Energy Utility

Rate Setting
A Practical Guide to the Retail
Rate-Setting Process for
Regulated Electric and Natural
Gas Utilities

by Lowell E. Alt Jr.

Faris Hamidi
On The Job Training
(OJT)
Book Review 1
 About the
Author
Lowell E. Alt Jr. is a licensed Utah Division of Public Utilities where
professional electrical engineer and he was an energy advisor to the
former Executive Staff Director of the governor. He has testified in
Utah Public Service Commission. He numerous electric, natural gas and
held several positions in his twenty- telecommunication cases on cost of
five year career in Utah utility service, rate design, rate of return,
regulation including Director of the mergers, interim rates and tariff
policies.
Introduction
Overview of Gas Delivery Scheme
Overview of Energy Utility Regulation

• Regulated energy public utility monopolies have existed since the early 1900s
• Before regulation, competition existed, but resulted in the development of
natural monopolies due to the significant investment needed to provide
service (building infrastructure)
Natural Monopoly
Utilities operate at lower unit costs in a monopoly market than they do under competition, chiefly
because they achieve decreasing average unit costs as output increases. This occurs because the
heavy fixed costs of these industries are distributed more thinly to each unit of output as
production rises (i.e., economies of scale). By serving an entire market without competition,
utilities can concentrate their production in larger and more efficient plant and equipment,
producing services at lower operating expenses and less plant investment per unit of output than
smaller facilities.

Regulation → to protect the public

from adverse monopoly practices

The role of regulation → to act as

substitute for competition; to look
for the broad public interest; to
balance the interest of the utility
against that of the utility’s customer;
to ensure just and reasonable utility
rates and safe, reliable and adequate
utility service
• Public utility regulation evolution in U.S. :

1985 Federal
State laws
Energy Wellhead
allow energy
Regulatory Decontrol Act 1992 FERC
public utility
Commission of 1989: Order 636
monopolies
(FERC) Order deregulated required gas
and provide
436: required natural gas sales to be
for regulatory
natural gas allowing unbundled
oversight, and
pipelines to prices to be from
also granted
provide open set by market transportation
certificates for
access to supply and services
exclusive
transportation demand
service areas
services
 Regulator

❑ Bargain between
regulator and regulated
utility
❑ Private property put to
use in the public interest Shareholder
❑ Government will protect / Utility
the interests of both the Owner
consumer and the utility
❑ Utility has both rights
and responsibilities

Customer
Revenue Requirement
Revenue Requirement
• “Revenue requirement is the total annual revenue required by a public utility to
recover the cost of providing utility service to it’s customer including a fair return
on it’s investment.”
• The public service commission (regulator) sets the revenue requirement in a
utility rate case.
Revenue Requirement
• History/milestone in development of Revenue Requirement
formulation method:

✓ In 1923 Blue Water Works v. Public Service Commission of West

Virginia, it is stated that a public utility was entitled to earn a
return on the value of it’s property used in providing service
that is equal generally to the return earned by business with
comparable risk.

✓ In 1944 in Federal Power Commission v. Hope Gas Company, it is

stated that a utility’s revenues should be sufficient to cover
operating expenses and the capital costs of the business with
the return to the equity owner commensurate with return on
investments in other business with comparable risk.
Revenue Requirement

Revenue Requirement Calculation (example)

A Total Expenses ($) 1,278,500
B Total Rate Base ($) 1,763,432
C Cost of Capital 7.65%
D Return ($) on Rate Base (C x B) 134,903
E Revenue Requirement ($) (A + D) 1,413,403
Revenue Requirement

• Revenue Credits:
Utility may get revenues from sources other than rates and
charges to its retail customers. Commissions may determine a
utility’s revenue requirement by including all expenses and
investment and then substracting the revenues from these
other sources.
Revenue Requirement

• Revenue Conversion Factor

Use of the Revenue Conversion Factor (*example)
A Revenue ($) 1,404,902
B Expenses ($) 1,275,000
C Net Income ($) (A - B) 129,902
D Rate Base ($) 1,763,432
E Allowed Rate of Return 7.65%
F Allowed Return ($) (D x E) 134,903
G Return Deficiency ($) (F – C) 5,001
H Tax Rate 37%
I Revenue conversion factor (1-H)/H 1.70
J Adjusted revenue deficiency ($) (I x G) 8,501
K Income tax expense adjustment ($) (J – G) 3,500
L Adjusted expenses ($) (B + K) 1,278,500
M Revenue requirement ($) (F + L) 1,413,403
Rate Base
Rate Base

• Rate Base represents the capital utilities have invested in order to provide
service to customers.
• Rate Base is composed of several elements or types of capital investments;
some are additions to rate base, such as investments in facilities, while
some deductions, such as accumulated depreciation.

Average Rate
Rate Base
Base: average
Value: original
of beginning
cost of facilities,
and year-end
less
figures or a
accumulated
thirteen-month
depreciation
average
Rate Base

• Plant in Service : the largest category of capital investment/rate base

(transmission & distribution pipelines, metering equipment, compressor
stations, office buildings, computers, etc.).
• Accumulated Depreciation : to recognize the limited timespan of plant
investment that become obsolete over time. Utilities are allowed to treat
depreciation as an expenses. Regulation bodies usually uses the straight-line
method to determine annual depreciation (further explained in Expense
section).
Rate Base

• Materials and Supplies : Investment in materials and supplies are included

in the calculation of rate base if judged prudent. Utilities must keep spare
parts or equipment for any equipment or facilities used.
• Fuel Stock : Fuel stock is considered an investment and included in rate
base if judged prudent.
• Prepayments: prepayments that a utility makes for expenses such as
insurance or rents are included in rate base if judged prudent.
• Cash Working Capital : the money a utility needs to pay its operating
expenses necessary to provide service until the revenues from that service
are received.
• Customer Deposits: A utility, with public service commission approval, may
require some new customers to provide a security deposits as a condition of
service.
Rate Base

• Construction Work in Progress: Utilities often must make investments

during construction of facilities. A new natural gas pipeline may take months
to construct. The cost incurred is kept in an account called construction work
in progress (CWIP).
• Plant Held for Future Use: a utility may acquire property in advance of
actual need as part of a definite plan for the property’s future use
• Accumulated Deferred Income Taxes: Income taxes are calculated on net
income that results from subtracting expenses from revenue. Depreciation
expense is one of those expenses.
• Acquisition Adjustment: When utilities acquire property owned by others,
the price paid is often higher than the first owner’s original cost or the book
value. Book value is the original cost less accumulated depreciation. This
premium paid above book value is termed acquisition adjustment (may/not
may allowed as an addition to rate base).
Rate Base

• Rate Base Example:

Rate Base Elements (*example) Amount ($)
Plant in Service 2,300,000
Materials and supplies 70,000
Fuel stock 6,562
Prepayments 4,000
Cash working capital 76,870
Construction work in progress 5,000
Plant held for future use 3,000
Total Additions 2,465,432
Accumulated depreciation 680,000
Customer deposits 2,000
Accumulated deferred income taxes 20,000
Total deductions 702,000
Total Rate Base 1,763,432
Cost of Capital
Cost of Capital

• Cost of Capital used in calculating a utility’s revenue requirement is a

weighed-average cost of all sources of long term capital. This weighed-
average cost of capital becomes the rate of return on rate base that a utility
is allowed to earn.
• The source of capital used by a public utility to fund the needed large
investment commonly comes from three different sources:

Common Preferred
Bonds (Debt)
Stock (Equity) Stock
Cost of Capital

• The utility’s weighed average cost of capital is determined by first calculating

the average cost of each of the sources of capital and then weighing each
source by the percentage of the total capital from that source.

Source Percentage Cost Weighed Cost

Debt 55% 6% 3.30%
Preferred Stock 5% 7% 0.35%
Common Equity 40% 10% 4.00%
Totals 100% 7.65%
Cost of Capital

• Capital Structure:
• Market cost of common equity normally is higher than debt because
common stock in a firm carries more risk than its bonds (long terms).
• Bond rating agencies consider utilities more risky with a higher percentage
of debt in its capital structure. This increased risk is normally reflected in a
higher cost of common equity.

Risk of Risk of
Risk of
Common Preferred
Bonds (Debt)
Stock (Equity) Stock
Cost of Capital

• Preferred Stock: is a class of stock that is preferred as to its dividends. This

preferred stock entitles its holders to a dividend at a fixed rate before any
dividend is paid on the common stock.
• Debt: the common types of debt used in a utility’s capital structure are a
ling-term bonds. The cost of the utility’s bonds is determined by the capital
market at the time of the sale or issuance of the bonds and remains fixed for
the term of the bonds.
• Bond Ratings: agencies such as S&P/Moody’s use a number of financial
ratios such as pretax interest coverage, etc. The higher the bond ratings a
utility gets, the lower the interest rate it must pay on bonds it sells in
financial markets.
• Common Equity: is the capital provided by common stockholders in a
company.
Cost of Capital
Discounted Cash Flow Model: based on the theory that the market price (or
value) of a stock equals the present value of all future incomes, including
dividends and capital gains from the sale of the stock

k = required rate of return

Di = the next expected dividends
P0 = current market price of stock
g = constant dividend growth rate

Percentage (*example)
D1 Expected next annual dividend $2.50
P0 Current market price of stock $50.00
g Long term dividend growth rate 6%
k Rate of return on equity (D/P + g) 11%
Cost of Capital
Cost of Capital

CAPM Calculation (example)

Rf Risk free return 5%
Rm-Rf Market premium 6%
β Beta of the stock 0.8
k Rate of return on equity = Rf + β (Rm-Rf) 11%
Expenses
Expenses
Expenses included in the calculation of a utility’s revenue requirement are those
determined to be reasonable in amount and necessary for and related to the provision
of utility service or in some way benefit customers. Utility expenses that benefit only
company shareholders are normally not allowed in the revenue requirement. Expenses
normally included in the calculation of revenue requirement but not limited to:
Customer
Operation & Depreciation & Amortization: Plant
Accounts:
Maintenance: or facilities wear out or become Taxes:
Utilities must
Utilities incur obsolete over time. Depreciation is Utilities pay
maintain a
expenses in a term used to recognize this many types
customer account
operating and limited life span of plant. of taxes in
system to keep
maintaining Amortization is often used in utility providing
records of customer
facilities used to rate case to spread the cost of an service to
energy usage,
provide services unusual investment or expense customers.
billings and
to customers. over a few years.
payments.
Administrative and General: .
Customer Service: Regulated utilities are
include employee salaries not chargeable to a
expected to provide good customer service
particular utility function, benefits and
pensions; office supplies; insurance; outside Uncollectibles: Utilities normally have a
services; franchise requirements and number of customer that do not pay their
regulatory expenses. bills for a variety of reasons.
Expenses: Straight Line Depreciation

The straight-line depreciation method

assumes a constant rate of depreciation. It
calculates how much a specific asset
depreciates in one year, and then
depreciates the asset by that amount every
year after that.

Straight line depreciation is used to write

off the same amount every year
 Expenses (*example)
Expense items Amounts ($) Expense items Amounts ($)

Production Distribution Maintenance

Purchased power-demand 170,000 Station equipment 2,500
Purchased power-energy 370,000 Overhead lines 35,000
Hydro operation & maintenance 80,000 Line transformers 2,000
Other operation & maintenance 70,000 Meters 1,500
Fuel 250,000 Subtotal 34,000
Subtotal 940,000 Customer
Transmission Meter reading 9,000
Operation & maintenance 35,000 Records & collection subtotal 25,000
Distribution Operation Subtotal 34,000
Station 12,000 Adm & Gen. Depreciation
Overhead lines 35,000 Distribution, Production, 78,000
Transmission, General
Meters 2,000
Taxes 33,500
Subtotal 41,000
TOTAL EXPENSES 1,275,000
Revenues
Revenues

• Revenues are evaluated in a utility rate case to determine the amount of

revenue deficiency projected to occur in the test period. The revenue
deficiency is the difference between the revenue expected from current
customer rates in the rate case test period and the calculated revenue
requirement. This revenue deficiency represents the amount of revenue
increase the utility needs to be able to cover the cost of providing service.

Other Revenues: Unbundled Revenue Imputation:

utilities may get Revenues: is the assumption of
revenues from are expected additional utility revenues
sources other revenues for service based on the result of an
than rates and provided but not yet action deemed prudent, but
charges to its billed. A utility often not taken by the utility.
retail customers. has several meter Regulators may use
Some utilities reading and billing revenue imputation to
provide services cycles in a month in adjust the outcome of utility
to other utilities order to spread the actions that the commission
such as billing or work more evenly deemed imprudent, but did
maintenance. over the month. not need or get approval..
Rate-Making Objectives
Rate-Making Objectives
• A utility expects the set rates to yield revenues sufficient to cover its costs under varying
conditions. Objectives change over time. Often these rate-making objectives come into
play after the total revenue requirement has been established and during the actual
setting of rates.
• Cost of Services studies involves some decisions that can be guided by rate-making
objectives.
• Commonly used rate-making objectives include simplicity, revenue and rate stability, fair
cost apportionment, avoidance of undue discrimination, efficiency and conservation.
Cost of Service
Cost of Service
Cost of service for all of the retail customer of a utility is the total company
revenue requirement. Once the total revenue requirement has been determined,
the next step in the process of setting rate begins. Typically, the next step is the
determination of the cost of service, or revenue requirement for each class of
customers that separate rates are desired.

Customer Rate Classes:

• Simple rates may be perceived as unfair, may fail to recognize cost differences,
may encourage waste, may result in large subsidies between groups of
customers, may not encourage appropriate energy use and may divert use to
cheaper energy sources resulting in stranded cost.
• There are usage or service characteristic that may be different for different
customer include delivery voltage or pressure, maximum demand, peak day
use, load factor (ratio of average demand per peak demand), time of use,
metering requirements and coincidence with system peak load.
Cost of Service
• Cost of Service Study: is a process used to assign or allocate a fair share of
the total cost or revenue requirement of a utility to the various customer rate
classes or schedules. The end result is the cost of service or revenue
requirement for each rate class or schedule.

Common Cost:
are those that
Direct Assigned Joint Cost: are
common to all
Cost: are cost those clearly
rate classes yet
directly caused caused by two or
not directly
by only a single more rate classes
caused by any
rate schedule. or schedule.
single rate
classes.
 Cost of Service
• Cost of Service Study Steps:
Classification:
Allocation:
is the further
is the
division of
apportionme
Direct costs into
nt of joint
Assignment: groups
Functionalization: costs among
is the bearing a
is the two or more
assignment relationship to
arrangement of rate classes
to a rate class a measurable
cost according to in
of any cost cost-defining
major functions accordance
that clearly service
which begins with with each
are caused characteristic.
the Universal class’s
(incurred) by Example for
System of relative share
or for only typical natural
Accounts. of a
that rate gas utilities:
measurable
class. customer,
cost-defining
commodity
service
(energy),
characteristic.
demand.
Cost of Service
Cost-defining
Demand: function of
service customer’s maximum
characteristic in demand which related
Classification Step: to the capacity of the
customer’s connected
appliances. A utility
must size all parts of
its system to handle
the peak load at any
given hour.
Commodity (Energy): Customer: customer
commodity related related cost are a
cost are a function of function of the
the customer’s volume number of customers,
or duration of use since each and every
(KWh/BTU/therms). customer causes
these cost.
Cost of Service: Functionalization
example for electric utility

Poles,
Towers, Meters Fuel Costs
Backbone &
Subtransmission
Inter-tie
Fixtures Plant
Facilities
Generation
Line Step-Up
Facilities
Transformers Purchased
Production
Plant Costs Power

Distribution Production Transmission

Cost of Service: Classification
example for electric utility

Distribution Production Transmission

• Poles, towers, fixtures • Production Plant • Backbone & Inter-tie

• Line transformers • Fuel costs Facilities
• Meters • Purchased Power • Generation Step-up
• Station Equipment Facilities
• Subtransmission Plant

Demand & • Line transformers Demand • Purchased Power Demand & Energy
Customer • Poles, towers, fixtures
&
• Production Plant
Energy • Transmission costs are
charged to utilities based
Demand • Station Equipment
on MISO schedules,
some of which are based
Energy • Fuel costs on demand, some on
Customer • Meters energy.
Cost of Service

• Example of Allocation of Cost:

• For example, assume there are three natural gas customer rate
schedules: residential, commercial and industrial. Assume only energy
cost are included in the calculation.

(xample) Total Residential Commercial Industrial

Decatherms 10,000 3,000 2,000 5,000
Percentage 100% 30% 20% 50%

Gas Cost ($) 80,000 24,000 16,000 40,000

Cost of Service
• Generation Cost Allocation Methods:
Coincident Peak Method:
This method is based on
peak demands that are
perceived as the cause of
system demand related
costs such as generation
(electric).
Average and Excess Method:
this method uses two components
that are summed to develop the
allocation factors (1. each class’s
share of the total system average
demand times the system load
factor; 2. each class’s share of the
excess demand times one minus the
system load factor).
Weighed-Coincident Peak
Method:
This method applies weights
to the coincident peak
allocation factor. This method
might be used to recognize
the importance of energy
costs in the choice of
generation investments.
Other Generation Allocation Method :
Method such as all peak hours approach, the
equivalent peaker method, the base and peak
method, the peak and average demand method,
the production stacking method, the base-
intermediate-peak method, the loss of load
probability production cost method, the
probability of dispatch method can be further
reviewed in the 1992 NARUC Electric Utility Cost
Allocation Manual.
Cost of Service

• Allocation example using Coincident and Weighted-Coincident

Peak Method for Generation Cost :
Total Residential Commercial Industrial

A Sum 12 coincident 42,000 6,000 15,000 21,000

peaks @ Generator
(KW)
B Demand allocation 1.000 0.1429 0.3571 0.5000
factor (ratios for A)
C KWh @ meters 20,822,727 2,694,545 7,928,182 10,200,000

D Energy allocation 1.000 0.1294 0.3807 0.4898

factor (ratios for C)
E Demand weighting 0.75 0.1071 0.2679 0.3750
(B x 0.75)
F Energy weighting 0.25 0.0323 0.0952 0.1225
(D x 0.25)
G Weighed 12 CP 1.000 0.1395 0.3630 0.4975
allocation factor (E
+ F)
Cost of Service

• Distribution Allocation Methods:

• Costs such as meters that have been classified as customer-related might be allocated
using a weighted-customer factor. This factor, for example, may be calculated by
multiplying the average number of customers in each class by the average meter
investment for each class.

• Rate of Return Analysis:

• The earned rate of return on rate base is calculated for each rate schedule so that it may
be compared with the target system average rate of return. The target system average
rate of return is the commission-determined allowed rate of return on rate base for the
utility as a whole. The earned rate of return is calculated by substracting the allocated
expenses for a rate schedule from its test period revenues to get net income or return
which is then divided by the rate schedule’s allocated rate base.
• Under the aforementioned principle, a rate schedule that has an earned rate of return on
rate base of less than the target system average is not covering its costs and needs a
rate increase.
Cost of Service
Cost of
Service
Principles: Equal Rate of Return:
are a traditional
measure of a fair
sharing of total costs
among rate classes or
schedules.
Gradualism:
is a principle used in
implementing cost of
Cost Causation: service study results.
is the principle that Cost of service is a
cost should be borne moving target
by those who cause because of shifts in
them to be incurred. cost allocations over
time due to changing
service
characteristics.
Cost of Service
• Load Research Study:
• A load research study is done to estimate demand data for customer rate schedules that
do not have time of day demand meters. To properly allocate demand related costs, the
relative coincident peak demands of each rate schedule are used.

• Unit Costs:
• In the pursuit of cost-based rates, unit costs are often used in the design of retail rates.
The calculation of unit costs can be done as an added step to a cost of service study.
This step is accomplished by first calculating the total cost, for each of the previously
discussed cost classification categories (demand, commodity, and customer), for each
rate class or schedule. The total demand cost for a particular rate is divided by the total
monthly billing demand units for that rate schedule to get a unit demand cost in dollars
per kilowatt per month. The same method were applied to commodity and consumer
costs.
Case for
Load
Factor
Study
Rate Design
Rate Design
• Rate design is the development of prices for utility service. The utility’s tariff is a
collection of all the different rate schedules offered and the related prices and terms and
conditions for service. A rate schedule contains a set of prices for a particular utility
service together with some conditions of service.
• Rate design involves the formulation of prices for specific rate elements that will, when
multiplied by the related test period billing units, recover the revenue requirement for
each rate schedule and meet other rate-making objectives.

• Rate Design Objectives:

• Some of the objectives used include recovery of the class revenue requirement; simple,
understandable and acceptable for customer; rate stability; revenue stability; correct
price signal; fair cost apportionment among customers within the class; ease of
administration; economic efficiency; nondiscriminatory; and conservation of resources.
Rate Design
• Rate Elements:
• Rate Elements are the separate prices or charges for a single rate schedule that are
related to individual utility service characteristics. Common rate elements include energy
or commodity charges, demand charges, customer charges and fuel adjustment charges.
• These are the commonly included elements in rate design:
1. Energy or commodity charge
2. Customer charge
3. Minimum charge
4. Demand charge
5. Fuel adjustment charge
6. Power factor charge
7. Connection charge
8. Facility charge
Rate Design

• Variations of Rate Elements:

• Some rate elements such as energy charges or demand charges are implemented in rate
schedules in many different variations:
1. Flat Rates: only one rate for all levels of usage
2. Declining Block Rates: prices that decline with increasing blocks of usage
3. Inverted Block Rates: prices that increase with increasing blocks of usage
4. Seasonal Rates: prices that vary by season
5. Time-of-Day Rates: prices that vary by different time periods of the day
Rate Design
• Cost of Service study discussed the use of multiple rate schedules for pricing of energy to customers.
The number of rate schedules offered varies from utility to utility. The variations usually are as
follows;
1. Interruptible: sometimes offered to large commercial/industrial customers. The interruptible rate
schedule offers customers lower rates than for normal service. Interruptible customers are those
willing to accept occasional service interruption, when the system might need or benefit from the
load reduction, in return for the lower rates.
2. Standby: prices for service only needed occasionally by a customer. The customer normally uses
another energy source other than the local utility, but might still need the utility as a backup or
standby energy source if needed.
3. Lifeline: are discounted rates available only to low-income residential customers.
4. Lighting: may be offered that apply only to electric lighting loads such as street lights, area lights or
ball park lights
5. Natural Gas Vehicles: may be offered for service to refuel natural gas-powered vehicles with CNG at
utility-owned refueling stations.
6. Natural Gas Transportation: Rate schedules may be offered from firm or interruptible transportation
of natural gas from interstate pipelines over the natural gas utility’s system to the customer’s
premises.
7. Tariff Riders: is a separate rate schedule that spells out a special additional rate to be changed to all
customers on a number of other rate schedules.
8. Special Contracts: a special contracts is a contracts between the utility and a single large customer
for utility service with rates, terms or conditions different from those found in normal rate schedules.
Example
for Electric Utility
Example

Source Percentage Cost Weighed

Cost
Debt 55% 6% 3.30%
Preferred Stock 5% 7% 0.35%
Common Equity 40% 10% 4.00%
Totals 100% 7.65%
 Example
• 3. Expenses

Expense items Amounts ($) Expense items Amounts ($)

Production Distribution Maintenance

Purchased power-demand 170,000 Station equipment 2,500
Purchased power-energy 370,000 Overhead lines 35,000
Hydro operation & maintenance 80,000 Line transformers 2,000
Other operation & maintenance 70,000 Meters 1,500
Fuel 250,000 Subtotal 34,000
Subtotal 940,000 Customer
Transmission Meter reading 9,000
Operation & maintenance 35,000 Records & collection subtotal 25,000
Distribution Operation Subtotal 34,000
Station 12,000 Adm & Gen. Depreciation
Overhead lines 35,000 Distribution, Production, 78,000
Transmission, General
Meters 2,000
Taxes 33,500
Subtotal 41,000
TOTAL EXPENSES 1,275,000
Example
• 4. Rate Base

Rate Base Elements Amount ($)

Plant in Service 2,300,000
Materials and supplies 70,000
Fuel stock 6,562
Prepayments 4,000
Cash working capital 76,870
Construction work in progress 5,000
Plant held for future use 3,000
Total Additions 2,465,432
Accumulated depreciation 680,000
Customer deposits 2,000
Accumulated deferred income taxes 20,000
Total deductions 702,000
Total Rate Base 1,763,432
Example
• 5. Return Deficiency Adjustment

Use of the Revenue Conversion Factor

A Revenue ($) 1,404,902
B Expenses ($) 1,275,000
C Net Income ($) (A - B) 129,902
D Rate Base ($) 1,763,432
E Allowed Rate of Return 7.65%
F Allowed Return ($) (D x E) 134,903
G Return Deficiency ($) (F – C) 5,001
H Tax Rate 37%
I Revenue conversion factor (1-H)/H 1.70
J Adjusted revenue deficiency ($) (I x G) 8,501
K Income tax expense adjustment ($) (J – G) 3,500
L Adjusted expenses ($) (B + K) 1,278,500
M Revenue requirement ($) (F + L) 1,413,403
 Example
• Cost of Service Study:
• 6. Direct Assignment
• No cost were direct assigned in this example in order to keep it simple
• 7. Functionalization
• The functionalization step is considered already done by the booking of the utility’s costs into
functional accounts in the Uniform System of Accounts (USA). Production, Transmission and
Distribution costs are assumed to have been booked into the respective functional accounts in
the USA.
• 8. Classification
Classification Factors CF Total Demand Energy Customer

Demand 1 1.000 1
Energy 2 1.000 1
Customer 3 1.000 1
Distribution Plant 4 1.000 0.8853 0.0000 0.1148
General Plant 5 1.000 0.7995 0.1294 0.0711
Transmission Plant 6 1.000 1.0000 0.0000 0.0000
Production Plant 7 1.000 0.3290 0.6711 0.0000
Prod + Transmis + Dist Plant 8 1.000 0.7995 0.1294 0.0711
Hydro Plant 9 1.000 0.1639 0.8361 0.0000
Other production Pplant 10 1.000 1.0000 0.0000 0.0000
Rate Base 11 1.000 0.7804 0.1500 0.0696
Example
• Cost of Service Study:
• Each cost item is multiplied
by the three decimal
fractions of the selected
classification factor
Example
• Cost of Service Study:
• The same applied for
expenses
 Example
• Cost of Service Study:
• 9. Allocation
• Is the apportionment of joint costs among two or more rate classes in accordance with each
class’s relative share. In this step customer load data is needed to develop allocation factor. For
example, the data (only for residential class) is obtained from meter readings and load research
data.

Classification Factors Jan Feb Mar

A Kilowatt-hours from meter readings 346,654 286,431 257,184

B Secondary energy loss factor from loss study 1.10 1.10 1.10
C Kilowatt-hours @ generators (A x B) 381,320 315,074 282,902
D Load factors from load research study 0.150 0.148 0.143
Sum of max customer demands (in kilowatts) (A/(D 3,106 2,880 2,417
E
x hours in month))
Schedule coincidence factors from load research 0.280 0.300 0.380
F
study
G Schedule peak @ meters (kilowatts) (E x F) 870 864 919
H Secondary demand loss factor from loss study 1.11 1.11 1.11
I Schedule peak @ generator (kilowatts) (G x H) 965 959 1,020
System coincidence factors from load research 0.620 0.625 0.660
J
study
K Coincidence peak @ generator (kilowatts) (I x J) 599 599 673
 Example
• Cost of Service Study:
• 9. Allocation
• The table below summarizes the annual load data from the prev. table and for commercial and
industrial classes (not shown).
Summary – Load Data Total Residential Commercial Industrial

Kilowatt-hours @ meters 20,822,727 2,694,545 7,928,182 10,200,000

Kilowatt-hours @ generator 22,497,000 2,964,000 8,721,000 10,812,000
Kilowatt @ meters 90,451 26,778 40,969 22,704
Average # of customers 640 400 190 50
Sum 12 Coincident Peaks @ generator 6,000 15,000 21,000
42,000
(kW)
 Example
• Cost of Service Study:
• 9. Allocation

Allocation Factor AF Total Residential Commercial Industrial

Demand – sum 12 CP 1 1.0000 0.1429 0.3571 0.5000

Energy-kilowatt-hours 2 1.0000 0.1318 0.3877 0.4806
Average # customers 3 1.0000 0.6250 0.2969 0.0781

Allocate Expenses AF Total Residential Commercial Industrial

Demand 1 518,777 74,111 185,277 259,388

Energy 2 709,642 93,496 275,094 341,052
Customers 3 50,081 31,301 14,868 3,913
Total Expenses 1,278,500 198,908 475,239 604,353

Allocate Rate Base AF Total Residential Commercial Industrial

Demand 1 1,376,256 196,608 491,520 688,128

Energy 2 264,468 34,844 102,521 127,103
Customers 3 122,708 76,692 36,429 9,587
Total Rate Base 1,763,432 308,144 630,470 824,817
 Example
• Cost of Service Study:
• 9. Allocation

Return on Rate Base Total Residential Commercial Industrial

Equal Rates of Return 7.65% 7.65% 7.65% 7.65%

Demand 105,284 15,041 37,601 52,642
Energy 20,232 2,666 7,843 9,723
Customer 9,387 5,867 2,787 733
Total Return ($) 134,903 23,573 48,231 63,099

Total Cost of Service Total Residential Commercial Industrial

Return ($) + Expense ($) 7.65% 7.65% 7.65% 7.65%

Demand 105,284 15,041 37,601 52,642
Energy 20,232 2,666 7,843 9,723
Customer 9,387 5,867 2,787 733
Total Cost of Service ($) 134,903 23,573 48,231 63,099
 Example
• Cost of Service Study:
• 9. Unit Cost
• Unit cost are calculated by dividing the total annual cost of service by the total annual billing
units. To get a monthly unit customer cost, the annual customer billing units must be calculated.
This is equal to the average number of customers over the year times twelve months.

Annual Billing Units Total Residential Commercial Industrial

Avg. # of customers x 12 months 7680 4800 2280 600

Metered energy (kWh) 20,822,727 2,694,545 7,928,182 10,200,000
Metered demands (kW) 90,451 26,778 40,969 22,704

Total Unit Cost of Service Total Residential Commercial Industrial

Demand cost ($/kW/month) 6.90 3.33 5.44 13.74

Energy cost (cents/kWh) 3.51 3.57 3.57 3.44
Customer cost ($/customer/month) 7.74 7.74 7.74 7.74
 Example
• Cost of Service Study:
• 10. Rate Design
• The following table shows three common alternative rate designs for monthly charges using
average embedded costs of service unit costs. All three are expected to recover the utility’s
revenue requirement. The choice among the three alternatives would normally be made based
on other rate design objectives beyond revenue requirement recovery.

Annual Billing Units Residential Commercial Industrial

1. Energy charge (cents/kWh) 8.26 6.60 6.54

2. Customer + energy charges
Customer ($/month) 7.74 7.74 7.74
Energy (cents/kWh) 6.88 6.38 6.50
3. Customer + Energy + Demand
charges
Customer ($/month) 7.74 7.74 7.74
Energy (cents/kWh) 3.57 3.57 3.44
Demand ($/kW) 3.33 5.44 13.74
 The End
Thank You