Principles of Sound Rate Design

ABSTRACT: A number of rate design principles or objectives find broad acceptance in utility regulatory and policy literature. These include:

• Efficiency;

• Cost of Service;

• Value of Service;

• Stability;

• Non-Discrimination;

• Administrative Simplicity; and

• Balanced Budget.

These rate design principles draw heavily upon the “Attributes of a Sound Rate Structure” developed by James Bonbright in Principles of Public Utility Rates. Each of these principles plays an important role in analyzing the rate design proposals of utility clients.

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I. RATE DESIGN PRINCIPLES – FROM AUTHORITATIVE SOURCES

Efficiency

The principle of efficiency broadly incorporates both economic and technical efficiency. As such, this principle has both a pricing dimension and an engineering dimension. Economically efficient pricing promotes good decision-making by gas producers and consumers, fosters efficient expansion of delivery capacity, results in efficient capital investment in customer facilities, and facilitates the efficient use of existing gas pipeline, storage, transmission, and distribution resources. The efficiency principle benefits stakeholders by creating outcomes for regulation consistent with the long-run benefits of competition while permitting the economies of scale consistent with the best cost of service. Technical efficiency means that the development of the gas utility system is designed and constructed to meet the design day requirements of customers using the most economic equipment and technology consistent with design standards.

Cost of Service and Value of Service

These principles each relate to designing rates that recover the utility’s total revenue requirement without causing inefficient choices by consumers. The cost of service principle contrasts with the value of service principle when certain transactions do not occur at price levels determined by the embedded cost of service. In essence, the value of service acts as a ceiling on prices. Where prices are set at levels higher than the value of service, consumers will not purchase the service. This principle puts the concept of stand-alone cost into practice and is particularly relevant for utility that customers with competitive supply alternatives that effectively place a cap on rates. Theoretical economists have developed the theory of subsidy-free prices to evaluate traditional regulatory cost allocations. Prices are said to be subsidy-free so long as the price exceeds the incremental cost of providing service but is less than stand-alone costs (“SAC”). The logic for this concept is that if customers’ prices exceed incremental cost, those customers make a contribution to the fixed costs of the utility. All other customers benefit from this contribution to fixed costs because it reduces the cost they are required to bear. Prices must be below the SAC because the customer would not be willing to participate in the service offering if prices exceed SAC.

Stability

The principle of stability typically applies to customer rates. This principle suggests that reasonably stable and predictable prices are important objectives of a proper rate design.

Non-Discrimination

The concept of non-discrimination requires prices designed to promote fairness and avoid undue discrimination. Fairness requires no undue subsidization either between customers within the same class or across different classes of customers.

This principle recognizes that the ratemaking process requires discrimination where there are factors at work that cause the discrimination to be useful in accomplishing other objectives. For example, considerations such as the location, type of meter and service, demand characteristics, size, and a variety of other factors are often recognized in the design of utility rates to properly distribute the total cost of service to and within customer classes. This concept is also directly related to the concepts of vertical and horizontal equity. The principle of horizontal equity requires that “equals should be treated equally” and vertical equity requires that “unequals should be treated unequally.” Specifically, these principles of equity require that where cost of service is equal – rates should be equal and, where costs are different – rates should be different. In this case, this principle is an important requirement that supports Montana-Dakota’s proposed use of a single monthly Basic Service Charge for all customers within certain of its tariff schedules.

Administrative Simplicity

The principle of administrative simplicity as it relates to rate design requires prices be reasonably simple to administer and understand. This concept includes price transparency within the constraints of the ratemaking process. Prices are transparent when customers are able to reasonably calculate and predict bill levels and interpret details about the charges resulting from the application of the tariff.

Balanced Budget

This principle permits the utility a reasonable opportunity to recover its allowed revenue requirement based on the cost of service. Proper design of utility rates is a necessary condition to enable an effective opportunity to recover the cost of providing service included in the revenue authorized by the regulatory authority. This principle is very similar to the stability objective previously discussed from the perspective of customer rates.

II. THE POTENTIAL FOR COMPETING PRINCIPLES

Like most principles that have broad application, these principles can compete with each other. This competition or tension requires further judgment to strike the right balance between the principles. Detailed evaluation of rate design alternatives and rate design recommendations must recognize the potential and actual competition between these principles. Indeed, Bonbright discusses this tension in detail. Rate design recommendations must deal effectively with such tension. For example, as noted above, there are tensions between cost and value of service principles.

The conflict between proper price signals based on incremental or marginal cost and the balanced budget principle arises because marginal cost is below average cost due to economies of scale. Where fixed delivery service costs do not vary with the volume of sales, marginal costs for delivery equal zero. Marginal customer costs equal the additional cost of the customer accessing the entire delivery system. Marginal cost tends to be either above or below average cost in both the short run and the long run. This means that marginal cost-based pricing will produce either too much or too little revenue to support the utility’s total revenue requirement. This suggests that efficient price signals may require a multi-part tariff designed to meet the utility’s revenue requirements while sending marginal cost price signals related to energy consumption decisions. Properly designed, a multi-part tariff may include elements such as access charges, facilities charges, demand charges, consumption charges, and the potential for revenue credits.

In the case of a distribution utility, for residential and small commercial customers, the combination of scale economies and class homogeneity may permit the use of a single fixed monthly charge that meets all of the requirements for an efficient rate that recovers the utility’s delivery service (non-energy supply related) revenue requirement that is derived on an embedded cost basis. For larger customers, a combination of these elements permits proper price signals and revenue recovery; however, the tariff design becomes more difficult to structure and likely will no longer meet the requirements of simplicity. Therefore, sacrificing some economic efficiency for a customer class in order to maintain simplicity represents a reasonable compromise. For larger customers, the added complexity of a demand charge may not be a concern. Further, for the largest customers, the cost of metering is customer-specific and each customer creates its own unique requirements for utility distribution service based on factors such as distance from the utility’s transmission system or supply/generation source, gas pressure/voltage requirements, and demand levels.

There are potential conflicts between simplicity and non-discrimination and between value of service and non-discrimination. Other potential conflicts arise where utilities face unique circumstances that must be considered as part of the rate design process.

III. FUNDAMENTAL CONSIDERATIONS FOR SOUND RATE DESIGN

Bonbright identifies the three primary criteria for sound rate design as follows:

• Capital Attraction

• Consumer Rationing

• Fairness to Ratepayers

These three criteria are basically a subset of the list of principles above and serve to emphasize fundamental considerations in designing public utility rates. Capital attraction is a combination of an equitable rate of return on rate base and the reasonable opportunity to earn the allowed rate of return. Consumer rationing requires that rates discourage wasteful use and promote all economically efficient use. Fairness to ratepayers reflects avoidance of undue discrimination and equity principles.

The process of developing rates within the context of these principles and conflicts requires a detailed understanding of all the factors that impact rate design. These factors include:

• System cost characteristics such as established in the Cost of Service Study required by the jurisdictional utility commission, or embedded customer, demand, and commodity related costs by type of service;

• Customer load characteristics such as peak demand, load factor, seasonality of loads, and quality of service;

• Market considerations such as elasticity of demand, competitive fuel prices, end-use load characteristics, and utility bypass alternatives, including the impact of distributed energy resources; and

• Other considerations such as the value of service ceiling/marginal cost floor, unique customer requirements, areas of underutilized facilities, opportunities to offer new services and the status of competitive market development.

In addition, the development of rates must consider existing rates and the customer impact from modifications to the rates. In each case, a rate design seeks to recover the authorized level of revenue based on the billing determinants expected to occur during the test period used to develop the rates.

IV. CONCLUDING REMARKS

The overall rate design process, which includes both the apportionment of the revenues to be recovered among customer classes and the determination of rate structures within customer classes, consists of finding a reasonable balance between the above-described criteria or guidelines that relate to the design of utility rates. Economic, regulatory, historical, and social factors all enter into the process. In other words, both quantitative and qualitative information is evaluated before reaching a final rate design determination. Out of necessity then, the rate design process has to be, in part, influenced by judgmental evaluations.