For vertically integrated electric utilities (i.e., those that own assets across the value chain, including generation, transmission, and distribution), as well as for the natural monopoly activities of unbundled entities, the basis for setting rates is what is known as cost of service (“COS”). Simplistically, a utility adds up all of its costs (the total of which is referred to as its revenue requirement) and allocates them across its customers, who are sometimes referred to as ratepayers.

A utility’s costs include capital costs associated with the construction of generating stations, transformers, wires, poles, and associated infrastructure (collectively, the rate base), divided by the number of years of expected service; operating costs, which are largely related to the cost of employees; and the cost of capital, which is the return on ratebase and compensates lenders and shareholders of the utility. Some costs are charged on a per unit (usually a kilowatt-hour (“kWh”)) basis, meaning customers only pay based on what they use; some are charged based on peak demand (per kilowatt, or “kW”); while some other costs are charged on a per customer basis, meaning a portion of the customer’s bill is not impacted by usage. Rates may be based on forecast or historical costs; in either case, a true up to actual costs may be necessary periodically.

Revenue requirement: Compute the total cost of service

Functionalization: assign costs to the appropriate utility function (generation, transmission, distribution, billing/ customer service)

Classification: classify functionalized costs to energy- (kWh), demand- (kW), or customer-related (number of customers)

Allocation: assign cost responsibility to different customer classes (e.g., residential, commercial, industrial)

Rate design: develop tariffs to recover assigned costs

high-level summary of the COS ratemaking methodology
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