Setting Your Retail Rates Correctly

By October 16, 2014 February 19th, 2015 uPDate

Retail rate setting has become much more challenging in recent years in response to time-differentiated wholesale rates and demands by consumers for more rate options. These challenges have only been exacerbated by seasonal weather variations, making it more difficult to implement retail rates that collect sufficient revenues to recover distribution costs while providing an adequate margin to cover contingencies.

The first and most obvious test for whether retail rates are set properly is to do a quick revenue requirement analysis. Adequate and appropriate cost recovery is essential for maintaining a financially viable power distributorship. A good rule of thumb, which has proven effective over many decades, is that the net income from electric sales should generate a revenue margin of one to two percent. This is only considering the electric sales revenue and not the other miscellaneous sources such as pole attachment fees, late payments and interest on cash reserves. This one to two percent should be margin from the core business, not from other activities that may or may not generate revenue over the long term. If the margin from electric sales revenue is below one percent, there may be an inadequate margin to sustain the utility through unforeseen problems, and to adequately address future system enhancements.

In recovering total costs, it is essential to differentiate and recover appropriate costs for both wholesale power and retail distribution. For this discussion, we focus only the distribution costs incurred in delivering electricity to consumers. These distribution costs include expenses associated with substations, distributions lines, transformers, capacitors, regulators, meters, and billing, as well as administrative and general costs.

A Cost of Service Study (COSS) is a key consideration in establishing appropriate rates classes. With the utility’s revenue requirements identified, a COSS provides the information needed to design rates that recover expenses from each of the major classes of consumers. A COSS excluding wholesale power costs should be calculated to determine if the present rates adequately recover revenue from the various rate classifications. In a COSS, the total costs are separated into both fixed and variable costs, since monthly charges to consumers are both fixed and variable. Fixed costs do not vary with usage and are recovered by the distributor through customer charges. Variable costs are sensitive to the amount of energy used, and may be either demand or energy charges. A COSS often reveals that 75% or more of distribution costs are fixed, occurring monthly, and should be recovered from the rate structure as fixed revenue. In recent years, power distributors have been recognizing that salaries, insurance, interest and depreciation and many other expenses are totally independent of energy sales. As a result, customer charges have been rapidly increasing to maintain a more constant revenue stream, regardless of the level of sales.

There are several advantages of recovering more fixed costs through customer charges. First, this allows the more timely recovery of costs for facilities for new services. Secondly, higher customer charges assure a more steady revenue stream to pay ongoing operational expenses that do not fluctuate significantly with energy sales. Thirdly, a larger customer charge is consistent with the distributor charging for being the “wires company” and simply delivering the wholesale energy product over its facilities. This decoupling of retail rates from wholesale rates is essential to allowing the utility to fully support and promote conservation and alternative energy sources like solar, wind and biomass. Finally, larger customer charges provide a slight advantage with leveling the retail billing by increasing the costs during off-peak periods and lowering costs during peak times.

As technology evolves, it will become increasingly more important for electric power distributors to know more about how their retail customers use electricity, and how loads vary with weather patterns. This information is essential when implementing peak shaving strategies to minimize wholesale power costs. With the advancing technology in AMI, a wealth of information is now available, offering opportunities for distributors to further refine their retail rate structures, and more accurately recover costs while maintaining adequate operating margins. Load research studies should be performed using this data to help refine retail rates to fully recover expenses and maintain adequate margins.