Cost of Service, Rate Design,
and Price Efficiency
Bruce Chapman
Christensen Associates Energy Consulting
October 3, 2012
Wisconsin Public Utility Institute
Fundamental Course: Energy Utility Basics
Agenda

Regulation and Ratemaking

Cost of Service

Rate Design
October 3, 2012
2

Regulation and Ratemaking
Rationale for Regulation

Not all markets for electricity services are
“workably competitive,” capable of
producing competitive outcomes

Rate regulation tries to approximate
competition:
 Price ≈ Marginal Cost

In practice, regulation strives to satisfy
many goals
October 3, 2012
4
Goals of Public Utility Ratemaking:
A Balancing Act






Reasonable rates for consumers
Fair return for investors, comparable to
return earned by other businesses with
corresponding risk
Rates that reflect cost
Minimization of subsidies
Protect customers from large bill impacts
Social concerns
October 3, 2012
5
Rate Application Challenges

Energy and demand forecast

Revenue requirements

Rate of return and return on equity

Cost of service:
 Allocate costs to jurisdiction, customer
class and rates within each customer class

Rate design:
 Design rate structures and set prices
October 3, 2012
6

Cost of Service
Why Compute Cost of Service?

Per the National Association of Regulatory
Utility Commissioners (NARUC), the cost-ofservice standard remains the primary criterion
for reasonableness of rates

What is an embedded Cost-of-Service Study?
 An analysis in which a utility's embedded cost of
providing service (i.e., revenue requirements) is
determined by jurisdiction and customer classes or
other groupings within jurisdiction
 Embedded costs are the accounting costs on the
company’s balance sheet and income statement,
adjusted for regulatory conventions
October 3, 2012
8
Cost-of-Service Steps
1. Compile
2. Functionalize
3. Levelize
4. Classify
5. Assign
6. Allocate
7. Determine Return
October 3, 2012
9
Cost-of-Service Steps
1. Compile
2. Functionalize
3. Levelize
4. Classify
5. Assign
6. Allocate
Step 1
Compile appropriate rate
base, expenses, and
revenues (often by FERC
account); decide upon
categories of customers to
be analyzed
7. Determine
Return
October 3, 2012
10
Step 1: Total Company Summary
Total
System
Rate base
$16,826,786
Revenues
$8,049,850
Residential
Commercial
Expenses
O&M – fuel
O&M – other
$2,236,885
2,245,054
Depreciation &
amort. expense
779,145
Taxes other than
income taxes
431,509
Total adjusted
expenses
$5,692,593
Income taxes
$927,414
Net operating
income
$1,429,843
Rate of return
8.50%
October 3, 2012
11
Industrial
Lighting
Total
Retail
Service
Total
Other
Service
Cost-of-Service Steps
1. Compile
2. Functionalize
3. Levelize
4. Classify
Step 2
Functionalize rate base and
expense items by four
major functions:
a.
5. Assign
b.
6. Allocate
c.
7. Determine
d.
Return
October 3, 2012
12
generation/supply
transmission
distribution
general plant and
administration
Step 2: Functionalization

Production (Generation)
 Process of converting other forms of energy
into electricity

Transmission
 Process of sending the electricity generated at
the centralized power station through wire at
high voltage to the substation where it is
transformed to low voltage

Distribution
 Process of delivering electricity to customer
meters through low voltage lines

General plant support and other
October 3, 2012
13
Cost-of-Service Steps







Compile
Functionalize
Levelize
Classify
Assign
Allocate
Determine
Return
October 3, 2012
Step 3
Identify rate base, expenses,
and customers (and their
usage) with voltage service
levels:
Customers are responsible
for costs at their level and
higher.
14
Develop Levelized Demand
and Energy Allocators
Service Level Designation and Power Flow Diagram
Service
Level
Generation and Territorial Input
1
2
3
4
5
Transmission Line
46kW to 500 KW lines
Transmission to Distribution
Transformation
Primary Distribution Lines
25kV and lower
Line Transformers
Indicates power flow
October 3, 2012
15
Cost-of-Service Steps
1. Compile
2. Functionalize
3. Levelize
4. Classify
5. Assign
6. Allocate
7. Determine
Return
October 3, 2012
Step 4
Classify rate base and
expense items by cost
causative (and observable)
characteristics:
a.
b.
c.
d.
16
Energy-related
Demand-related
Customer-related
Revenue-related
Step 4: Classifying Costs

Gross plant assets (and depreciation):
demand, energy, and customer components
Service Level
Generation
Energy


Demand
Distribution
Demand
Customer
Level 3


Level 4


Level 5


Level 1
Demand
Transmission

Level 2
October 3, 2012
17
Cost-of-Service Steps
1. Compile
2. Functionalize
3. Levelize
4. Classify
5. Assign
6. Allocate
7. Determine
Return
October 3, 2012
Step 5
Assign those rate base
expense and revenue
items that can be
directly associated with
serving the previously
decided upon customer
categories
18
Step 5: Directly Assign





Revenue from sales
Customer substations
Radial customer-specific lines
Meters
Sales support and billing costs
October 3, 2012
19
Cost-of-Service Steps
1. Compile
2. Functionalize
3. Levelize
4. Classify
5. Assign
6. Allocate
7. Determine
Return
Step 6
Allocate those common
rate base, expense, and
revenue items to the
customer categories
* appropriate allocators
must be developed
October 3, 2012
20
Step 6: Develop Allocators



Determine customers for each class by
voltage level of service
Determine energy consumption (kWh)
by voltage level and customer class
Determine demand (kW) by voltage
level and customer class


October 3, 2012
Coincident peak (CP)
Noncoincident peak (NCP)
21
Developing Demand Allocators
Load Shape
Determinants
Rate Class
Information
October 3, 2012
Demand Allocation
Methods:
1) Average & Excess
2) 12 NCP
3) 12 CP
4) Marginal Cost
5) Equivalent
Peaker
6) Proportional
Responsibility
7) Other
22
Allocation Factors:
Allocating Costs by
Rate Class and
Function
Cost-of-Service Steps
1. Compile
2. Functionalize
3. Levelize
4. Classify
5. Assign
6. Allocate
Step 7
Determine rate of
return for evaluation
7. Determine
Return
October 3, 2012
23
Illustrative Cost-of-Service Study:
Rate Base ($million)
Description
Investment
Gross Plant
Accumulated Depreciation
Net Plant
Current Assets & Liabilities
Materials & Supplies
Cash Working Capital
Other
Net Current Assets
Rate Base
October 3, 2012
System
Residential
Small
Business
Large
Business
Lighting
Other
Wholesale
1,500
600
900
700
280
420
300
120
180
250
100
150
25
10
15
75
30
45
150
60
90
55
35
10
100
26
15
5
46
12
8
3
22
10
6
2
18
0
0
0
0
2
3
0
5
5
3
0
8
1,000
466
202
168
15
50
98
24
Illustrative Cost-of-Service Study
Revenues, Expenses, Rate of Return ($million)
Description
System
Residential
Small
Business
Large
Business
Lighting
Other
Wholesale
Revenues
Electricity Sales
Other Operating Revenues
Revenue-Nonassociated
Adjusted Revenues
450
5
45
500
200
3
2
205
125
1
1
127
100
1
1
102
8
0
0
8
17
0
1
18
0
0
40
40
Expenses
Operation & Maintenance
Depreciation
Taxes excl. Income Tax
Adjusted Expenses
325
50
25
400
150
25
12
187
75
10
6
91
65
9
5
79
5
1
1
7
10
1
1
12
20
4
2
26
100
25
75
18
5
14
37
9
27
24
6
18
2
0
1
6
2
5
15
4
11
7.50%
2.90%
13.55%
10.49%
7.40%
8.93%
11.05%
Operating Income
Income Taxes
Net Operating Income
Rate of Return (NOI/RB)
October 3, 2012
25
Cost-of-Service Summary

COS analysis distributes rate base, revenues,
and costs across tariff groups according to a
well-defined set of rules:
 Create rows for each function and voltage level
 Classify each row by cost causation factor
 Spread across columns of rates according to
assignment and allocation

COS Results: essentials for rate design
 Revenue requirement (target: 12%, actual 8.94%)
 Unit costs and current rate of return by tariff
October 3, 2012
26
Common Criticisms of
Cost-of-Service Ratemaking

Incentives to utilities:
 Cost-plus: cost coverage except for
expenditures deemed imprudent by regulator
 Potential to distort utility capital decisions

Pricing outcomes:
 Use of accounting/embedded costs means that
prices will not necessarily be close to marginal
cost
 Inefficiency of price signals can encourage
excessive/needlessly low consumption
October 3, 2012
27

Rate Design
Bonbright Principles
Criteria of a Sound Rate Structure
From James C. Bonbright, Principles of Public Utility Rates,
1968. Although dated, many still look to these for guidance in
setting public utility rates.








Simple and acceptable
Freedom from controversy
Yield total revenue requirements
Revenue stability
Rate stability
Fair
Avoid undue discrimination
Encourage efficient use
October 3, 2012
29
Goal Compatibility


How do we resolve competing goals?
Examples:
 Rate simplicity vs. price pattern matching cost
pattern.
 Cost responsibility vs. customer incomes.
– Customer charges are typically below fixed costs
 Revenue recovery of embedded cost vs. price
efficiency of marginal cost
 Desire to promote conservation and
renewables vs. pursuing least cost
October 3, 2012
30
Considerations



Does the approach recognize all costs?
Can revenue recovery be separated from
pricing to some degree?
Can we achieve with pricing what we first
try to achieve with rules and regulations?
 Prices are self-policing.
 Can prices be used to support regulations and
rules?
October 3, 2012
31
Rate Design Flow Chart
Metering &
Billing Data
Market
Research
Embedded
COSS
Accounting
Information
Load
Research
& Analysis
Marginal
COSS
Competitive
Forces
Rate Design Process
Choose
Alternative
Designs
Bill
Impact
Analysis
Verify
Revenues
Strategic
Goals
Tactical
Goals
Resulting Rate Design
October 3, 2012
32
Post-Rollout
Post
Rollout
Evaluation
Types of Charges

Three major ways to bill a customer
 Customer or base charge: $/customer/month
 Demand (highest level of measured
consumption): $/kW/month
 Energy: $/kWh usage/month
October 3, 2012
33
Traditional Rate Designs

Energy-only Rates
 Flat Rates
 Blocked Rates

Demand and Energy Rates
 Customer, Demand, and Energy rates (Hopkinson)
 Hours-of-Use rates (Wright)

Time-Differentiated Rates
 Seasonal Rates
 Time-of-Use Rates
October 3, 2012
34
Flat Rates


Customer billed via customer and energy
charges. Energy price is a single number
applying to all consumption in period.
The flat rate is a guaranteed price for a
product which depends on:





Load-weighted average of embedded cost
Hourly cost volatility
Customer load volatility
Hourly cost volatility/ customer load correlation
Provider offers risk management of electricity
service costs to customers
October 3, 2012
35
Blocked Rates

Energy price varies with amount consumed
 Surpassing a block threshold causes the marginal price for
energy to change
 Beyond the first block, the average price paid differs from
the marginal price
 There can be multiple thresholds; n thresholds results in
n+1 blocks

Block prices can be set to be decreasing, increasing,
u-shaped, or n-shaped with load

Moving block prices in the direction of marginal cost
can improve price efficiency
 e.g., high summer tail block price for air conditioning
October 3, 2012
36
Blocked Tariff Pricing
Hourly
Consumption
(kWh)
III
II
High
Cost
I
1
Hour of the Day
24
Price
III
I
II
1400 Monthly Consumption (kWh)
700
October 3, 2012
37
Demand and Energy Rates

Hopkinson demand rate:
 Bills customers for maximum measured
demand and for energy usage, plus customer
charge
 Example:
– $10.00 per kW of maximum demand per month
– $0.08 per kWh usage in a given billing month
– $200 per month customer charge
 Rates can have declining or inverted block
demand and/or usage charges
October 3, 2012
38
Wright Hours-of-Use Rate

Requires measurement of monthly demand (kW)
and usage (kWh), but

Charges customers according to usage per
demand unit: (HOU = kWh/kW)

Acts as a customer-specific blocked rate

Provides blocked pricing efficiency under
traditional metering

Example:
 e.g., 5 ¢/kWh for first 300 “hours of use,” 4¢/kWh
thereafter
 Watch out! Increase your peak demand and you
push kWh back across the block boundary.
October 3, 2012
39
Hours-of-Use Tariff Pricing
Hourly
Consumption
(kWh)
II
High
Cost
I
1
Hour of the Day
Price
Hours of Use = kWh/(kW)
(max = 720 (100% load factor))
I
II
400
October 3, 2012
24
40
Hours of Use
Summary

Regulation and Ratemaking
 Leads to embedded cost-based COS

Cost of Service
 Seven steps yield costs and rate of return by rate;
provide basis for revenue request and rate setting

Rate Design
 Rates serve multiple objectives, leading to tradeoffs
– Revenue recovery and pricing efficiency are central
 Innovative rates add pricing efficiency and
complexity
October 3, 2012
41
 Appendix 1. Illustrative COS Tables
Typical Power Company
Cost-of-Service Study
Present Rate Summary
($000’s)
Line
No.
1
Description
2
Total
Electric
System
3
Residential
4
Small
General
Services
5
Large
General
Service
6
High
Load Outdoor
Factor Lighting
8
7
Total
Retail
Service
9
Total
All Other
Service
10
Unit
Power
Sales
11
Investment
1
2
3
4
5
6
7
Electric Gross Plant
Accumulated Depreciation
Net Plant
Materials and Supplies
Cash Working Capital
Other Rate Base Items
Total Electric Investment
1,591,960
630,023
961,937
62,495
44,079
20,856
1,089,367
825,803
339,107
486,696
28,685
20,200
8,288
543,869
295,638
124,597
171,041
13,877
9,443
2,893
197,254
154,890
68,486
86,404
9,392
6,402
1,464
103,662
61,577
26,438
35,139
3,649
2,646
589
42,023
494,911
5,847
58,078
558,836
248,383
4,262
1,345
253,990
120,912
782
734
122,428
75,423
275
568
76,266
29,018
105
241
29,364
30,527 1,368,435
8,127 566,755
22,400 801,680
56,179
576
39,177
487
13,586
352
23,815 910,622
36,340
16,147
20,193
1,866
1,226
343
23,628
187,185
47,121
140,064
4,450
3,676
6,927
155,117
481,243
5,460
2,915
489,618
13,668
387
106
14,161
0
0
55,057
55,057
Revenues
8
9
10
11
Revenue from Sales
Other Operating Revenues
Revenue-Nonassociated Sales
Total Adjusted Revenue
October 3, 2012
43
7,507
36
27
7,570
Typical Power Company
Cost-of-Service Study
Present Rate Summary
($000’s)
Line
No.
1
Description
2
Total
Electric
System
3
Residential
4
Small
General
Services
5
Large
General
Service
6
High
Load Outdoor
Factor Lighting
7
8
Total
Retail
Service
9
Total
All Other
Service
10
Unit
Power
Sales
11
Expense
12
13
14
15
16
17
18
Operation & Maintenance
Depreciation
Amort. of Inv. Tax Credit
Real & Personal Prop. Tax
Payroll Tax
Other Taxes
Expenses Exc. Inc. Tas
352,635
57,998
-2,238
16,560
4,055
1,002
430,012
161,599
31,449
-1,116
8,992
2,426
613
203,963
75,542
11,030
-392
3,338
828
216
90,562
51,215
5,575
-198
1,851
385
99
58,927
21,165
2,153
-76
732
143
36
24,153
3,897
2,001
-71
279
63
16
6,185
313,418
52,208
-1,853
15,192
3,845
980
383,790
9,809
1,288
-46
440
87
22
11,600
29,408
4,502
-339
928
123
0
34,622
128,824
50,027
31,866
17,339
5,211
1,385
105,828
2,561
20,435
20 State & Federal Income Tax
31,487
10,575
9,128
5,026
1,336
152
26,217
609
4,661
21 Net Operating Inocme
97,337
39,452
22,738
12,313
3,875
1,233
79,611
1,952
15,774
19 Operating Income
22 Rate of Return
October 3, 2012
8.94%
7.25%
11.53%
44
11.88%
9.22%
5.18%
8.74%
8.26%
10.17%
 Appendix 2. Time-Dependent Rates
Time-Differentiated Rates



Price differs by season and/or hour of the day
Pricing can be tariff-based or “dynamic,” based on
recent wholesale prices or marginal cost
Why?
 Costs differ by time; prices better reflect cost causality
 Can induce load shifting, lowering overall costs
 Customer’s time pattern of usage determines cost

Why not?
 Large price differences are needed to induce significant
shifting (e.g., peak/off-peak ratio of 3:1)
 Wide range of bill impacts: instant winners, losers, and
adverse selection produce revenue attrition
 Many customers do not like them
October 3, 2012
46
Seasonal Rates

Rates that differ by the season of the year

Seasonal rates are still fixed for the season
and are not dynamic

May have two or more seasons
October 3, 2012
47
Time-of-Use Pricing
Off-Peak
Peak
$/kWh
$/kWh
PP
MCP
PF
PF
POP
MCOP
DP
Q1P
Q 0P
DOP
Q0OP
kWh
Q1OP
Prices can be moved closer to marginal cost.
October 3, 2012
48
kWh
Time-of-Use Pricing

Prices differ by the period of the day

Two or more pricing periods in a day
– Peak/off-peak
– Peak/shoulder/off-peak

Traditional TOU rates are set well in advance
and fixed by period, rather than being
dynamic, i.e., reflecting current marginal cost

Summary: time differentiating traditional
rates can improve costing accuracy but
prices still have limited marginal costing
October 3, 2012
49
 Appendix 3.
Alternatives to Traditional Rate Cases
Strategic Planning and
Alternatives to Rate Cases

Rate Cases are expensive. Must we have
Rate Cases? Are there ways to avoid Rate
Cases?

Are there ways to dampen Cost-of-Service
impacts and Rate Case shock?
October 3, 2012
51
Adjustment Clauses

Some clauses are automatic; some require a
hearing and audit

Apply to major expense categories such as
fuel, purchased power, and purchased gas

Allow adjustment to rates based on
fluctuation in specific costs from a base level

Key criterion: costs are largely beyond the
control of the utility
October 3, 2012
52
Strategic Planning and
Alternatives to Rate Cases

Move from historical test period basis:
 Future test period
 Historical test period with pro forma
adjustments

Accounting orders

Decoupling

Automatic Revenue Adjustment
Mechanisms
 Formulary-Based Ratemaking (FBR)
October 3, 2012
53
Formulary-Based Ratemaking

Automatic, pre-scheduled review of a
company’s earnings
 Defined formula for evaluations
 Provides rates of return or margin coverage
 Usually specific about allowed cost and revenue
inputs
– Typical disallowances include: lobbying, charitable
donations, advertising, civic, and club dues
– Cash working capital and construction work in progress are
usually allowed, with limitations
October 3, 2012
54