NARUC Energy Regulatory Partnership Program The Georgian National Energy Regulatory Commission and The Vermont Public Service Board by Ann Bishop Vermont Public Service Board June 28, 2008 Tariff Development II: Rate Design

2 Overview v What is rate design? v Rate design objectives v Steps in developing a rate design –Determine customer groups –Allocate costs among customer groups –Assign costs to individual rate components v Issues with tariff design

3 What Is Rate Design? v Rate design is the structure of a utility’s rates; rate design determines the prices customers pay for utility services v Rate designs vary from utility to utility v All rate designs address: –Customer classes –Types of charges (customer, energy, demand) v Some rate designs also address: –Time (real-time, time-of-day, season of year, etc.) v Rate design is highly technical and detailed, but it is more art than science

4 Rate Design Objectives v Rate design has a variety of objectives, some of which conflict with each other v Revenue-related objectives: –Rates should yield the total revenue requirement –Rates should provide stable and predictable revenues

5 Objectives of Rate Design v Cost-related objectives: –Rates should be set to promote economically efficient consumption –Rates should apportion costs fairly among customers and customer classes –Rates should avoid undue discrimination –Rates should promote innovation in supply and demand

6 Objectives of Rate Design v Practical considerations: –A rate design should be, to the extent possible, simple, understandable, acceptable to the public, and easily administered –A rate design should provide for rate stability

7 Revenue-Related Issues v Rates should give a utility a reasonable opportunity to: –Recover prudently incurred expenses, including investment –Earn a fair rate of return on the remaining costs (the undepreciated portion) of its prudent investment v Such rates enable a utility to cover its debt- service obligation, pay dividends to shareholders, and attract new capital investment

8 Cost-Related Issues v Will rates set at average cost per unit be economically efficient? –Average cost vs. marginal cost –Long run vs. short run v Private financial vs. total social cost –Cost of environmental damage from electricity production and delivery v Who pays what costs? –Principle of cost causation

9 Developing a Rate Design v Basic principle: assign costs to customers who cause a utility to incur them v Steps: –Determine customer groups –Allocate utility costs among the customer groups –For each customer group, assign allocated costs to individual rate components (customer, kWh, kW charges)

10 Determining Customer Groups v Generally based on usage characteristics v Number of customer groups varies among utilities v Common groups: –Residential –Commercial –Industrial –Street lighting –Agricultural

11 Determining Customer Groups v Sometimes groups may be designated for public policy reasons –For example, low income or elderly v Occasionally one customer with very unique usage characteristics is a group

12 Class Cost-of-Service Study v Utility performs a class cost-of-service study –Embedded or fully allocated cost study –Incremental or marginal cost study v Sometimes a utility performs both studies

13 Embedded Cost Study v Uses capital and operating costs that have been historically embedded (spent or invested) v Built on accounting cost data generated in the day-to-day operations of the utility –Need fairly detailed accounting records so costs can be categorized into generation, transmission, distribution, billing, etc.

14 Embedded Cost Study v Uses a variety of “allocation factors” to assign costs to each customer group –Sample allocation factors: winter kWh, system peak month coincident peak, average monthly customers v Some costs cannot be easily allocated (for example, administrative) –Often allocated in proportion to all other costs –Other options include: u Considering other policy goals u Allocating them in some reasonable manner

15 Embedded Cost Study v Most simple embedded cost allocation: –Revenue requirement ÷ number of customers = rate, billed annually, semi- annually or quarterly v Complexities arise due to desire to distinguish between –Types and amount of service –Types of customers

16 Embedded Cost Study v Advantages: –Based on actual costs –Automatically reconciled with the revenue requirement –Perceived to be fair v Disadvantages: –Hard to allocate joint and common costs –Does not reflect current market trends –May produce inefficient prices

17 Marginal Cost Study v Allocates the cost of providing additional service v Based on marginal cost pricing which equals the economic costs of providing the next increment of service v Forward-looking study of resource costs

18 Marginal Cost Study v Challenges: –What is the appropriate increment of output, or margin, to measure? u Generating capacity costs: $/kW-yr u Energy costs: $/kWh u Transmission and distribution costs: $/kW-yr –How can marginal-cost prices be reconciled with the revenue requirement –What kinds of pricing distortions are acceptable? –Should the incremental costs of environmental damage be reflected in rates?

19 Marginal Cost Study v Advantages: –Forward looking, economic costs –Promotes economic efficiency u Exception: The problem of “second best” –Those who cause the costs pay the costs v Disadvantages: –Definitions more contentious –Hard to reconcile with revenue requirement –Requires forecasted demand and costs –Potential for rate volatility

20 Cost Allocation Issues v Are all classes equally risky to serve? v If cross-subsidies between classes exist, how quickly should they be eliminated? –Potential for rate shock and irate ratepayers –Impact on vulnerable customers (for example, low income)

21 Cost Allocation Issues v How should public policy considerations be factored in to cost allocation? –Rates can provide assistance to specific customer classes u Economic-development or business-retention rates u Residential lifeline rate –Rates can promote social objectives u Conservation/environmental considerations u Universal service

22 Designing Tariffs v Primary tariff price components: –Customer charge –Energy charge –Demand charge v Interaction of these components sends price signals

23 Tariff Components v Customer charge –Recover costs that do not vary with consumption (for example, metering and billing) –Can be fixed amount per day, month, or other billing period v Energy charge (kWh) –Recover costs that vary with consumption (for example, energy) –Can vary depending on usage patterns

24 Demand Charge v Demand charge (kW) –Recover cost of building capacity to provide energy –Reflects fact that utility must have power available to serve customer –Encourages reduced usage at peak periods (especially load shifting) –Typically only larger customers pay a demand charge –Often includes a “ratchet”

25 Demand Charge v “Ratchet” – customers are billed the higher of either their highest demand from the current month, or some percentage of their highest demand from some previous period –Advantages: encourages customers to reduce their peak usage, helping to reduce the need for new utility infrastructure –Disadvantages: if the ratchet does not change after the customer reduces demand, the ratchet could be a disincentive to the installation of on- site generation or energy efficiency measures

26 Usage Patterns Price/ Unit Quantity Consumed Price/ Unit Offpeak Peak Offpeak Price/ Unit Quantity Consumed Price/ Unit Quantity Consumed Time-Based Rates Inclining Block Rates Declining Block Rates Flat Rates

27 Usage Patterns v Flat v Declining block –Based on assumptions that it is cheaper to serve large customers and that marginal cost is less than average cost –Encourages consumption, discourages conservation, so is particularly important to ensure prices are right

28 Usage Patterns v Inclining block –Marginal cost is greater than average cost –Discourages consumption and encourages conservation v Peak and off-peak rates –Encourage customers to use less power during peak periods

29 Usage Patterns v Time-based rates –Can be based on season, time of day, or real-time –Provide more accurate price signals –Rates that change based on time of day or real- time require special metering capabilities u Many large customers already have meters with these capabilities u Most smaller customers do not u Board is currently investigating whether utilities should provide meters with these capabilities to more customers

30 Usage Patterns v Customers with their own generation options may want utilities to provide “stand-by” service –If generator is down for any reason, utility would supply power to customer v Considerable debate over what are appropriate stand-by tariffs –Utility must build capacity to serve customer –Least-cost for society might not be least-cost for the customer u Sometimes customer-owned generation is the least-cost option for the utility but, if stand-by rates are too high, the customer may opt not to install the generation

31 Issues with Tariff Design v Uniform tariffs are easier to administer but can result in subsidies within rate classes v Does the rate design appropriately balance all the objectives? –Sometimes adjustments are made to better meet certain objectives (for example, make the kWh price closer to the utility’s marginal cost of power) v Does the rate design significantly increase rates for any customer group? –Sometimes the rate design is phased-in over multiple years to minimize “rate shock”

32 Customer-Specific Tariffs v Individual customer cost-based tariffs –More precise (assuming can identify separate costs) –Generally not used in VT and most of U.S., except where customer has very clear distinguishing characteristics –Difficult to calculate u What are the cost differences in an integrated electrical system? u For most customers, costs outweigh benefits

33 Other Items in Tariffs v Tariffs also include terms and conditions of service –Some examples: u Late fees u Disconnection policies and fees u Line extension policies