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Tariff Development IIIDeveloping a Rate Design
Energy Regulatory Partnership ProgramAbuja Nigeria
July 14-18 2008
Ikechukwu N Nwabueze PhDDirector Regulated Energy Division
Michigan Public Service Commission
Fair and Just Rates
Late 19th Century concern over the growing economic power of certain corporations that were affected with the public interest Suspect behavior fell into four groupsndash Prices were ldquotoo highrdquo reflecting monopoly powerndash Prices were ldquotoo lowrdquo (implying predatory pricing
which discouraged economic entry)ndash Prices that were ldquotoo highrdquo for some but ldquotoo lowrdquo for
others (involving ldquounduerdquo discrimination andor subsidies for some markets)
ndash Prices that were ldquounstablerdquo (making it difficult for producers and consumers to plan ahead)
2 of 79
Todayrsquos Pricing Issues
bull Few issues today are fundamentally different from those at the turn of the century This is due in part to the early recognition of the fundamental characteristics of a natural monopoly (Farrer 1902)ndash Capital intensive (having significant fixed costs or scale
economies)ndash Necessity (essential to the community)ndash Nonstorable (yet subject to fluctuating demands)ndash Produced in particularly favored locations (yielding rents)ndash Involve direct connections with customers
bull The unregulated monopolist has the power to set prices that are not in the public interest
3 of 79
Goals of Rate Designbull Equity (ldquofairnessrdquo) goals
ndash Be just and reasonable (fair to various groups)ndash Be subsidy free
bull No group or service charged less than its incremental cost or more than its stand alone cost (ie the utility receives a positive rate of return from each group or service but not a monopolistic profit)
4 of 79
Goals of Rate Design (Continued)
bull Efficiency Goalsndash Give correct signals to consumers and to the
utility (ie Price = Marginal Cost) bull Promote efficient use of resources and efficient
planning by the utility
ndash Allow for efficient competitive entry bull Prevent predatory pricing price squeezes
uneconomic bypass and cross-subsidization of competitive services by monopoly services
5 of 79
Goals of Rate Design (Continued)
bull Social goals may includendash Promoting universal servicendash Promoting conservation (eg inverted rate
structure) or at least discouraging wasteful use of a utility service
ndash Promoting environmental protectionndash Promoting economic development and full
employmentndash Assisting seniorlow income consumers
6 of 79
Goals of Rate Design (Continued)bull Operational Goals
ndash Be sufficient to allow the utility to collect its legitimate costs (ie allowed capital and operating costs)
ndash Be relatively stable from period to period bull Avoid rate shock
ndash Promote revenue stability for the utilityndash Be understandable and administratively feasiblendash Avoid undue discrimination across rate classes or
servicesndash Apportion costs fairly
7 of 79
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Fair and Just Rates
Late 19th Century concern over the growing economic power of certain corporations that were affected with the public interest Suspect behavior fell into four groupsndash Prices were ldquotoo highrdquo reflecting monopoly powerndash Prices were ldquotoo lowrdquo (implying predatory pricing
which discouraged economic entry)ndash Prices that were ldquotoo highrdquo for some but ldquotoo lowrdquo for
others (involving ldquounduerdquo discrimination andor subsidies for some markets)
ndash Prices that were ldquounstablerdquo (making it difficult for producers and consumers to plan ahead)
2 of 79
Todayrsquos Pricing Issues
bull Few issues today are fundamentally different from those at the turn of the century This is due in part to the early recognition of the fundamental characteristics of a natural monopoly (Farrer 1902)ndash Capital intensive (having significant fixed costs or scale
economies)ndash Necessity (essential to the community)ndash Nonstorable (yet subject to fluctuating demands)ndash Produced in particularly favored locations (yielding rents)ndash Involve direct connections with customers
bull The unregulated monopolist has the power to set prices that are not in the public interest
3 of 79
Goals of Rate Designbull Equity (ldquofairnessrdquo) goals
ndash Be just and reasonable (fair to various groups)ndash Be subsidy free
bull No group or service charged less than its incremental cost or more than its stand alone cost (ie the utility receives a positive rate of return from each group or service but not a monopolistic profit)
4 of 79
Goals of Rate Design (Continued)
bull Efficiency Goalsndash Give correct signals to consumers and to the
utility (ie Price = Marginal Cost) bull Promote efficient use of resources and efficient
planning by the utility
ndash Allow for efficient competitive entry bull Prevent predatory pricing price squeezes
uneconomic bypass and cross-subsidization of competitive services by monopoly services
5 of 79
Goals of Rate Design (Continued)
bull Social goals may includendash Promoting universal servicendash Promoting conservation (eg inverted rate
structure) or at least discouraging wasteful use of a utility service
ndash Promoting environmental protectionndash Promoting economic development and full
employmentndash Assisting seniorlow income consumers
6 of 79
Goals of Rate Design (Continued)bull Operational Goals
ndash Be sufficient to allow the utility to collect its legitimate costs (ie allowed capital and operating costs)
ndash Be relatively stable from period to period bull Avoid rate shock
ndash Promote revenue stability for the utilityndash Be understandable and administratively feasiblendash Avoid undue discrimination across rate classes or
servicesndash Apportion costs fairly
7 of 79
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Todayrsquos Pricing Issues
bull Few issues today are fundamentally different from those at the turn of the century This is due in part to the early recognition of the fundamental characteristics of a natural monopoly (Farrer 1902)ndash Capital intensive (having significant fixed costs or scale
economies)ndash Necessity (essential to the community)ndash Nonstorable (yet subject to fluctuating demands)ndash Produced in particularly favored locations (yielding rents)ndash Involve direct connections with customers
bull The unregulated monopolist has the power to set prices that are not in the public interest
3 of 79
Goals of Rate Designbull Equity (ldquofairnessrdquo) goals
ndash Be just and reasonable (fair to various groups)ndash Be subsidy free
bull No group or service charged less than its incremental cost or more than its stand alone cost (ie the utility receives a positive rate of return from each group or service but not a monopolistic profit)
4 of 79
Goals of Rate Design (Continued)
bull Efficiency Goalsndash Give correct signals to consumers and to the
utility (ie Price = Marginal Cost) bull Promote efficient use of resources and efficient
planning by the utility
ndash Allow for efficient competitive entry bull Prevent predatory pricing price squeezes
uneconomic bypass and cross-subsidization of competitive services by monopoly services
5 of 79
Goals of Rate Design (Continued)
bull Social goals may includendash Promoting universal servicendash Promoting conservation (eg inverted rate
structure) or at least discouraging wasteful use of a utility service
ndash Promoting environmental protectionndash Promoting economic development and full
employmentndash Assisting seniorlow income consumers
6 of 79
Goals of Rate Design (Continued)bull Operational Goals
ndash Be sufficient to allow the utility to collect its legitimate costs (ie allowed capital and operating costs)
ndash Be relatively stable from period to period bull Avoid rate shock
ndash Promote revenue stability for the utilityndash Be understandable and administratively feasiblendash Avoid undue discrimination across rate classes or
servicesndash Apportion costs fairly
7 of 79
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Goals of Rate Designbull Equity (ldquofairnessrdquo) goals
ndash Be just and reasonable (fair to various groups)ndash Be subsidy free
bull No group or service charged less than its incremental cost or more than its stand alone cost (ie the utility receives a positive rate of return from each group or service but not a monopolistic profit)
4 of 79
Goals of Rate Design (Continued)
bull Efficiency Goalsndash Give correct signals to consumers and to the
utility (ie Price = Marginal Cost) bull Promote efficient use of resources and efficient
planning by the utility
ndash Allow for efficient competitive entry bull Prevent predatory pricing price squeezes
uneconomic bypass and cross-subsidization of competitive services by monopoly services
5 of 79
Goals of Rate Design (Continued)
bull Social goals may includendash Promoting universal servicendash Promoting conservation (eg inverted rate
structure) or at least discouraging wasteful use of a utility service
ndash Promoting environmental protectionndash Promoting economic development and full
employmentndash Assisting seniorlow income consumers
6 of 79
Goals of Rate Design (Continued)bull Operational Goals
ndash Be sufficient to allow the utility to collect its legitimate costs (ie allowed capital and operating costs)
ndash Be relatively stable from period to period bull Avoid rate shock
ndash Promote revenue stability for the utilityndash Be understandable and administratively feasiblendash Avoid undue discrimination across rate classes or
servicesndash Apportion costs fairly
7 of 79
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Goals of Rate Design (Continued)
bull Efficiency Goalsndash Give correct signals to consumers and to the
utility (ie Price = Marginal Cost) bull Promote efficient use of resources and efficient
planning by the utility
ndash Allow for efficient competitive entry bull Prevent predatory pricing price squeezes
uneconomic bypass and cross-subsidization of competitive services by monopoly services
5 of 79
Goals of Rate Design (Continued)
bull Social goals may includendash Promoting universal servicendash Promoting conservation (eg inverted rate
structure) or at least discouraging wasteful use of a utility service
ndash Promoting environmental protectionndash Promoting economic development and full
employmentndash Assisting seniorlow income consumers
6 of 79
Goals of Rate Design (Continued)bull Operational Goals
ndash Be sufficient to allow the utility to collect its legitimate costs (ie allowed capital and operating costs)
ndash Be relatively stable from period to period bull Avoid rate shock
ndash Promote revenue stability for the utilityndash Be understandable and administratively feasiblendash Avoid undue discrimination across rate classes or
servicesndash Apportion costs fairly
7 of 79
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Goals of Rate Design (Continued)
bull Social goals may includendash Promoting universal servicendash Promoting conservation (eg inverted rate
structure) or at least discouraging wasteful use of a utility service
ndash Promoting environmental protectionndash Promoting economic development and full
employmentndash Assisting seniorlow income consumers
6 of 79
Goals of Rate Design (Continued)bull Operational Goals
ndash Be sufficient to allow the utility to collect its legitimate costs (ie allowed capital and operating costs)
ndash Be relatively stable from period to period bull Avoid rate shock
ndash Promote revenue stability for the utilityndash Be understandable and administratively feasiblendash Avoid undue discrimination across rate classes or
servicesndash Apportion costs fairly
7 of 79
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Goals of Rate Design (Continued)bull Operational Goals
ndash Be sufficient to allow the utility to collect its legitimate costs (ie allowed capital and operating costs)
ndash Be relatively stable from period to period bull Avoid rate shock
ndash Promote revenue stability for the utilityndash Be understandable and administratively feasiblendash Avoid undue discrimination across rate classes or
servicesndash Apportion costs fairly
7 of 79
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Additional Commentsbull It is often difficult mdash or impossible mdash to
achieve all these goals at oncebull Almost all real-world rate designs are
compromisesbull Certain goals may be conflicting
ndash Rates that are efficient may not be considered fairbull Efficiency involves maximizing total net economic valuebull Fairness involves distribution of net economic value
among customers and the utilityndash Rates that promote energy conservation may not
be efficient or considered fair
Goals of Rate Design (Continued)
8 of 79
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Allocation of Revenue Requirementsto Various Classes of Service
bull Group customers into rate classesbull Rate classifications should produce
homogeneous groups based upon characteristics of each groupbull Residentialbull Commercial ndash Secondary and Primarybull Industrial ndash Secondary and Primarybull Retail Open Access ndash ROA
9 of 79
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Structures
bull The existing rate structures for the various rate classes is the best source of information to assist in selecting rate structuresbull Evaluate the performance of current structure
bull Do rates provide revenue stabilitybull Do rates provide for recovery of revenue
requirements for that class of servicebull Are the rates perceived to be fair by the
customers
10 of 79
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
The Traditional Ratemaking Process
Revenue
Requirement
CostAllocation
Rate Design(prices)
11 of 79
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Steps in Traditional Ratemaking
bull Three basic stepsndash Determination of revenue requirements (cost
assessment) for a test yearndash Allocation of costs to customers based on
usage patternndash Rate design to recover costs through rates
and chargesbull Considerable discretion is involved in all three
steps
12 of 79
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
What Stakeholders Want from the Ratemaking Process
bull Utilities a reasonable return on investment (compensatory and non-confiscatory) to ensure financial viability protection from ruinous competition
bull Customers Nondiscriminatory service at fair reasonable and affordable rates protection from monopoly abuse (captive customers)
bull RegulatorsSociety Utility services that promote the public interest including price signals that encourage efficient use of resources and promote other social goals
13 of 79
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Ratemaking Process
bullCost allocation determines how many dollars to collect from various classes or services
bullRate design determines how to collect dollars from various customer groups and services
bullLike cost allocation rate design is as much art as science ndash more ldquosausage makingrdquo
14 of 79
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Designing Sound Tariff Structures
Pricing principles provide a foundation for rate design and sound tariff structures
bull Fairness to both the regulated utility and the ratepayers
bull Avoidance of unjust or undue discrimination between rate classes or customers
15 of 79
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Design Rates to Provide for Recoveryof Revenue Requirements
bull General Attributes of a Sound Rate Structurebull Effectiveness in yielding total revenue requirementsbull Revenue and rate stability and predictabilitybull Fairness and avoidance of undue discrimination among
the different rate classesbull Political and public policy issues eg subsidiesbull Simplicity understandability and public acceptabilitybull Practicability metering and billing constraints
16 of 79
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Objectives in Setting Rates
bull Protect the ratepayerrsquos interest by assuring safe reliable and reasonably priced services
bull Fairly apportioning cost among customersbull Protect the shareholderrsquos interest by allowing the
utility a reasonable opportunity to earn a fair rate of return on its investment
17 of 79
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Structure v Rate Levels
bull Regulators must approve both the rate structure and rate levelsbull The term rate structure refers to how the prices are designed The
rate structure may reflect various attributes For example- Number of rate levels (eg declining block or constant rate per kWh)- Customer classes (industrial commercial government residential)- Time of day (peak v off-peak)- Capacity (kilowatt)
bull The term rate level refers to the price per unit sold (eg 5 cents per kWh or $1050 per kW)
18 of 79
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Pricing Attributes
Dr James C Bonbright in his book ldquoPrinciples of Public Utility Ratesrdquo (1961) which is often quoted by rate design witnesses provides a list of eight traditional rate-making or pricing attributesndash Simplicity and public acceptabilityndash Freedom from controversyndash Revenue sufficiencyndash Revenue stabilityndash Stability of ratesndash Fairness in apportionment of total costsndash Avoidance of undue rate discriminationndash Encouragement of efficiency
19 of 79
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Simplicity and Public Acceptability
bull The costs associated with regulatory hearings on rate structures will be reduced if policies can be easily understood by the affected parties
bull Consumersrsquo information processing costs should be included in the derivation of efficient prices
bull Why do consumers prefer flat-rate telephone service
20 of 79
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Simplicity and Public Acceptability (Continued)
bull ATampTrsquos vice-president EJ Hall conjectured in 1898 that although customers could understand paying a flat fee for unlimited use of the local network or no connection charge and a usage charge for each call they were confused by the combination of paying an entry and usage fee
ldquoThe claim that [a two-part tariff] is easy for the customer to understand and would therefore be popular is not justified by history nor will it stand logical analysis No compound proposition [ie two-part tariff] can be as easily understood as can either one of the simple ones from which it is composedrdquo
bull Simple rate structures may conflict with other pricing objectives (eg efficiency)
21 of 79
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Freedom from Controversy
bull Hard to modify an existing rate structure or rate levels in a manner that is free from controversy
bull In order to minimize the level of controversy regulatory commissions will often phase in the change
bull Controversy can also be reduced if a well accepted pricing or costing methodology can be used to explain the need for the change in rates
22 of 79
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Revenue Sufficiency
bull In 1930s and 1940s the view came to be held that the right policy was to make public utility prices everywhere equal to marginal cost even where marginal cost was less than average cost and a government subsidy was required to maintain production
bull This policy proposal had serious weaknesses It did not take into account the benefit of a subsequent market test whether consumers were willing to pay the total cost it ignored the probable effects on the administrative structure it involved a redistribution of income in favor of consumers of products produced in conditions of decreasing costs it failed to take into account the misallocation of resources resulting from the additional taxation necessitated by the subsidies
bull But if prices are not to equal marginal cost the question of what the structure of rates should be needs to be examined
23 of 79
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Revenue Stability
bull Concern is not so much revenue stability as it is net revenue (revenue ndash cost)
bull When comparing alternative rate structures regulators must examine how rates customer responses and production costs interact to yield net revenue stability
24 of 79
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Stability of Rates
bull Stability allows consumers to plan ahead Alcoa for example needs to know the long-term cost of purchasing electricity before it decides where to build a new smelter
bull But if costs are changing and rates are inflexible there can be shortages or excess supply
bull To avoid imposing hardships on particular customers regulators will tend to prefer a gradual transition to new rates
25 of 79
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Fairness in the Apportionment of Costs
bull Bonbright discussed fairness in terms of apportionment of total costs When you move away from rate base regulation and towards price caps the discussion evolves to a debate over the apportionment of costs (eg common costs)
bull Can the winners compensate the losing group when a new rate structure is adopted If they could then an economist might contend that the change should be implemented even if no compensation is paid
26 of 79
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Fairness in Ratemaking
bull An inherent tension exists between equity v efficiencybull Sometimes cost differences are ignored (eg old and
new customers)bull Values and perceptions of equity vary from place to
place and evolve over timebull Regulation considers whether rates are ldquojust and
reasonablerdquobull In practice rate design can be a mix of art science and
politics
27 of 79
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Avoidance of Undue Rate Discrimination
bull Price discrimination exists where the mark-up above marginal cost is greater in percentage terms of product A than product B
bull Price discrimination is often seen as welfare enhancing Telephone and airline pricing
bull Regulatory and anti-trust concern that a vertically integrated firm will foreclose competition in the downstream market
28 of 79
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Encouragement of Efficiency
bull Technical efficiency requires that the least-resource-consuming production processes be used to produce a given level of output
bull Allocative efficiency requires that the economically correct level (and mix) of output be chosen from among the technically efficient outputs
bull Innovative efficiency depends on how well firms perform the intertemporal tasks of cost reduction and new product development
29 of 79
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
A Feedback Loop
Revenue Requirement
CostAllocation
Rate Design(prices)
CustomerBehavior
30 of 79
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Design
bull There are a wide variety of rate structures to choose from ndash flat rates step rates declining block rates demand rates
bull Michigan employs a three step structurebull Customer Charge ndash Fixed monthly chargebull Delivery or Distribution Charge ndash Energy (and Demand for
some Commercial amp all Industrial rates) charge on each unit of sale
bull Power Supply Charge ndash Energy charge (and Demand for some Commercial amp all Industrial rates) on each unit of sale
bull Additional surcharges are sometimes used to recover specific cost items such as Power Supply Cost Recovery (fuel and purchased power expenses under PA 304 Nuclear Decommissioning or expanded security at power plants
31 of 79
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Unbundling
bull Michigan uses tariffs broken down by delivery and power supply charges on customersrsquo bills so that customers can shop for the power supply portion of their service from an alternate energy supplier
bull Transmission is included in production as it is now billed
as component of power supply just as purchased power
bull Customer costs are recovered along with distribution costs under delivery charges
32 of 79
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Unbundling (Continued)bull Unbundled rates are designed to meet the
functionalized power supply and distribution revenue deficiencysufficiency targets derived in the cost of service study by major rate class or sometimes by rate
bull With the restructuring of utility industries customer charges are being unbundled mdash broken down into smaller components ndash Metering billing line maintenance and
transmission may appear separately on the bill with transmission as a usage-sensitive charge
33 of 79
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
A Point to Consider
bull Utility rates are pricesbull People respond to prices
ndash Prices provide incentives and signals to producers and consumers
bull Rate design will affect behaviorndash Expect a different response to a high customer
charge and low usage charge than to a low customer charge and a high usage charge even if the two are designed to produce equal revenues in the short run (Why)
bull Rate design affects behavior which affects future costs
34 of 79
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
A Point To Consider (Continued)
ndash Illustrationbull Rate design 1 customer charge = $500
energy charge = 4 centskWhbull Rate design 2 customer charge = $1000
energy charge = 2 centskWhbull The utility expects sales of 250 kWhs or
revenues of $15 no matter which rate design is applied
bull But assuming a price elasticity of -02 one would expect sales to be 20 higher under rate design 2
35 of 79
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Designs
bull Marginal cost-based rates ndash Definition of MC change in cost due
to change in output represents economic opportunity cost
ndash Favored over fully allocated cost rates by economists
36 of 79
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Designs (continued)
bull Multi-part rates ndash Also called nonlinear prices or two-part
tariffsndash Include a fixed customer charge plus a
usage chargendash Relatively high fixed or customer charges
and relatively low usage chargesbull May be efficient but do not promote energy
conservationbull Shift risks away from the utility
37 of 79
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Designs (continued)
bull Peak-load seasonal real-time or time-of-day rates
ndash Vary by time of day or season of usendash Used for energy services and sometimes
for telephone services
bull Inverted block rates ndash May promote conservation (Why)
38 of 79
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Designs (Continued)
bull Demand-side management (DSM) rates
bull Energy efficiency discounts
bull All-electric rates
bull Load-control rates
bull Reliability-based pricingndash Interruptible vs firm power rates
39 of 79
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Designs (Continued)
bull In principle usage charges should recover only usage-sensitive costs
ndash Some fixed charges however are typically recovered through usage charges (particularly for residential and other small customers) bull Exhibited in declining-block rates for
electricity
40 of 79
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Cost of Service Issues
Allocation of costs to rate classes or specific rates remains one of the biggest issue of controversy in rate proceedings
Various intervening parties to a case employ methods that reduce the costs derived in the cost of service for their particular rate class or specific tariff
An example of this can be seen with the on-going debate of production plant allocation methods High load factor industrial customer groups pursue allocation methods based on demand rather than energy or based on coincident peaks that they are less responsible for
41 of 79
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Block Tariffs Decreasing-block rate
42 of 79
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Increasing-block rate
43 of 79
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Seasonal rate
44 of 79
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Examples of Rate Designs
Flat Rate per period no usage charge
Uniform Flat Rate per unit
Declining Block Inverted Block
$
Q
$
Q
$
Q
$
Q
45 of 79
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Rate Designs (Continued)
Seasonal or Time of Use
$
Period1
Period2
Q
46 of 79
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Illustration of the Hopkinson Demand Rate for Industrial Customers
bull Bills customers for maximum measured demand (eg the maximum KW demand by a customer for any 15-minute period during the month) and for energy usage
bull Two-part tariff that has a separate demand and energy rate
bull Examplendash $950 per kW of maximum demand per monthndash $0065 per kWh usage in a given billing month
bull Rates can have declining (inverted) block demand andor energy charges
bull Higher load-factor customers pay a lower average price
47 of 79
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Pricing Philosophies
bull Cost of Service Pricingndash Tends on average to collect more-or-less
equal rates of return from all classes of customers and all services (ldquorate-of-return parityrdquo)
bull Each covers its variable costs and an equal relative contribution to common overhead and capital costs
bull For example if a utilityrsquos overall allowed rate of return is 125 it would earn 125 from each customer class
48 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Pricing Philosophies (Continued)
bull Value-of-service pricing ndash Form of price discrimination
bull Charging different prices for the same service when no equivalent cost difference exists (eg economic development rates)
bull Charging different customers the same price when a significant cost differential exists (eg rural customers charged the same rate as urban customers)
49 of 79
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Pricing Philosophies (Continued)
bull Value-of-service pricing - continuedndash May consider customers willingness to pay
ability to find alternative suppliers or ability to engage in self supply
50 of 79
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Pricing Philosophies (Continued)
Commentsbull Non-cost-based pricing methods may not be
sustainable in a competitive environment ndash They may either promote inefficient competition
(eg uneconomic bypass) or thwart efficient competition
bull Rates that do not reflect current cost conditions do not give correct signals to either consumers or producers
51 of 79
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Conflicting Goals Efficiency vs Equity
bull The classic conflict in regulation Achieving the correct balance between efficiency and equityndash Rebalancing rates in accordance with
costsndash Offering special rates to customers with
alternative choices
52 of 79
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Efficiency Goals
bull Economic efficiency as a goal reflects the concerns that are inherent in economic regulation ndash namely a monopolist supplying too little of a service and charging a too high price or engaging in excessive price discriminationndash The economic objective of regulation would be to
maximize total social welfare (total economic efficiency) without regard to who gets the money
53 of 79
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Economic Efficiency
bull Economic efficiency requires correct pricing starting with cost-based rates that reflect the marginal cost of service
ndash Marginal cost can be differentiated by service type or level as well as by time of servicebull Services that differ in quality or reliability
may have different marginal costs
54 of 79
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Equity
bull Cannot forget the goal of equity or fairness
bull To repeat equity must be balanced against efficiencyndash Equity is subjective and many views of
fairness existndash What is fair to one group may often be
considered unfair to another
55 of 79
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Price Discrimination Due and Undue
bull The common law like customers pay the same price for the same service
bull The conflict between efficiency and equity is addressed by the undue price discrimination testndash Not all price discrimination is goodndash Not all price discrimination is evilndash Only undue price discrimination is illegal
56 of 79
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Price Discrimination (Continued)
bull Price differentials that reflect differences in the cost of providing service is not price discrimination
ndash Price differences can be related to different services being provided
bull Different reliability or voltage levels
bull Different load or usage patterns
ndash Such price differences cannot be considered discriminatory from an economic perspective
57 of 79
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Reasons for a Utility to Price Discriminate
bull Reduce surplus capacityimprove utilization of existing capacity
ndash Examples include daynight and weekend differentials in long-distance pricing promotional rates for industrial customers
bull Accommodate competitive forces (may be necessary for a utility to compete in certain markets)
bull Encourage economic development (must get the blessing of regulators)
58 of 79
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Reasons for a Utility to Price Discriminate (Continued)
bull Boost profits through increased sales to price-elastic customers ndash Special contracts ndash Economic development rates
bull Meet a social goalndash Lifeline ratesndash Businessresidential differentials in local
telephone accessndash Universal service support for high-cost
areas59 of 79
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Permissible Discrimination
bull Ramsey pricing (prices based on customersrsquo elasticities) maximizes social welfare (given a revenue-requirement constraint) and may be the most extreme form of permissible price discrimination
bull Price discrimination is often found to be permissible if authorized or directed by a state public utility commission ndash State action doctrine or legislation ndash The discrimination serves some public
interest such as economic development or capacity (cogeneration) deferral
60 of 79
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Price Discrimination The Zone of Reasonableness
bull Discriminatory prices must fall within the ldquozone of reasonablenessrdquo
bull At the high end of the zone rates can not be exorbitant or unconscionablendash Rates cannot be or exceed what an
unregulated monopolist would charge ndash Rates cannot be above the ldquostand-alonerdquo
cost of the service (eg the cost of self-supply)
61 of 79
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Price Discrimination The Zone of Reasonableness
(Continued)bull At the low end of the zone rates cannot be so low
as to be predatory ndash Rates cannot be below incremental costndash Pricing below incremental cost may constitute anti-
competitive behaviorbull Courts are reluctant however to make a finding of
predatory behavior unless recoupment is possible
ndash Pricing below incremental cost implies that the service or customer is receiving a cross-subsidy from other services or customers ndash ie the utility is collecting a negative rate of return from the service or customer 62 of 79
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Tariffs (Time-of-Use Rates Rates to Encourage Targeted Energy
Usage Stand-by Tariffs)
63 of 79
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Time-of-Use Tariffs
Rates are designed to increase existing on-peak to off-peak rate differentials Shifting loads to off peak periods lowers peak demand and can reduce the need for additional generation capacity
Section 1252 of the Energy Policy Act of 2005 Public Law 109-58 requires each state regulatory authority to decide whether certain electric utilities under its jurisdiction should implement time-based rate schedules in accordance with 16 USC 2621(d)(14)
64 of 79
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Energy Policy Act of 2005
Sec 2621 Consideration and determination respecting certain
ratemaking standards
(1) Cost of service
(2) Declining block rates
(3) Time-of-day rates
(4) Seasonal rates
(5) Interruptible rates
(14)(b) (i-iv) Time-based metering and communications 65 of 79
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Standby Tariffs
Standby backup and maintenance tariffs allow customers with their own generation the availability to purchase power from the utility during times of need when their own sources of power are not operating
Parallel generation presents issues of cost recovery for metering distribution and transmission plant that may only be used part of the year along with how much to bill for actual energy purchased from the utility or sold back to the utility
Ideally tariffs should reflect appropriate costs for standby capacity in the utilityrsquos generation plant or purchased power contracts
66 of 79
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Attributing Costs to Different Categories of Customers Based on How Those Customers Cause Costs to be
Incurred (Customer Classes Categorization)
Customers are grouped together for rate design purposes based on like cost causation attributes (such as usage patterns load factor etc) into classes similar to the following
Residential - Single family1048678- Alternative Residence Nonresidential - Industrial such as manufacturing or automotive production - Commercial such as stores and offices - Wholesale (usually non-jurisdictional) - Irrigation and Farming - Public authorities such as Lighting and Pumping
67 of 79
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Calculating Costs of Individual Types of Service Based on the Costs Each Service Requires the Utility to Expend
Specific costs that are required to be expended for a particular customerrsquos needs are calculated to allow proper rate design to generate revenue to fully recover the expenditure
An example would be inclusion of a higher rate for Delivery Charges to recover additional costs of time-of-day metering under rates requiring time-of-day metering
The reverse is also true that for tariffs that allow utilities to reduce costs such as interruptible rates cost savings are passed on in the form of reduced rates to the customer who agrees to non-firm service
68 of 79
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Determining How Costs Will be Recovered From Customers Within Each Customer
Classbull Customer Charge
ndash Covers basic fixed cost of serving a customer (eg cost of customer hook-up)
bull Meter reading billing etc bull Charge for basic facilities used to provide service
bull Capacity or Demand Chargendash Covers cost imposed on the system by the userrsquos
maximum load or usagendash Usually excluded for residential service
bull Usage Chargendash Covers incremental cost of each unit of service
69 of 79
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Separating Costs Between Regulated and Non-Regulated Operations of a Utility
The cost of service study process also includes determining the ldquojurisdictionalrdquo amount of each base input Jurisdictionalization means separating the costs associated with providing electric service to retail customers which falls under MPSC jurisdiction from those costs associated with providing service at wholesale which is subject to FERC jurisdiction
70 of 79
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Jurisdictional Total Costs
Non-regulated Costs
Non-jurisdictional Costs
Jurisdictional Costs
Class 1 Class 2Class 3
Total Costs
71 of 79
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Determining Allowable Costs and Prudent Business Expenses
Part of the audit function in a rate proceeding is to determine if expenses were properly incurred or if a disallowance should be made A disallowance will reduce the necessary revenue requirement
Examples of improperly incurred expenses may be for items such as inappropriate donations and bonus compensation plans excessively high payments made to a parent companyrsquos service division or for non-regulated business expenses that were incorrectly allocated to the regulated utility
72 of 79
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Marginal Cost Pricing
bull Marginal cost pricing can conflict with certain regulatory objectives
ndash Possible large one-time increase in rates (transition problem)
ndash Revenue reconciliation via the Ramsey-pricing rule would tend to
bull Favor large price-elastic customers and
bull Hurt small price-inelastic customers (namely residential customers)
73 of 79
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
From Costs to Regulated Prices A Rate Design Example
bull Commission-approved revenue requirement $100 million
bull Customer-class cost allocationndash Residential $40 millionndash Commercial $35 millionndash Industrial $25 million
74 of 79
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
An Example (Continued)
ndash Thus the energy charge would have to be set so that the utility collects $28 million
ndash Namely the energy charge would equal $28 million360 million kWhs or 78 cents per kWh
ndash Overall the average price of electricity to residential customers would be 111 cents per kWh ($40 million360 million kWhs)
ndash The customer charge and the energy charge could be set at different values that would allow the utility to collect $40 million from the residential class
75 of 79
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Real-World Pricing
bull Regulators typically adhere to cost-based pricing (allowing the utility the opportunity to receive an adequate rate of return for its regulated services)
bull Regulators have the authority however to deviate from cost-based pricing in order to achieve certain social objectives ndash and often they do exercise it
ndash Examples Discounted rates to ensure affordability of electricity to low-income households or senior citizens economic development rates
76 of 79
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
General Factors to remember
bull Regulatory and statutory requirements
bull Economics ndash cost based or not
bull Gradualism ndash previous levels of rates
bull Physical constraints ndash firm or interruptible
bull Revenue stability
77 of 79
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
Acknowledgements
Thanks to National Association of Regulatory Utility Commissioners (NARUC) Institute of Public Utilities (IPU) National Regulatory Research Institute (NRRI) Detroit Edison and Consumers Energy for use of slides from previous presentations on cost of service and rate design
I want to also acknowledge the use of Dr James C Bonbrightrsquos book on ldquoPrinciples of Public Utility Ratesrdquo (1961)
78 of 79
79 of 79
Questions
79 of 79
Questions
