• • Cost Allocation and Revenue Requirement
    • Cost allocation is one of the major steps in the traditional regulatory process for setting utility rates. In this step, the regulators are primarily determining how to equitably divide a set amount of costs, typically referred to as the revenue requirement, among several broadly defined classes of ratepayers. The predominant impact of different cost allocation techniques is which group of customers pays for which costs. In many cases, this is the share of costs paid by residential customers, commercial customers and industrial customers.³³
  • Revenue Requirement Determination
    • The basic formula for Revenue Requirement Determination can be expressed as follows: 
      RR =ra (RB) + O&M + D + T
      where:
      RR = total test year (annualized) revenue requirements from rates
      ra= authorized (not guaranteed) rate of return to compensate debt holders and equity shareholders 
      RB = rate base (original cost of invested utility plant in service net of accumulated depreciation & adjustments) – a regulatory construct
      O&M= operation & maintenance expenses, including administrative & general
      D = depreciation and amortization expense 
      T = taxes other than income and income tax expense
      Rates generally reflect RR divided by billing determinants,³⁴  such as sales.
      Alternatively, for regulated utilities, the Revenue Requirement = Net Income (“profit”) + Expenses.³⁵
  • Other Accounting Terms frequently used in RR determination rate case:
    • Contributions in Aid of Construction (CIAC). CIAC is a nonrefundable donation or contribution in cash or properties from individuals, governmental agencies or others for construction or property-addition purposes. Usually, the associated plant is excluded from the rate base on which the utility may earn an approved return.
    • Allowance for Funds Used During Construction (AFUDC). AFUDC is a non-cash item representing the estimated composite interest costs of debt and the required return on preferred and equity funds used to finance construction. The allowance is included in the CWIP accounts and income. This portion of the carrying value of property (along with the rest) is included in a utility company's rate base and is recovered through depreciation in rates.
    • Construction Work In Progress (CWIP). CWIP is a plant under construction at a regulated utility. The regulator can include some or all assets under construction into the rate base (CWIP) as they are constructed to benefit current consumers.³⁶
      • Recoverable costs generally include used and useful plant in service and prudently incurred capital and operating expenses.³⁷  Sometimes the state commission sets budget ceilings for capital expenditures in merger or rate cases, and if such a ceiling is exceeded, utilities' excessive spending will not be allowed and also may incur additional penalty based on the commission's prior decisions.
  • Cost allocation includes three steps: (1) Functionalization; (2) Classification, and (3) Allocation.
    • Functionalization: In the case of vertically integrated utility, costs can be related to generation, transmission, distribution, or billing and customer service.  To classify the cost items to each function is called functionalization.  For a restructured retail choice state, the utility functions are limited to distribution, billing, and customer service from a distribution rate case.
    • Classification: The next step after functionalization is classification.  The costs can be classified as energy related (kWh), demand-related (kW) or customer-related (such as billing and metering).
    • Allocation:  The third step is allocation.  The detailed cost categories can be attributed to cost causers.  These ratepayers could be residential, commercial, or industrial.  Subclasses exist for each category.  For example, within commercial, there could be small commercial and large commercial classes.
      • In cost allocation,  two principles are generally followed: (a) Fairness of the specific rates in the apportionment of total costs of service among the different consumers and (b) Avoidance of “undue discrimination” in rate relationships.³⁸
      • In the rate case, the utilities generally submit a class cost of service study that will fully demonstrate the cost allocation for each customer class, from functionalization, classification, to allocation.
      • After finishing the class cost of service study, the utility can work on the rate design. The revenue allocation among customer classes are inter-class rate design and the determination of how much increase for customer charge, volumetric charge and demand charge is intra-class rate design.
      • Thus, the revenue requirement determines the size of the pie, while the rate design (inter-class) will decide how much revenue is allocated to which class – or determining the slicing of the pie.
      • Obviously, the utility generally pays more attention to size of the pie rather than the slicing of the pie.  However, different groups of customers will be affected by both the size of the pie and the percentage allocation (out of total revenue requirement), assigned to the class. Given it is a zero-sum game, it is difficult to align residential/commercial/industrial customers interests.  For example, if one assigns 30 percent to residential class and 40 percent to commercial class, then the remaining costs need to be shouldered by industrial class – 30 percent. When other classes are allocated more, the costs for remaining classes will be less.
      • In such rate design, people also pay attention to the following guidelines:
        • (a) Cost causation and cost averaging will be considered.
        • (b) Marginal cost pricing sometimes was considered but is used less and less in recent years.
        • (c) Matching benefits with costs.
        • (d) Gradualism. Keep rate stability for customer groups rather than create significant rate shock.
        • (e) Rates should not be discriminatory.
        • (f) Rates should be designed based on accurate revenue requirement. If RR is wrong, the rate design needs to be resubmitted.
        • (g) Rate design should also consider efficiency and equity.  Fully allocated costs to ratepayers is considered both efficient and equitable.
        • (h) Socialized costs. In many cases, the socialized costs (such as low-income assistance) can be allocated based on kWh (or volumetric rates).  Another example is the System Benefit Charge, which is used to finance the demand-side management programs such as energy efficiency and demand response.
      • There are many ways to slice the pie in rate design and cost plus non-cost factors should be considered.
      • Ideally, if there is no subsidy, then each class should earn a rate of return equal to the system average rate of return.  However, from various considerations, some classes could be subsidized.  For example, residential customers could be subsidized by commercial and industrial customers. When subsidy exists, each class could earn a different rate of return. Some classes will be earning more, and some classes will be earning less comparing to system average ROR.  The Class with negative rate return implies that the cost of the class exceeds the revenue of the class.

^33. Electric Cost Allocation for a New Era A Manual by Jim Lazar, Paul Chernick and William Marcus. RAP, January 2020.

^34. For customer charge, billing determinants would be total number of customers times 12. For demand charge, the billing determinants would be annual kW for the class and for kWh charge, the billing determinants would be annual kWh by the class.

^35. Notes from IPU, Annual Regulatory Studies Program, CAMP NARUC, August 2021 by Ken Rose.

^36. https://financialaccounting.com/freebook.html

^37. Notes from CAMP NARUC, August 2021.

^38. Ibid. at 27.

There are three basic rate components:

• Customer charge: monthly charge that generally does not vary with respect to any usage characteristics.   Costs relate to customer charge include billing, metering, and customer service.
• Volumetric energy charges: prices based on kWh usage during the billing period.
• Demand charges: prices based on metrics of kW or kilovolt-ampere (kVA) power draw during the billing period. These three basic options allow for a wide range of variations based on season, time of day and type of demand measurement. All types of rates can vary from season to season or month to month.  Both demand charges and energy charges measure the same thing: electricity consumption over a period of time. Even though demand charges are typically denominated in kWs as a measurement of power draw, virtually all demand charges are actually imposed on consumption within short windows, often the highest 15-, 30-, or 60-minute window during the billing period.³⁹

^39. Ibid. at 30.

• Rate Case generally requires both technical and legal staff’s joint efforts in the Commission.
• Commission’s Accounting Staff will look into utility’s revenue requirement determination and Economics Staff will handle the rate design and final tariff (rates) determination.
• Some states have a legislative mandate for rate case length, and some do not.
• One of the most controversial finance/accounting issues is Rate of Return determination.  Such a rate of return will compensate holders of debt and equity for the Company.
• Obviously, the Company generally prefers higher rate of return and the ratepayer groups would prefer lower rate of return.  Thus, ROR is therefore one of the most controversial issues in rate case.
• Most rate cases involve formal litigation, testimony, rebuttal testimony and cross examination in the hearing.  If parties are not happy about state Commission’s decision, they could submit a “reconsideration” filing after the final decision.  If the state Commission’s decision on reconsideration is still not satisfactory, the party could seek court decisions against the state Commission’s decision.
• Sometimes Settlement is reached for rate case.  Settlement generally reduces litigation costs for various parties.

•  Time of Use Rates (TOU rates)
  • Rates vary with time of the day.  TOU rates can have two or three rating periods – Peak, off-peak, (with or without intermediate).  TOU rates are designed to stimulate more consumption in the off-peak period.  For example, EVs can be charged in the evening to reduce peak impact.  Electric dish washers can be run during off-peak period to reduce the total bill if TOU rates are offered.
• Dynamic Pricing
  • Dynamic pricing is designed to link retail and wholesale price signals so that consumption will be sensitive to high price signals caused by extreme weather or high peak demand.  Customers with advanced meters will be able to participate in the dynamic pricing program options (Critical Peak Pricing (CPP), Critical Peak Rebate (CPR) or Hourly Pricing) so that the system peak demand will be reduced due to behavior change by customers.  Customers will receive day-ahead notice through e-mail text or phone calls so that they anticipate extreme weather the next day and are expected reduction in demand for next day.  With conservation, customers can earn additional rebates under CPR program and also contribute to reduced system peak for the electric system.⁴⁰
• Income based rates
  • o Low-income customers may receive different rates (lower rates) or receive credits for their bills and such discount level will be decided by state PUCs.  For example, D.C. has the low-income customer  class who do not need to pay the distribution portion of their bill.    D.C. also has a senior and disabled citizen’s class who receive $7.50 monthly discount for their bill.
• Net Metering rates
  • Net metering customers have on site solar panels or DG facilities which allow them to import or export power to the grid.  If they import, they would need to pay full retail rates but if they export, they would be getting export compensation.  Such compensation could be generation rate only, or full retail rates (including generation, transmission and distribution.)  States have established different net metering rates for such programs.
• Declining Block Rates and Increasing Block Rates
  • Declining block rates – Some states have set their rates by blocks of consumption.  For example, the first block could be “basic block”, e.g., first 400 kWh of consumption.
  • The subsequent block could have higher or lower block rates.  If it is lower, it encourages additional consumption and if it is higher, it encourages conservation. This type of rate structure is called Increasing block rates.

^40. In PJM, Maryland and Delaware have adopted CPR and customers received rebates during summer for reduced consumption in critical peak days.

• Some State Commissions have switched to Alternative Forms of Regulation rather than adopting traditional cost of service rate cases.   If the  AFOR: (A) protects consumers; (B) ensures the quality, availability, and reliability of regulated utility services; and (C) is in the interest of the public, including shareholders of the utility, then the regulators may choose AFOR over traditional cost of service regulation.  The types of AFOR generally include the following categories:
  • Multi-Year Rate Plan: MRPs are a price mechanism that sets a utility’s base rates and revenue requirements for longer than a single 12-month period. MRPs specify rates beyond the rate effective year of a rate case by applying a formula or index, or detailed forecasts for allowable rate changes over the duration of the plan.   For example, instead of a utility filing a new general rate case when conditions change, an MRP may forecast what these conditions are and adjust rates within a single rate case.⁴²
  • Performance-Based Regulation Plan (“PBR”):PBR is an approach to regulation designed to try to improve utility performance as compared to traditional regulation by tying growth in revenues or rates to a metric other than costs and by providing the utility with an opportunity for greater profits by constraining costs rather than increasing sales.  PBRs generally include revenue adjustment mechanisms (e.g., multi-year rate plans, revenue decoupling) and/or performance incentive mechanisms (e.g., performance incentive mechanisms, benchmarking, earnings sharing mechanisms).
  • Formula Rates: Formula rates allow utilities to make prospective annual adjustments to base rates outside of a general rate case. With formula rate regulation, utilities can make prospective rate adjustments based upon an agreed formula determined in a base rate case. Generally, the formula rate is primarily centered on a utility’s allowed rate of return (“ROR”). The rate effective period of formula rates spans multiple years and rates may change annually based on projected allowed RORs that are set in the base rate case. Therefore, the formula is set to allow the utility the opportunity to earn a ROR within a specified range or “band.” The band acts as a cap/limitation on the amount that rates can change year-over-year in order to minimize the risk of rate shock.
  • A Fully Forecasted Test Year (FFTY): A FFTY is a ratemaking tool that allows utilities to submit, for review, reasonable forecasts of all sales and revenue of a hypothetical future 12-month period that will help to improve planning and cost recovery.  Generally, the FFTY is the first year of the rate effective period that follows a base rate case.⁴³
  • Surcharges and Riders: See section below.

^41. See DCPSC website, www.dcpsc.org, Order No. 20273.
^42. See NRRI, Report No. 16-08 October 2016, Multiyear Rate Plans and the Public Interest by Ken Costello.
^43. DCPSC Order No. 20273 at 10 and 11.

• Defining Riders, Trackers, and Decoupling Mechanisms
  • Riders, trackers, and decoupling mechanisms allow a utility to recover its actual costs for a specified function outside of a formal rate case. Decoupling mechanisms allow utilities to separate profits from total sales to ensure that revenue aligns with incurred costs and the utility earns no more or less than its revenue requirement.⁴⁴
• List of States that have Water-Related Riders⁴⁵
  • Will include a list of states with DSICs/QIPs, CWIPs, or CapEx riders and those with conservation adjustments, decoupling, and revenue stabilization riders.
• Distinguished from Ratemaking
  • Trackers, riders, and decoupling are unique methods of cost recovery because they can be implemented by utilities without filing a general rate case. Riders are for single volatile and variable costs/items and have no statutory deadlines.
• Purpose & Policy
  • Riders, trackers, and decoupling mechanisms all function as means through which utilities recover predetermined expenditures with more certainty and less risk to investors.
• Procedure, Reconciliation, True-Ups
  • Procedural Mechanisms & Considerations  
    1. Riders, trackers, and decoupling mechanisms are either created statutorily through a state’s legislative body or created through state utility commission action.
  • Considerations for Regulators
    2. When making decisions related to the implementation of riders and trackers, regulators must conduct a prudency review to confirm whether:
    a) A utility’s costs were incurred prudently and, 
    b) If the need exists for infrastructure of the specific size or type requested.
  • The True-Up 
    3. The annual reconciliation, or “true-up” mechanism reconciles amounts collected under each surcharge (with forecasted billing determinants) with the actual, prudently incurred recoverable costs during each year the surcharge is in effect.  The need for true-up is generally due to the difference between actual cost recovered vs. projected cost recovery.
  • Deadline for action
    4. Rider filings often do not have statutory deadlines for commission action, but they should be completed in a timely manner each year.
• Benefits and Limitations of Riders
  • Policy
    5. The implementation of riders can cause rates to increase gradually annually, helping to reduce the rate shock that might arise from a sudden increase in rates after a formal rate case. They can also reduce regulatory lag and additional expenses that arise from more lengthy formal rate cases.
  • Perceived Benefits and Limitations 
    6. Surcharges can effectively guarantee recovery of variable utility costs. However, guaranteeing recovery of a specific expense can reduce the utility’s incentives to control costs and encourage utilities to spend more on infrastructure than they would otherwise.
  • o Actual Benefits and Limitations
    7. In a traditional rate case, regulators can only investigate whether these costs were reasonable and prudently incurred and whether  the project expenditures became used and useful.
    8. However, surcharges allow regulated utilities to make necessary infrastructure improvements and proactively replace aging systems to improve the quality of service to customers. Infrastructure related surcharges will reduce the regulatory lag and provide utilities more timely cost recovery for reliability related capital expenditures.  Pennsylvania’s distribution system improvement charge – DSIC – is one good example.

 ^44. https://www.moenergy.org/publications/energy-perspectives/summer-2015/decoupling-faqs/
^45.https://brattlefiles.blob.core.windows.net/files/7485_alternative_regulation_and_ratemaking_approaches_for_water_companies_wharton_villadsen_bishop_nawc_sep_23_2013.pdf

^46. https://www.puc.pa.gov/general/consumer_ed/pdf/DSIC_FS.pdf