The Four Key Steps to Understanding Utility Rates

 

by Bob Shively, Enerdynamics President and Lead Instructor

Perhaps the most important factor in the gas and electric utility business is the setting of iStock_000005541542_Medium (1)rates.  This determines what customers pay for their services and establishes the utility’s opportunity to remain financially viable.

Rate setting is accomplished via a proceeding called a rate case. In the case of the Investor Owned Utility (IOU), remaining financially viable means covering costs, being able to attract sufficient debt and equity to maintain reliable service levels, and earning a sufficient profit.  For municipal utilities and co-ops, it means covering costs and being able to attract sufficient debt.  For the purposes of this article, we will discuss the process for IOUs, but the process for the other types of utilities is similar except that there is no component for return on equity.

Utility ratemaking can seem quite esoteric, but understanding ratemaking can be broken down into four key steps:

  1. Determine the authorized rate of return

    The regulator[1] must the set the authorized rate of return on debt and equity. This is covered in our recent blog post What is Reasonable Rate of Return on Utility Infrastructure?

  2. Determine the revenue requirement

    This is the total amount of money that the utility must bring in over the course of a year to cover costs plus a reasonable profit. Key factors in this step include forecasting the cost to service (called “cost-of-service” or COS) and determining the ratebase, which is the depreciated cost of capital assets plus any working capital[2].

Ratemaking diagram 1

  1. Allocate the revenue requirement

    Next, the total amount of money the utility needs to receive is divided up among each customer type and then within each customer class. The revenue is divided up among charge types such as customer charges, demand charges, and variable usage charges. Then the money associated with each charge is divided by forecasted determinants (number of customers, amount of demand, or amount of usage) to get a rate.

    Ratemaking diagram 2

  2. Adjust rates between rate cases

    Since rate cases are usually held only every few years (or in some cases, only when requested by a utility or the regulator) the regulator must specify how rates can be adjusted between cases as circumstances change. For instance, the commodity cost of gas or electric supply may go up or down, utility operating and maintenance costs may go up, utilities may become more efficient thus reducing operating and maintenance costs, or utilities may need to make significant capital investments.

    Ratemaking diagram 3

So there you have it – now you know how utility rates are set! While each of the steps shown here have sub-steps that can get complex, if you just focus on these four key processes you’ll be well on your way to understanding the origin of the rates your utility charges.

 

Want to understand more about ratemaking and how your utility makes money? Enerdynamics has both online and classroom seminars that explain this topic is a simple manner.  Enerdynamics’ How Utilities Make Money online class is appropriate for beginner audiences, while Enerdynamics’ classroom seminars on the topic range from beginner versions to executive-level sessions.


 

Footnotes:

[1] The regulator is the Federal Energy Regulatory Commission (FERC) for federal assets such as interstate pipelines and electric transmission lines and the state regulatory commission for state level assets such as electric and gas distribution utilities.

[2] When capital assets are put into service, their original capital cost is put into ratebase. Over time, this value drops due to depreciation amounts. Working capital is money needed to pay day-to-day expenses to bridge between when expenses are incurred and customer bills are paid.

About Enerdynamics

Enerdynamics was formed in 1995 to meet the growing demand for timely, dynamic and effective business training in the gas and electric industries. Our comprehensive education programs are focused on teaching you and your employees the business of energy. And because we have a firm grasp of what's happening in our industry on both a national and international scale, we can help you make sense of a world that often makes no sense at all.
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