NRRI-14-03-Alternative-Rate-Mechanisms


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Ratemaking is a major regulatory function that touches all aspects of utility operations. It also has wide-ranging ramifications for the different objectives that state utility regulators try to achieve. In pursuing these objectives, regulators attempt to promote the public interest. As this paper contends, good ratemaking is difficult, requiring both good analytics and sound judgment on the part of regulators.
Rate of return (ROR) ratemaking, or what this paper also refers to as “traditional ratemaking,” has been a mainstay of state public utility regulation since its inception. It has allowed utilities to be financially healthy and invest in needed new capital, while at the same time protecting customers from the natural-monopoly power of utilities. The rationale for regulation is the need to assure adequate, reliable electric service at rates that are just and reasonable. Thus, regulation recognizes that financially healthy utilities are necessary for the long-term economic welfare of customers. At the same time, customer protection against the exercise of utility monopoly power is a core principle of ratemaking.
Over several decades, state utility commissions have modified ROR ratemaking to accommodate new technologies—as well as economic, operating, and market conditions, in addition to new policy mandates—for the purpose of preserving the implicit regulatory bargain. During that time, pressures from different quarters have raised fundamental questions on the necessary conditions for effective ROR ratemaking, including stable market conditions and well-informed regulators. Utilities generally have initiated calls for alternative ratemaking approaches, but other stakeholders have done so as well. For example, conservationists and environmentalists have pushed for revenue decoupling and net energy metering rates to advance the development of energy efficiency and renewable energy. In the coming years, revenue decoupling in particular may become increasingly attractive to electric utilities as their sales growth flattens and distributed generation proliferates. State utility commissions have begun to reconsider the merits of existing net metering rates, as adverse effects have become more transparent.
As another example of non-utility stakeholders pushing for alternative rate mechanisms, since the 1980s large customers have pushed for special contracts, economic development, and flexible rates in general, which are discriminatory in nature although under certain conditions in the public interest. These rates arguably are a response to the legacy of utility ratemaking favoring small utility customers relative to large customers.
These pressures from different stakeholders have provoked state legislatures and public utility commissions to modify utility ratemaking, sometimes fundamentally. Whether these changes, or what some observers call “reforms,” have improved utility performance and long-term customer welfare awaits empirical analysis. There is also the question of whether state legislatures, given their lack of expertise in technical and often complex utility matters, should have any role in reforming ratemaking practices. We observe, in particular, alarmingly more intrusive state legislation in ratemaking matters that regularly promotes the interests of a single stakeholder while damaging the interests of others. These actions, in other words, often violate the “balancing act” principle that lies at the heart of state public utility regulation.
This paper takes on the more modest task of identifying and reviewing alternative rate mechanisms that have come to the forefront in state utility regulation over the past several years. It focuses on how each mechanism affects different regulatory objectives, including core and secondary objectives. After all, rate mechanisms are desirable only if they are compatible with the objectives set out by regulators, assuming they satisfy statutory and other legal requirements. The reader can skip to Part V to get the gist of this paper.
This paper excludes endorsing specific rate mechanisms, since it argues that their efficacy is case-specific and depends essentially on the weights commissioners place on the different objectives ascribed to ratemaking. The challenge for commissions, then, is to weigh these objectives and measure (if possible) the effect of a rate mechanism on each one, as well as on the overall public interest. Assigning weights requires judgment by commissions, while examining the effect demands data and other unbiased information derived from sound analytical methods. This paper addresses the latter task. If a commission assigns a top priority to economic efficiency, for example, it would tend to favor mechanisms that set prices compatible with marginal-cost principles and provide utilities with strong incentives for technological advances and productivity.
All rate mechanisms have mixed effects on the public interest. The presumption is that when a rate mechanism impedes some regulatory objective it sets back the public interest, while improving the public interest when it advances an objective. One example is cost trackers or riders in which the tradeoff exists between timely utility recovery of costs and robust incentives: Trackers and riders allow utilities to recover their costs more quickly and with more certainty, but they also can create incentive problems when (1) regulators fail to adequately scrutinize those costs and (2) cost recovery methods differ across different utility functional areas.
Before reviewing alternative rate mechanisms, this paper outlines a theoretical framework for decision making by commissions. This framework, in addition to identifying the cardinal objectives and core principles of utility ratemaking, describes conceptually how a commission can (1) take the available information and (2) process it using its subjective values for decision making that intends to advance the public interest. These values can include relevant regulatory objectives and the relative weights of each in affecting the public interest. The public interest, as argued in this paper, relates closely to the aggregation of objectives that regulatory actions try to achieve.
This paper concentrates on alternative rate mechanisms that affect regulatory objectives both positively and negatively.

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