Ratemaking

Background

Federal and state governments share responsibility for regulating utilities. Federal jurisdiction primarily relates to any interstate transmission and wholesale sales of electricity and transmission of natural gas between states. States and their public utility commissions generally regulate retail rates (charges to ratepayers) and approve construction of new power plants. They also often decide which power plants may be built in their state and other resource planning matters. Before allowing utilities to change rates, regulators traditionally require a rate case review. This is called “cost of service” or “rate of return” regulation. State regulators determine, based on evidence, how much revenue is needed for the utility to recover its costs and 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 determines fair rates based on evidence. Regulators can review costs, applying decreases that might partially offset a proposed rate increase. This process ensures a transparent examination of utility costs based on intervenor participation, evidence, and analysis.

Proponents of alternative ratemaking say it streamlines the regulatory process. This allows for rates to be adjusted automatically outside of a full rate review. A related concept is “piecemeal ratemaking” in which a rate change is made in isolation, outside of a full rate case review. Guaranteed revenue is one benefit of alternative ratemaking for utilities. It often includes opportunities for bonus earnings as well. However, it puts ratepayers at risk of automatic rate increases. These price hikes are not always thoroughly scrutinized.

the most common types of alternative ratemaking are:

  • formula rate plans—allow for automatic rate adjustments using predetermined formulas that are based in whole or in part on the utility’s earnings.
  • 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 pre-determined performance goals.
  • 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.
  • future test years—use projected costs to set rates rather than actual 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 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 are unlikely to result in just and reasonable rates.
  • Earning higher profits through cost-cutting creates an incentive for utilities to increase profits by decreasing quality.
  • 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

RATEMAKING: Policy

Ratemaking

In this policy: FederalState

Policymakers should not move away from fully contested rate cases in which rates are based on just and reasonable expenses. If alternatives are proposed, they should be done under limited-term pilots. They should also include minimum consumer protections.

At a minimum the following principles should guide rate reviews:

  • 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 and used and useful to ratepayers.
  • 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 customers.
  • Ratepayers should not subsidize the costs of competitive market products and technologies. This includes electric vehicles, electric vehicle charging, and electric vehicle charging stations. In addition, policymakers should independently assess what infrastructure investments are needed. 
  • Regular full rate case reviews should be used to determine whether the alternative achieved its intended result.
  • Performance data should be publicly reported.
  • Annual limits should be put in place for capital expenditures.
  • Proceedings should be transparent, open to the public, and include an evidentiary record.
  • The number of allowable surcharges should be limited.
  • Recovery should be restricted to clearly defined costs for a limited period.
  • The authorized rate of return should be downwardly-adjusted to reflect the reduced business risk from the alternative regulation;
  • The utility should absorb any cost overruns related to investments financed through alternative methods such as trackers, and any underspending should be returned to ratepayers.

Stranded Costsstranded 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. 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 occur when a utility seeks to make new investments to update or replace infrastructure that is still useful but not yet fully paid for.

Stranded-cost recovery

In this policy: FederalState

Policymakers should ensure that any stranded costs are reasonable and verifiable and that no customer or customer class is exempt from paying for 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.