How do you determine the revenue requirement?

Cost of service rate design rests on a deceptively simple set of calculations. In its most basic form, the revenue requirement is representative of the totality of costs of operating an enterprise to provide electricity service and is formulaically reflected as
Revenue requirement = ( Rate base x Rate of return ) + Operating expenses
Rate base is the total of all of the utility’s long-lived investments, net of accumulated depreciation. Such investments include power plants, the transmission and distribution network, buildings, and other similar assets. The rate base also includes adjustments for working capital, deferred costs (known as regulatory assets – such as environmental costs, extraordinary weather damages, losses on asset retirements, among others), and deferred taxes.

Rate of return needs to be fair to investors and reasonable from the customer’s perspective. There are different methods to establish a reasonable rate of return – a commonly applied litmus test is to determine if the rate of return allows the utility to attract additional capital to pay for its investment needs, without reaching levels of return that are expected by speculative, high-risk investors. A utility with a simple funding structure (equity plus debt) will have a cost of capital that is equal to the weighted average cost of both sources of funding (i.e., the weighted average cost of capital, or “WACC”).
Operating expenses comprise of costs related to labor, materials, depreciation, and tax, among others. In order to be included in the revenue requirement, these expenses must be necessary and prudent.
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