PrintThe Way Rates Are Made
Remember back in the beginning of the course when we started talking about certain accounting terms and definitions? Well here we go again. In the first sections, we focused on starting with developing a time series of revenue and expenses by assuming some prices and volumes and costs (both capital and O&M). Using some financial analysis techniques we determined whether we had a viable project or not. Well, the way that the utility makes its rates is a little sideways from that. The utility starts with certain assumptions about the return required to allow investors to buy equity in the enterprise. This cost of equity is a heavily debated topic in a rate case because there are many views on how to determine how risky an enterprise is. But let’s just say that we agree that this cost of equity for the utility can be determined. Once this cost of equity is determined, we can then determine the total cost of capital because the debt used to finance the capital in the utility is already a known quantity and the capital structure has been set by how much capital is financed through debt vs equity. Now the next step, once we know the cost of capital, is to determine the amount of net operating income (NOI) that is required to be earned by the utility to recover its cost of capital. This is derived by multiplying the cost of capital by the “rate base” for the utility. The utility’s rate base is defined as the total value of a utility’s assets (e.g., plant, equipment, working capital, and deductions for accumulated depreciation). This then gives us our targeted NOI. We then add to NOI all the expenses of the utility. This includes taxes, depreciation and amortization, operating expenses and administrative and general expenses. The sum of these is equal to the revenue requirement for the utility. This revenue requirement is then divided by the billing determinants (in energy this could be kWh, MMBtu or MCF). Dividing the revenue requirement by the volumes then gives a rate in $/kWh or $/MMBtu. This is called then the rate for service.
Rates are set in quasi-judicial proceedings called rate cases. These are usually presided over by administrative law judges at the state and federal level. The utility “puts on” its rate case through a very large filing of a lot of data. Other parties to the case like consumer advocates, Commission Staff, Industrial Intervenors and activists will also file evidence in the rate case. These parties will typically represent the interests of their constituencies. You could imagine a large industrial customer saying his rate was too high so that the other customers should pay more. Consumer advocates will say that residential customers are paying too much so those folks will advocate for higher costs to other rate classes. All the intervenors will likely say that the utility is asking too much in general and will try to argue for a lower cost of equity, a smaller rate base and higher volumes, as each of these factors would keep rates lower overall.