Utility Rates


Federal and state governments share responsibility for regulating utilities. Federal jurisdiction primarily relates to any interstate electric transmission and wholesale sales of electricity and interstate transmission of natural gas between states. States and their public utility commissions generally regulate retail rates (charges to ratepayers, efficiency programs, local grid investments, and reliability costs). In addition, unless restructuring has been adopted, states approve the construction of new power plants . In restructured states, the prices for generation and transmission are set in the regional wholesale markets. Before allowing utilities to change rates, regulators usually require a rate case review. Traditional rate cases use a “cost-of-service” or “rate-of-return” model, but some states have developed multi-year performance-based regulation. State regulators review evidence to determine how much revenue is needed for the utility to recover its costs and have an opportunity to earn a reasonable profit. The state then sets the rates based on the required revenue. Once established, those prices remain in place until a new rate case is filed and approved. A rate case ensures transparency by allowing scrutiny of all a utility’s costs and revenues. It determines fair rates based on evidence. Regulators can review costs and revenues, applying decreases that might partially offset a proposed rate increase. They can also disallow certain costs or reject certain future planned expenditures. This process ensures a transparent examination of utility costs based on intervenor participation, evidence, and analysis. 

Alternative ratemaking: This refers to mechanisms that allow rates to be adjusted automatically or outside a full rate review. Examples include performance-based rate plans and multi-year rate plans. Closely related to rate cases, they are policies that allow utilities to change rates on one particular expense item rather than going through a rate case to consider all expenses and revenues. These “riders” are not always itemized on a customer’s bill. 

Alternative rate plans often include opportunities for bonus earnings. And they can subject ratepayers to automatic rate increases. These price hikes are not always thoroughly scrutinized. 

 The most common types of alternative ratemaking are the following: 

  • Formula rate plans allow for automatic rate adjustments using predetermined formulas based in whole or in part on the utility’s revenues in relation to external economic indicators. 
  • Earnings-sharing mechanisms allow for rate adjustments outside of a full rate case based on the level of the utility’s earnings. If earnings fall or rise above a predetermined level, rates are increased or decreased. 
  • Performance-based ratemaking gives utilities earnings incentives for achieving specific predetermined performance goals or impose penalties for performance failures. 
  • Revenue decoupling and lost revenue adjustment mechanisms adjust rates between rate cases to account for lost revenues as a result of lower sales (see also this chapter’s section on Energy Efficiency Programs). 
  • Multi-year rate plans allow for automatic rate changes in years between full rate reviews based on predetermined and approved factors. 
  • Future test years use projected costs to set rates based on estimated future expenditures rather than historical costs. 
  • Cost trackers allow the recovery of specific costs outside of a rate case. 
  • Infrastructure surcharges provide a utility with the recovery of capital costs outside of a rate case, similar to cost trackers. 

Among the criticisms of alternative regulatory models are the following: 

  • They undermine the comprehensive review of utility costs and revenues and prudence of investment decisions; consumers cannot be assured they are paying just and reasonable rates. 
  • Formulas and rate changes made in isolation without regard to overall costs and revenues are unlikely to result in just and reasonable rates. 
  • When earnings are protected in a multi-year rate plan, utilities have incentives to cut costs for reliability or customer service. 
  • Rate case cost savings are questionable. Although the number of rate cases may be reduced, the cost of tracking, monitoring, and evaluating alternative mechanisms may offset those savings. 
  • They create unintended results in which utilities pursue strategies to maximize their revenues under the alternative ratemaking, rather than through actual improvements in overall service and reliability. 

Cost allocation: This refers to how regulators divide costs among the customer classes: residential, commercial, and industrial. If costs are not appropriately assigned, at least one kind of customer will have to pay more than its fair share. 

Rate design: This is how rates are structured to recover the approved revenues decided in a rate case. 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. Typically, rate design for residential customers results in a modest monthly fixed customer charge and a rate for each unit of usage. The rate for usage can be offered at a fixed price or can vary based on the season or to reflect certain tiers or blocks of usage. In a tiered or inclining block rate structure, the usage rate increases with greater consumption in each predetermined tier or block. Other rate designs focus on charging different rates based on time of day or season of the year. 

In some states, utilities have proposed an alternative rate design that significantly increases fixed monthly charges while reducing usage-based fees. This structure shifts the cost burden onto small households and those with lower usage. It can be especially difficult for older adults on fixed incomes. 

Examples of these alternative rate designs include the following: 

  • High fixed charges: Utilities increasingly are seeking to recover more of their costs through fixed customer charges that all users pay. At the same time, they are deemphasizing charges that vary based on usage (known as 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 toward those who use less. Straight fixed-variable rate design 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 specified period. Using a lot of power over a short period results in a higher demand charge than steady usage does. 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 Consumer-focused programs policy in the Energy Efficiency Programs section of this chapter). 
  • Time-variant rates (see  Rate Programs to Decrease Energy Use section of this chapter). 

Stranded Costs: Stranded costs refer to previously approved costs that a utility may no longer recover because of a change in law or policy, the introduction of competition, or the replacement of infrastructure or technology. Stranded costs are sometimes called transition or uneconomic costs. Stranded costs can occur when a utility seeks to make new investments to update or replace infrastructure that is still useful but not yet fully paid for. A utility’s stranded cost usually is calculated as the difference between the sunk costs of the asset and its current value or earnings. Stranded costs can run into the hundreds of millions of dollars and significantly impact utility rates. 



Ratemaking regulations

Policymakers should continue to use traditional rate cases to set utility rates. Rates should be based on just and reasonable expenses, as is done in rate cases. 

Rate proceedings should follow the traditional cost-of-service model. 

The utility’s revenue requirement should be based on just and reasonable expenses necessary to provide service and investments that are prudent, used, and useful to ratepayers. 

Policymakers should independently assess what infrastructure investments are needed. 

The utility’s rate of return should be fair and based on current market conditions. 

Rates should be stable, predictable, and understandable, with costs allocated fairly among customer classes. 

In general, ratepayers should not subsidize the costs of products and technologies that can be provided in the marketplace competitively or, if appropriate, with general taxpayer subsidies. All taxpayer subsidies should comply with AARP’s taxation principles

As society transitions toward greater use of electric vehicles, ratepayers, particularly those with low and moderate incomes, should not bear the burden of paying for the transition. They should not subsidize the cost of electric vehicle charging stations and solar energy (see also residential solar and metering policy). 

If alternatives to traditional rate cases are proposed, they should be narrowly focused and conducted under limited-term pilots. They should also include consumer protections. Any performance-based incentives should be narrowly focused. They should be tied to achieving positive outcomes for consumers, such as increased reliability, customer service performance, and affordability. Policymakers should also ensure: 

  • regular full-rate case reviews are used to determine whether the alternative achieved its intended result; 
  • performance data are publicly reported; 
  • annual limits are put in place for capital expenditures; 
  • proceedings are transparent, are open to the public, and include an evidentiary record; 
  • allowable surcharges are limited; 
  • recovery is restricted to clearly defined costs for a limited period; 
  • the authorized rate of return is downwardly adjusted to reflect the reduced business risk from the alternative regulation; and 
  • the utility absorbs any cost overruns related to investments financed through alternative methods such as trackers, and any underspending should be returned to ratepayers. 

Equitable allocation of costs

Regulators should assign system costs appropriately to customer classes. This should be consistent with universal service and affordability goals. Costs should not be unfairly shifted to residential customers. 

Equitable rate structures

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. 

Stranded-cost recovery

Policymakers should ensure that any stranded costs are reasonable and verifiable. No customer or customer class should be exempt from paying for approved stranded costs. 

Any reasonable and verifiable stranded costs should be allocated equitably among shareholders and all classes of consumers. 

In calculating stranded costs, regulators should consider all mitigating factors that could reduce costs to consumers, including: 

  • previously compensated risk, 
  • investments made as a result of poor management decisions, 
  • ongoing profitable investments, and 
  • new revenue opportunities, including increases in the market price of power. 

Policymakers should provide a mechanism by which consumers would get back any stranded costs they overpaid because the market price of energy exceeded the estimate used in the stranded-cost calculation. If policymakers allow stranded-cost recovery, the reduced risk to the utility should be reflected in a reduced rate of return.