Chapter 7 Rate-Setting
Principles And Procedures
7.1 Introduction
• Final (five) step---determining prices
• Basic level: dividing the allocated costs by appropriate
consumption measures.
• In practice, more complex:
different rate-setting and tariff design; different social and
economic goals
7.2 Billing Determinants
---the units on which prices are levied.
• Based on:
(1) overall energy consumption & peak demand
(2) types of cost allocators used to divvy up costs bw the
diff rate classes
• Components:
(1) accurate forecast:
naïve forecast; sophisticated forecast; simultaneous
equations
(2) weather normalization
Estimation Methods
Regulators:
(1) Select the types of billing determinants to be uses
(2) Choose to base on historical test year data or rate year
Why rate and tariff structures take numerous forms—the
design characteristics of natural gas and electric
distribution.
(1) Serve peak loads (both NG &electric)
(2) So regulated rates and tariffs always incorporate
multiple consumption measures and take one different
structures.
(3) Electric: both consumption and peak demand will
change constantly
NG: more complex, depends on whether the focus is on
local distribution to retail consumers or pipeline transport
for wholesale consumers
(4) Different types of peak demand are calculated by
utilities to estimate rates and tariffs.
coincident peak; non-coincident peak
(5) Utilities also estimate load factors for rate and tariff
setting.
system load factor; sector load factor; customer load
factor
• Demand info is more difficult to gather than usage info.
peak demand studies
• NG faces measurements issues different from those of
electric utilities.
(cold weather, storage retail tariffs)
Forecasting
•
Focus on conceptual aspects of forecasting billing
determinants.
1. Forecasting Energy Consumption (easier)
(1) econometric way: time series data
(2) bottom-up engineering approach: special equipments
2. Forecasting peak demand (harder)
Reasons for the difficulty:
(1) forecasters tend to be less adept at predicting extreme
events (peak demand)
(2) the physical characteristics of a distribution or
transmission system (solved by simultaneous equations)
(3) investment impacts of additional demand and
additional customers classified into:
horizontal growth & vertical growth
conflicting goals: obligation to serve & fair, just and
reasonable
Weather Normalization Method
• Degree day:
heating degree day (HDD)=diff bw average temperature
for the day & a reference average temperature (68 F)
cooling degree day (CDD)= (same manner)
• Humidity; cumulative temperatures over the past few
days; hours of daylight
• Linear regression techniques
energy consumption= Fn (energy price, no. of customers,
weather conditions)
• Defining “normal weather:
the average over the previous 30 years
(not the best predictor)
7.4 Alternative Design Structures
•
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Under traditional ratemaking principles (excluding
incentive rate designs such as performance-based
regulation), there are 8 broad types of tariff design:
One-part tariffs
Two-part tariffs
Multiblock tariffs
Incentive rate structures
Entry-exit tariffs
Interruptible rates
Time-of-use rates
Seasonal rates
• (1) One-part tariff:
simply a single volumetric charge based on consumption
(but any single price is charged with welfare loss)
• (2) Two-part tariff:
combines a fixed charge with a volumetric charge.
(See Figure next page):
the variable cost component would be set such that
.P*=MC, consumption Q*
the firm collect the shaded area to cover the fixed costs
So the regulator could set a fixed charge equal to this
amount divided by the expected number of customers in
the rate year.
Figure: two-part tariff pricing
• (3) Block tariffs:
--distribute the price among blocks of consumption. P can
be set efficiently w/o resorting to a fixed charge.
Figures: next two pages
 Three-part declining block price structure
 Increasing block price structure
Reasons for designing increasing block rates:
subsidies for low-income consumer; increasing MC
structures; social policy designed to reduce energy
consumption)
Figure: Bock Rate Design
Figure: Block rate design under increasing marginal
cost
• (4) Incentive rate:
--paired with special economic development rates that
provides lower-cost energy in exchange for a firm
creating new jobs.
Problem: easy to go from incentive to cross-subsidy.
• (5) Entry-exit:
Ex: European natural gas pipeline
similar to multipart tariff with fixed charges (entry and exit
fees) and variable charges ( commodity usage fees)
• (6) interruptible rates:
---the utility offers lower price in exchange for an ability to
curtail or interrupt service to customers. (usually during
periods of high demand)
interruptible rates: depends on how the firm’s fixed costs
are allocated among customers

Customers frequently argues that they are allocated
additional fixed costs that would otherwise be allocated
to interruptible customers. --price discrimination
• Above argument is weak for reasons as:
(1) probability of service interruption, not a guarantee of
interruption.
(2) a guarantee of interruption lacks foundation of
economic efficiency and equity
(3) many interruptible customers, will have alternatives to
taking regulated service.
•
(7)Seasonal rates
(8) time-of-use rates
--incorporate the time dependence of consumption.
Drawbacks of these two:
(1) Customers do not like overall rates to increase in peak
seasons, wrongly perceiving that the regulated firm is
taking advantage of them.
(2) Time-of-use rates can only be implemented if
customers have more sophisticated meters that
measures consumption in each hour.
(3) Both conflict with regulatory goals of rate stability.
Embedded and Marginal Cost Method
1. Embedded Cost Approaches
•
adding up the prudent and known-and-measureable
costs incurred by a firm to establish the firm’s revenue
requirement.
• Rely on accounting costs on company’s books for the
test year.
2. Marginal Cost Approaches
• Based on the principles of competitive markets—the
amount consumers are willing to pay for the last
(marginal) unit of a good or service is the cost of
producing that unit.
• Allocative efficiency
• take observed demand as a given, set rates equal to MC
at that level of output.
• Revenue checks show whether over- or underrecovery.
apply revenue reconciliation (Ramsey Pricing, Inverse
Elasticity)
• Equal Proportion of MC (EPMC): increasing MC in
proportion to the revenue diff. (additional cost are
allocated w/o regard to price sensitivity.)
• Problem:
charging all customers the marginal P firms collect
revenue requirements only by chance needs
reconciliation.
otherwise, if P diverges from MC, no way to know
whether allocatively efficient.
3. Which Approach is Better?
Difference lies in—how to define “cost”
Embedded cost: accounting costs on the company’s
books for the test year as the basis for setting rates and
tariffs.
Marginal cost: incremental costs of the firm providing an
additional unit of production.
Supporters of—
Embedded: outweigh imperfect approximations to MC
pricing
MC pricing: efficient resource allocation cannot be had
w/o it.
1. Pipeline Tariff Methods:
--key point: whether access to pipeline capacity is based
on a contract carriage or an entry-exit regime.
 Contract carriage: (US, Canada, most Latin America)
a pipeline assigns a contract amount of capacity to the
shipper on any given day;
Take-or-pay; capacity right.
Two methods to allocate fixed and variable pipeline
costs: zone-gate & Mcf-mile
• Zone gate:
cost are first allocated by geographic zone, then based
on zone-specific billing determinants.
Problem: arbitrary
• Mcf-mile:
to calculate “distance-weighted” allocation factors.
Good side: No specific zones
2. Peaker Methods:
--whereas energy revenues are simply revenues from the
sale of electricity on a volumetric, capacity revenues are
meant to compensate generators for the fixed costs of
providing capacity to the system.
ensure enough investment in new generating plants
and to maintain long-term system reliability.
Same concept of regulators:
capacity payments are designed to compensate investors
for the fixed investment and operation costs associated
with a peaking unit.
In determining the capacity payments, regulators:
(1) choose an “efficient” peaking plant
(2)calculate the total fixed investment cost for the plant.
(3) levelize the total fixed investment cost over the plant’s
expected lifetime.
(4) add a fixed O&M cost to the annual fixed cost
3. Electric Transmission Tariffs:
--electric transmission: large fixed costs and small variable
ones.
None methods we are aware of has provided appropriate
economic signals to encourage long-term investment.
Ex:
Argentina: transmission usage charge (locational pricing)
Great Britain: a connection charge and a usage charge
(MC pricing)