understand how this pricing structure works. And even when they do, they typically do not monitor their usage on an hourly basis. In addition, some households cannot safely shift usage to a different time of day. For example, older adults may need to run heat or air-conditioning at peak hours to stay safe and healthy.
• Tiered rates: Sometimes called inclining block rates, this is a pricing structure that increases the rate paid as households use more energy. Households pay the lowest rate in the first tier. They pay more for energy in the second tier, more yet for the third tier, and so on.

Stranded costs: Stranded costs refer to previously approved expenses that a utility can no longer recover because of a change in law, policy, competition, or infrastructure replacement. These costs can arise when a utility invests in updating or replacing infrastructure that remains useful but has not been fully paid for. Stranded costs can run into the hundreds of millions of dollars and significantly impact utility rates.

For example, stranded costs are expected to increase as society moves away from the use of natural gas and toward the use of electricity. This is happening as consumers buy more energy-efficient electric-powered goods, such as electric cars and heat pumps. Consumers who continue to use natural gas are left to pay for the investments in gas infrastructure that still have to be paid off. This can have an impact on the affordability of their heating and cooling bills.

Energy technology subsidies: Regulators in many states are promoting the increased use of renewable energy resources. Although more efficient, these technologies require significant consumer investment. Ratepayers are increasingly being asked to pay higher rates to subsidize new technologies such as electric vehicle charging stations, home heating system replacements, and solar energy. Ratepayer subsidies for these technologies can be especially burdensome for households with low incomes. They often cannot afford these new technologies themselves, even with the subsidies. Moreover, people with low incomes tend to pay a higher percentage of their income on energy bills. They are likely to face the biggest challenges if their energy costs go up in order to pay for these new technologies. In contrast, taxation is more progressive and may provide a more appropriate mechanism for funding such technologies.