Step 3: Assess whether the existing tariff is cost reflective; if not cost reflective, determine an approach to reach cost recovery

Revenue requirement
Average rate
converting the revenue requirement into rates
Once the three core components of the revenue requirement are calculated (i.e., the rate base, rate of return, and operating expenses), the utility’s revenue requirement can be estimated. Again, this represents the total revenues that a utility requires to cover the costs it incurs in providing electric service. To assess whether the existing tariff is cost reflective, it is useful to compare the product of the average rate (i.e., the average of the existing rates charged across different customer classes) and the total volumes delivered by the utility, against the estimated revenue requirement. Simplistically, if the average revenues earned by the utility are not equal to the estimated revenue requirement, then the existing tariff may be deemed to not be cost reflective.
If the existing tariff is determined not to be cost reflective, an approach will need to be selected to reach cost recovery. Policymakers can choose from several approaches to evolve the tariff design to become more reflective of underlying costs:
tariff increases – if existing rates under recover the utility’s costs of providing electric service, tariff increases may be required to improve the utility’s financial stability;
hybrid approach – policymakers may choose to adopt a hybrid approach to reach cost recovery, where the rates for some customer classes are increased, while the rates for others are subsidized.
subsidies – if increasing tariffs is politically unfeasible, direct payments from the government may make up the difference in cost of service. Such subsidies need to be transparent, and only cover the shortfall in efficient costs as approved by the regulator.   Subsidies may be linked to particular customer classes, such as low-income residential, or to particular industries. Regardless, customer bills should clearly show the full cost of power, and the amounts paid by the government on their behalf. To maintain the fiscal health of the utility, subsidies need to be paid in full on a predictable schedule; it is not the utility itself that is being subsidized, but rather the utility’s customers. Governments should have a strategy for minimizing, and ultimately phasing out, subsidies which is communicated to all stakeholders. At the same time, the regulator needs to assure the utility’s costs are appropriately scrutinized, so that when rates increase as subsidies are reduced, it is not due to waste on the part of utility management
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