Utility ratemaking

Utility ratemaking is the formal regulatory process by which public utilities set the prices (more commonly known as "rates") they will charge consumers.^[1] Ratemaking, typically carried out through "rate cases" before a public utilities commission, serves as one of the primary instruments of government regulation of public utilities.

History and Overview

Historically, many different classes of business have been classified as public utilities, and thus have been legally mandated to go through the ratemaking process in order to determine the allowable service charges for their industry. Although the classification of public utilities has changed over time, typically such businesses must constitute a de facto monopoly (or "natural monopoly") for the services they provide within a particular jurisdiction. Prominent public utilities which must utilize ratemaking to set rates includes railroads, natural gas distribution, telecommunications, and electricity generation and distribution.

In the United States, where many industries classified as public utilities are either private businesses or publicly traded corporations, ratemaking is typically carried out through the authority of a state regulatory body, most often a public utilities commission in an administrative law format. At the national level the Federal Energy Regulatory Commission (formerly the Federal Power Commission) also exercises authority over matters of intrastate wholesale sales of electric power.

Ratemaking Goals

Ratemaking has an economic dimension because it attempts to set prices at efficient (nonmonopolistic, competitive) levels. Ratemaking is political because the product is determined to be a social necessity and rates must be fair across different classes of consumers. Additionally, ratemaking can be designated to serve other social purposes. Although it can be said that all regulation is a combination of politics and economics, ratemaking is frequently more technical. Ratemaking has five functions: ^[2]

1. Capital attraction;
2. Reasonable energy pricing;
3. Incentive to be efficient;
4. Demand control or consumer rationing; and
5. Income transfer.

These regulatory goals can conflict.^[3] When prices are kept below market, efficiency suffers. When prices exceed the market, prices may not be reasonable. Both events have occurred during the history of utility regulation. The above goals attempt to serve the interests of the utility, its shareholders, consumers, and the general public. To be constitutional, a rate cannot be so low as to be confiscatory. Most state statutes further require rates to be just, reasonable, and non-discriminatory.^[4]

Capital Attraction

Although utilities are regulated industries, they are typically privately owned and must therefore attract private capital. Accordingly, because of constitutional takings law, government regulators must assure private companies that a fair revenue is available in order to continue to attract investors and borrow money. This creates competing aims of capital attraction and fair prices for customers. Utility companies are therefore allowed to charge "reasonable rates," which are generally regarded as rates that allow utilities to encourage people to invest in utility stocks and bonds at the same rate of return they would in comparable non-regulated industries.^[5]

Demand Control or Consumer Rationing

A standard demand curve showing that as prices decline, consumption rises.

The price of a utility's products and services will affect its consumption. As with most demand curves, a price increase decreases demand. Through a concept known as rate design or rate structure, regulators set the prices (known as "rates" in the case of utilities) and thereby affect the consumption. With declining block rates, the per-unit price of utility consumption decreases as the energy consumption increases. Typically a declining block rate is offered only to very large consumers. If conservation is the goal, regulators can promote conservation by letting prices rise. A third possible rate design is a flat rate which charges the same price for all consumption.^[6]

Income Transfer

Ratemaking distributes wealth from consumers to utility owners. Ratemaking also involves redistribution of wealth among and within classes of customers. Utility customers are generally grouped in three categories - residential, industrial, and commercial. Each group is sometimes further subdivided.^[7]

Rate Formula

The traditional rate formula is intended to produce a utility's revenue requirement:

R = O + (V - D)r

The elements of the traditional rate formula are defined as:

R is the utility's total revenue requirement or rate level. This is the total amount of money a regulator allows a utility to earn.

O is the utility's operating expenses.

V is the gross value of the utility's tangible and intangible property.

D is the utility's accrued depreciation. Combined (V - D) constitute the utility's rate base, also known as its capital investment.

r is the rate of return a utility is allowed to earn on its capital investment or on its rate base.

The traditional rate formula encourages capital investment because it provides a rate of return on the rate base. The more a utility invests, the more money it earns.^[8]

Operating Expenses

A firm's operating expenses, such as wages, salaries, supplies, maintenance, taxes, and research and development, must be recouped if the utility is to stay operational. Operating costs are most often the largest component of the revenue requirement, and the easiest to determine. Occasionally, operating expense items have caught the attention of regulatory agencies and courts, and these items have been examined more closely.

Regulators must make two determinations. First, they must determine which items should be allowed as expenses. Second, regulators must determine the value of those expense items. The determination of value has generally been left to the management of the utility under the theory that these are essentially business decisions which will not be second guessed by a regulatory agency or a court. Managerial good faith is presumed. Although both agencies and courts have the legal authority to supervise the utility's management, they will not substitute their judgment unless there is an abuse of managerial discretion.^[9] Hence, litigation involving operating expense issues has been light.^[10]

Notes

References