Alternatives to Cost of Service: Not really
By
Branko Terzic
A while back I was asked to offer an alternative to cost-of-service (COS) regulation for a state-owned utility which was required to be financially self-sufficient. In other words, revenues had to recover all costs with no tax subsidy.
This is, of course, the same requirement of investor-owned utilities ( IOU) here in the U.S., Europe, Japan, United Kingdom and elsewhere, and potentially even for municipal utilities that are operated as free standing enterprises based on actual costs rather than subordinate city departments expected to support overall municipal budgets with customer revenues. To jump to the ending, I did not find any other method superior to the proven, objective, verifiable cost-of-service method.
Of course, public ownership sometimes is put forward in the U.S. as an alternative to an IOU monopoly under regulation but the technical matter of ownership does not address the required method of rate making. Even a municipally owned utility must recover its cost of service in rates absent tax support.
One alternative to COS considered was to set rates based on a “benchmark” of one or more rates from some other jurisdiction or country. This would, in practice, transfer ratemaking authority to whoever set rates for the “benchmark” utility. The next question is whether detailed rate design would also be copied from the “benchmark”. Finally, what is too be done if the rates set by “benchmark” do not produce sufficient revenue to make the target utility financially viable? Or in the opposite case what if the benchmark rates produce “excess” revenue. In this case “excess” would be defined as collecting a large surplus to accounting requirements.
The concept of “benchmarking” has usefulness for checking standard or universally incurred costs under similar conditions and technologies but not for setting rates.
Some analysts have viewed indexing and performance-based rates (PBR), as in the UK’s RPI-X formula, as an alternative to COS but this rate adjusting method is just a variant of COS as rates are reset to COS after some period of indexing.
Circa 2000 after the abandonment of communism in Central and Eastern I was informed that state-owned electric enterprises in Europe’s communist countries studied electric rates in the Western European democracies for guidance. Each year the there was a calculation done of what percentage of Western European household incomes was needed to pay monthly electric bills. So, if the Western Europeans households were spending 5% of income on electricity, then electric rates in the communist country would be set at whatever it took to produce 5% of local household monthly income. Shortfalls in revenue were made up in state budgets by other sources of revenue. Another method inapplicable to our situation.
A series of U.S. Supreme Court rulings have allowed the Federal Energy Regulatory Commission (FERC) to set rates in any way which would ensure that COS was collected including the opportunity for a fair return on investment. That meant the Court had agreed with earlier decisions resulting in three approved ways:
- using a “fair value” rate base with COS,
- using an “original cost” rate base with COS, or
- regulating a market to insure “market based” rates.
In the case of a monopoly electric utility ( vertically integrated with generation, transmission and distribution) or one with just transmission and distribution services) the “market based” option does not yet exist.
Competition could be introduced in the electric utility industry if new state laws would permit multiple franchise holders for distribution and transmission systems. This would mean that eventually our cities, towns and country sides would have duplicate or triplicate electric grids.
Implicit in such a decision to duplicate the electric grid would be some transition or substitution to the prior rules requiring universal service and prohibitions against discriminatory connection and disconnection and rates practices. For example, the new distribution service entrant may offer deeply discounted rates to the first vintage of customers to reach critical mass, and then raise rates to later customers. The question of what, if anything, to regulate would loom large.
The economic and political consensus a century ago was that duplication of facilities would result in higher costs to consumers than that of a single system. Proponents of introducing such competition would need to make the case that due to technology that assumption was no longer correct.
The COS methodology for rate setting is used by IOU and public owned electric utilities for good reason. The system works when applied correctly.
The Honorable Branko Terzic is a former Commissioner on the U.S. Federal Energy Regulatory Commission and State of Wisconsin Public Service Commission, in addition to energy industry experience was a US Army Reserve Foreign Area Officer ( FAO) for Eastern Europe (1979-1990). He hold a BS Engineering and honorary Doctor of Sciences in Engineering (h.c.) both from the University of Wisconsin- Milwaukee.
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