Step 1: Determine the underlying cost structure

The first step in implementing tariff reform involves determining the total cost to the utility of providing electric service, also known as its revenue requirement. The revenue requirement is a central construct of traditional cost of service ratemaking and is necessary for establishing cost-reflective prices for utility service. Essentially, the revenue requirement identifies the expected amount of revenue that the utility requires to cover its costs and earn a reasonable return on equity for its shareholders.

Rate base: with respect to physical assets, the rate base represents the value of the plant, equipment, and other assets employed by a utility to provide service to its customers (e.g., utility-owned generation facilities, buildings, poles, wires, transformers, meters, vehicles, computers). Conversely, with respect to the financing of the investment required to purchase and maintain these assets, the rate base reflects the money provided to the utility by investors expecting a return on their investment. Accordingly, material increases in the rate base due to additional capital investment can result in a significant increase in the utility’s overall revenue requirement. Rate base is normally calculated based on historical cost accounting, using accounts prepared regularly in accordance with generally accepted accounting principles (“GAAP”). However, in some cases, such accounts may not exist. For example, if the utility has operated as a government department, records of historical costs may not be available. In such cases, the starting point for determining the value of the utility’s assets consists of two parts:

  • determining the replacement cost of the assets, and then adjusting for age; and
  • performing a condition assessment to identify whether the assets are able to operate in a manner that is consistent with their age. If not, an additional discount to the asset value may be warranted.
Net book value assets
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Capital expenditures
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Depreciation
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Working capital
Operating expenses: another component of the revenue requirement is the utility’s operating expenses. Operating expenses are the ongoing costs related to operating and maintaining the utility’s equipment for providing service. These expenses do not include capital outlays, and the utility does not earn returns on them. Core expense items typically include fuel, purchased power, labor, materials and supplies, depreciation, and taxes.
FUEL
Commodity and transportation costs of oil, natural gas, or other inputs to generating electricity
PURCHASED POWER
Amounts paid by a utility for energy and/or capacity purchased from independent generators
LABOR
Costs associated with hiring and retaining employees (e.g., bonuses, benefits, pensions, etc.)
MATERIALS / SUPPLIES
Costs of items that are used quickly after purchase (i.e., are not capitalized for use over several years)
DEPRECIATION
Annual charge for use of capitalized equipment (expected to provide service for > 1 year)
TAXES AND FEES
Charges imposed on the utility by government agencies (e.g., industry regulators, the tax code)
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