Cost of Service Studies – Part II

ABSTRACT: The primary purpose of a cost of service study is to allocate a utility’s overall revenue requirements to the various classes of service in a manner that reflects the relative costs of providing service to each class. A cost of service study is an analysis of costs that assigns to each class of customers its proportionate share of the utility’s total cost of service, i.e., the utility’s total revenue requirement. The results of these studies can be utilized to determine the relative cost of service for each customer class and to help determine the individual class revenue responsibility.

IV. Considerations in Selecting Class Cost of Service Methodologies

There is an underlying logic to the choice of the most appropriate demand allocation factor. In the case of production, the choice of an allocation factor depends on how costs are incurred for the capacity portion of production costs. It is a basic proposition of reliable utility service that the utility must have adequate capacity to meet the peak load requirements of its customers plus a level of reserves to maintain reliability. This means that peak load causes capacity costs to be incurred. However, when a utility plans its system, it uses a combination of different technologies to meet both capacity and energy requirements by taking into account the system load duration curve as well as peak load. Typically, some units have high capital costs but low operating costs. Coal and nuclear plants typically have higher capital costs but lower operating costs. Certain intermittent resources such as utility scale solar and wind facilities also have higher capital costs and low operating costs. Units that are designed to run many hours of the year, referred to as baseload units, have the lowest total cost (capital costs and fuel) of any technology for long hours of operation. Units with lower capital cost but higher running costs such as combustion turbines are added to the system to operate flexibly at peak hours and when needed to meet rapidly changing load conditions. The higher cost for a baseload unit is incurred to produce lower annual fuel costs and recognizes that some of the higher capacity cost is offset by fuel cost savings. Under these circumstances, a portion of the cost of a baseload unit is incurred for the purpose of lowering energy costs. Thus, some portion of the capital cost for baseload is related to energy. The AED method recognizes a portion of cost is related to energy and the excess cost is a pure demand related cost.

Even though there are a variety of methods that have been accepted by utility regulators that may produce widely varying allocations for different classes of customers, some methods are more appropriate for a given utility based on the principles of cost causation. Determining the best option for a cost of service study relies on choosing a method that reflects the planning, engineering and operating realities of the particular utility system under review.

Most electric cost analysts look at peak hourly loads as the basis for allocating some or all of the cost of generation capacity. This is a narrow view of how system planners look at the need for capacity additions. To illustrate this point, one must understand the economics and operations of electric power generation. At any moment, the total demand on utility capacity is more than just the utility wholesale and retail load. System planners also include a reserve margin, usually determined as a percentage of peak loads, in order to allow for scheduled maintenance outages, unit forced outages and unit de-ratings. Understanding the utility system is critical to developing the proper measure of the peak demand for purposes of cost allocation.

The foregoing discussion has implications for the choice of allocation methodologies for a number of reasons including recognition of capacity costs incurred to reduce energy costs and the need to understand the critical peaks based on available reserve margins after including the total demand on the system resources.

V. Developing Classes of Service

Historically, classes of service have been based on the principle of homogeneity* . Typically rate classes have included such categories as:

• Class of service – residential, commercial, industrial;
• End-use classification – residential regular, residential all-electric;
• Voltage level of service, i.e., secondary, single-phase primary, three-phase primary;
• Quality of service – firm or interruptible;
• Type of service – full requirements, partial requirements.

Having customers with the same usage characteristics allowed relatively simple rate designs to track costs closely with a limited number of rate elements such as a customer charge and a volumetric energy charge.

There are reasons to question the relevance of current customer class structures. The electric supply market is changing. Perhaps the most important change is the development of a mix of competitive service offerings for electricity generation coupled with the continued monopoly status of other components of electric utility service. Where there is a mix of competition and monopoly in the market, the definitions of classes of service and the related rate structures must evolve to provide for more efficient electricity markets and for rates to be just and reasonable, and not unduly discriminatory. The first step in this process is developing fully unbundled cost of service studies as the foundation for properly designed rates.

However, some of the same concepts that matter today will also matter even more in the future as class costs are evaluated. The following list provides the major elements that will be used to develop rate classes:

• Voltage level of service
• Size of load
• Unique load characteristics and service attributes
• End-use load characteristics.

The voltage level of service is necessary to reflect the cost of distribution facilities and the loss adjustments for both energy and capacity related costs at the point of delivery. The size of the load will be a driver of the appropriate customer related costs because of the higher total cost of local facilities. Unique load and service attributes also impact costs. For customers that have one-of-a-kind service requirements, there will be a need to ensure cost recovery for the unique facilities required to provide service. Certain end use load characteristics must also be identified and managed such as leading or lagging power factor considerations or extra reliability requirements, as examples.

*Composition from like parts, elements, or characteristics.

VI. Summary and Concluding Remarks

Fundamentally, performing cost of service studies is comprised of both art and science. The science of the process involves calculations consistent with the methods outlined in the NARUC Manual. The art of the process involves the subjective application of those methods, in conjunction with consideration of policy objectives, regulatory case law, emerging issues, and other factors, within the framework of the regulatory process.

The cost of service study is useful in identifying cost causation that is a critical element of the allocation of costs between classes and customers within the class, and for adjusting rates to reduce or eliminate cross subsidies that result in rates that are not just and reasonable. A fully unbundled cost of service study provides critical information for the design of just and reasonable rates.