Utility ratemaking

Although utilities are regulated industries, they are typically privately owned and must therefore attract private capital. Accordingly, because of constitutional takings law, government regulators must assure private companies that a fair revenue is available in order to continue to attract investors and borrow money. This creates competing aims of capital attraction and fair prices for customers. Utility companies are therefore allowed to charge "reasonable rates," which are generally regarded as rates that allow utilities to encourage people to invest in utility stocks and bonds at the same rate of return they would in comparable non-regulated industries.[4]

State laws typically restrict utilities from large, sudden rate increases. Utilities should implement new rates over time so that consumers and business can adapt to the changing prices. This is known as the principle of gradualism.[5]

A standard demand curve showing that as prices decline, consumption rises.

The price of a utility's products and services will affect its consumption. As with most demand curves, a price increase decreases demand. Through a concept known as rate design or rate structure, regulators set the prices (known as "rates" in the case of utilities) and thereby affect the consumption. With declining block rates, the per-unit price of utility consumption decreases as the energy consumption increases. Typically a declining block rate is offered only to very large consumers. If conservation is the goal, regulators can promote conservation by letting prices rise. A third possible rate design is a flat rate which charges the same price for all consumption.[4]

Ratemaking distributes wealth from consumers to utility owners. Ratemaking also involves redistribution of wealth among and within classes of customers. Utility customers are generally grouped in three categories – residential, industrial, and commercial. Each group is sometimes further subdivided.[4]

The compensation received by the executive in utility companies often receives the most scrutiny in the review of operating expenses. Just as regulated utilities and their governing bodies struggle to maintain a balance between keeping consumer costs reasonable and being profitable enough to attract investors, they must also compete with private companies for talented executives and then be able to retain those executives.[6]

Constraints from regulation have been shown to affect the level of compensation received by executives in electric utilities. Executive compensation usually consists of four parts:[7]

1. Base salary
2. Short term incentive pay (STIP)
3. Long-term incentive pay (LTIP); and
4. Benefits such as retirement and health care

Regulated companies are less likely to use incentive-based compensation in addition to base salaries. Executives in regulated electric utilities are less likely to be paid for their performance in bonuses or stock options.[6]

Executives in regulated electric utilities also have less managerial control than those in unregulated or private industries. These executives are in charge of large numbers of workers as well as the company’s physical and financial assets. Limiting their control has been shown to reduce investment opportunities. The same constraints are placed on the board of directors for the utility by the monitoring or oversight of the utility commission and they are less likely to approve compensation policies that include incentive-based pay.[6] The compensation for electric utility executives will be the lowest in regulated utilities that have an unfavorable regulatory environment. These companies have more political constraints than those in a favorable regulatory environment and are less likely to have a positive response to requests for rate increases.[8]

Just as increased constraints from regulation drive compensation down for executives in electric utilities, deregulation has been shown to increase compensation. The need to encourage risk-taking behavior in seeking new investment opportunities while keeping costs under control requires deregulated companies to offer performance-based incentives to their executives. It has been found that increased compensation is also more likely to attract executives experienced in working in competitive environments.[9]

The Energy Act of 1992 in the United States removed previous barriers to wholesale competition in the electric utility industry. Currently twenty-four states allow for deregulated electric utilities: Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Texas, Virginia, Arizona, Arkansas, California, Connecticut, Delaware, Illinois, Maine, Maryland, Massachusetts, Michigan, Montana, New Hampshire, New Jersey, New Mexico, New York, and Washington D.C.[10] As electric utility monopolies have been increasingly broken up into deregulated businesses, executive compensation has risen; particularly incentive compensation.[11]

A firm's operating expenses, such as wages, salaries, supplies, maintenance, taxes, and research and development, must be recouped if the utility is to stay operational. Operating costs are most often the largest component of the revenue requirement, and the easiest to determine. Occasionally, operating expense items have caught the attention of regulatory agencies and courts, and these items have been examined more closely.

Regulators must make two determinations. First, they must determine which items should be allowed as expenses. Second, regulators must determine the value of those expense items. The determination of value has generally been left to the management of the utility under the theory that these are essentially business decisions which will not be second guessed by a regulatory agency or a court. Managerial good faith is presumed. Although both agencies and courts have the legal authority to supervise the utility's management, they will not substitute their judgment unless there is an abuse of managerial discretion.[12] Hence, litigation involving operating expense issues has been light.[4]

The above-described formula may be used to calculate a firm's allowed revenues (cost-of-service regulation). However, if the rates are set on the basis of a company's own costs, there is no incentive to reduce these costs. Furthermore, regulated utilities may have the incentive to overinvest.[13] The purpose of performance-based regulation is to reduce the negative impact of information asymmetries and to motivate regulated companies to reduce their costs in order to increase profit. Usually, this is done by setting a cap on prices or revenues. A general formula is:[14]

P(t) = (1 + RPI - X) . P(t-1)

where

P(t) is the price in time t.

RPI is the rate of inflation.

X is the efficiency factor (X-factor).

P(t-1) is the price in time (t - 1).

Since the price is set with regard to the overall inflation rate (RPI) and required growth of efficiency (X-factor), such kind of regulation is also called RPI-X regulation.