INTRODUCTION

Ratemaking consists of three distinct components: revenue requirements, cost allocation, and rate design. Ratemaking therefore determines how much revenue that utilities should collect from customers, from whom, and how. All of these parts have undergone scrutiny in recent years. For example, more jurisdictions in North America have switched from historical test years to future test years^[1] in setting new utility rates and have integrated some form of performance-based regulation (“PBR”) into their ratemaking portfolio.^[2]

Ratemaking is a primary regulatory function that touches all aspects of utility operations. It also has wide-ranging consequences for the different objectives that utility regulators pursue either because of legislative statutes or self-imposed directives. In pursuing these objectives, regulators (at least in theory) strive to promote the public interest.^[3] Good ratemaking is tough to achieve, requiring both sound analytics and judgment by regulators.

Throughout most of its history, utility regulation placed primary emphasis on ratemaking to assure the financial viability of utilities and achieve fairness for customers.^[4] Good ratemaking therefore protects customers from incompetent utility management and utility shareholders from capricious denial of cost recovery. Financial viability typically requires that a utility has a reasonable opportunity to earn a fair return.^[5]

A mantra often heard in regulation is “just and reasonable” rates, which translates into an opportunity for a utility to recover the reasonable and prudent costs incurred to provide public utility service. But, as discussed below, ratemaking has had to satisfy additional objectives recently brought on by new public policies, technological changes, and economic developments, making setting “just and reasonable” rates yet a harder task for regulators.^[6] Setting such rates requires regulators to reexamine all three parts of ratemaking: revenue requirements, cost allocation and rate design.

One widely accepted definition of the public interest relates to the common well-being or general welfare. It is central to policy debates, politics, democracy, and the purpose of government itself.^[7]

This definition of the public interest for utility ratemaking measures the composite indicator of the public well-being that combines the individual effects of an action on direct stakeholders, like utility customers and shareholders, and other societal interests (e.g., the environment).^[8] Another definition relates the public interest to the stakeholders’ collective consent to a regulatory action. For each definition, the aggregate interest of society matters most.^[9]

While few would dispute that advancing the public interest is an admirable goal, there is little consensus on how to define and achieve it. Many utility regulators associate the public interest with meeting minimum fairness requirements. For example, fair treatment of utility investors and protection of core customers.^[10] Even though fairness is a subjective term, regulators must establish bounds and rules to distinguish between fair and unfair actions.^[11]

When ratemaking goes sour, bad outcomes are inevitable. Faulty ratemaking^[12] can lead to undesirable consequences like undue discrimination, inequity, poor incentives for innovation, uneconomic bypass,^[13] and financially stressed utilities. As competition increases, for example, faulty ratemaking can lead to consumers choosing providers that have lower prices but have higher costs. A regulated utility with an unregulated affiliate might have an incentive to subsidize the affiliate by shifting some of the affiliate’s costs to its core customers (e.g., residential electricity customers). As stated by one late prominent economist: “Cross-subsidy becomes a pertinent possibility when a multiproduct firm sells some products for which there are competing suppliers but enjoys effective monopoly in the sale of other(s) of the outputs it sells.”^[14]

The following sections argue that changes in the electric industry will require regulators to reexamine their current and sometimes long-held ratemaking practices. This is especially pertinent in view of the new objectives that regulators must address. These objectives, in addition to the old objectives of utility financial viability and reliable/resilient utility service, include service affordability, the accommodation and even the subsidization of new technologies that compete with utilities’ core business, decarbonization of utilities’ generation portfolio, and the subsidization of utilities’ customers to use less electricity. No other private business comes to mind in which society forces firms to tackle such a wide range of social issues. While regulators in the past have adapted their ratemaking decisions to new economic, political and technological realities, they have taken a cautious position that lies within one of Bonbright’s principles for ratemaking, gradualism.^[15]

TRADITIONAL RATEMAKING

The transformation of the electric industry calls into question whether traditional ratemaking^[16] can accommodate the public interest by establishing just and reasonable rates.^[17] Back in the 1990s when the electric industry underwent major restructuring, many experts believed that traditional ratemaking would gradually end its long history.^[18] These experts thought that price caps (a form of multi-year rate plans) or other more “innovative” ratemaking mechanisms would replace it, but that did not happen. One reason was that most state utility regulators were unwilling to renounce traditional ratemaking, although they did modify it around the edges.^[19] From their history, regulators tend to favor a gradualist approach to ratemaking, rather than a radical one that unravels a long-held rate mechanism.

Four factors explain the popularity of traditional ratemaking in the US over time: (1) its perceived fairness to all parties under normal market and business conditions; (2) its ease of understanding; (3) the public’s general acceptance of average-cost approaches that relate rates to costs, even if not the correct costs from an economic-efficiency perspective; (4) fairness in due process for the different stakeholders; and (5) its attempt to achieve a balanced outcome that avoids, in most circumstances, extreme discontent by individual stakeholders. Regulators attempt to balance the rights of utilities and their customers by considering three major factors: (1) legal controls — for example, utilities have the constitutional right to be given a reasonable opportunity to be financially viable, and customers have a right to just and reasonable prices; (2) the regulator’s perception of fairness; and (3) compatibility with a broader interest. Regulators strive to reach balanced decisions with the ultimate objective of promoting the general good; at least, that is the premise behind the public-interest theory of regulation.^[20]

RECENT CONCERNS WITH TRADITIONAL RATEMAKING

Sources of discontent with traditional ratemaking through the years have come from different quarters: economic theory, real-world experiences, recent market and other developments triggering a revisit of “old” ratemaking practices. Many critics consider traditional ratemaking as old-fashion and out of touch with today’s environment.

Some stakeholders have expressed frustration with the rigid features of traditional ratemaking. As an example, it offers utilities inadequate incentives to invest in new technologies that are cost-beneficial (e.g., provide customers with new services, address new environmental regulations at least cost). Specifically, it may remove many of the economic benefits that induce unregulated firms to make technological improvements.^[21] On the other hand, traditional ratemaking also limits utility risk for unsuccessful new technologies, which at least partially, if not perfectly, compensates for the absence of potentially high profit. Overall, traditional ratemaking tends to socialize both the benefits and the risks of new technologies, which is contrary to how well-functioning markets normally operate.^[22]

A summary of the major arguments against traditional ratemaking over the years is as follows:

• Traditional ratemaking does not update rates for changes in costs beyond what regulatory practitioners call the “test period,” especially when historical in nature; this means in a dynamic cost environment, utilities would tend to file frequent rate cases.^[23]
• It gives utilities weak incentive to innovate.^[24]
• It creates excessive delay in cost recovery for capital projects.
• With frequent rate cases lessening regulatory lag, utilities have weak incentives to control their costs.^[25]
• It prices utility service based on average cost rather than the more theoretically correct marginal cost.^[26]
• It can create rate shock under inflationary and other conditions (leading to political difficulties for regulators and a disruptive effect on customers).
• Its standard rate design (i.e., volumetric rates) magnifies efficiency and equity problems with the availability of distributed and other non-utility generation.
• It places high demands on regulator’s staff and utility resources.
• It motivates utilities to increase both sales and rate base.^[27]
• It allows utilities to decide the timing of rate cases.^[28]

The following section illustrates the potential problems caused by utility regulators retaining a rate design long held but now debatable in the new electric industry. Influential stakeholders like consumer and clean-air advocates have opposed changes in the rate design.^[29]

PROBLEMS WITH THE STANDARD RATE DESIGN

The heightened interest in fixed and demand charges for residential electricity customers has sprung largely from the flaws in the prevailing rate design for residential electric service, namely, volumetric rates.^[30] This is especially true as those shortcomings have magnified with recent developments in electricity markets and public policy.

The following expression represents the typical two-part tariff for base rates set by utilities:

Bi = C + p∙qi

The base rate for customer i, Bi, equals the sum of the customer charge (C)^[31] applicable to all customers, and the volumetric charge (p) times the quantity of utility service consumed by customer i (qi).^[32] It excludes fuel, specific capital expenditures and other costs recovered by a utility through a tracker or other rate mechanism outside of a general rate case.

The base rate recovers those costs related to investment in, and operation of, a utility system. The customer charge typically includes the direct cost of serving a customer, including the cost for meters, meter reading, billing and collection, servicing an account, call centers, and other costs independent of usage.^[33] The volumetric charge recovers the remaining costs of a utility. It includes both operating costs and capital costs not recovered in the customer charge.^[34]

Major reasons for this longstanding rate structure include: (1) the ease in understanding by customers (which is one of Bonbright’s ratemaking criteria); (2) the perception that alternative rate designs like fixed charges are unfavorable to vulnerable customers, like low-income households, and discourage energy efficiency as well as roof-top solar;^[35] and (3) less-than-definitive rules for allocating fixed or common costs to different customers and services.

Volumetric rates present a number of social problems related to economic efficiency and equity. These problems have become more acute with new developments in the electric power industry. They include:

• A significant mismatch exists between a utility’s costs and its rate structure, with excessive fixed or network costs recovered in the volumetric charge; the consequence of that has become more damaging with the growth of self-generation like distributed generation; a more rational rate design that features the cost-causation principle of rate setting can prevent cost-shifting and uneconomic switching of customers to self-generation.
• Time- and location-invariant volumetric rates assume that each kWh consumed — irrespective or the time or the location — imposes the same cost on a utility; the reality is that both energy and capacity costs in the real world are higher during system-peak periods. The marginal cost to generate and distribute electricity varies significantly from hour to hour, season to season, and from different locations on a power grid.^[36]
• Self-generating customers avoid their fair share of fixed costs; when they self-generate, the utility recovers less fixed costs even though they were previously approved as prudent by the regulator and the self-generating customer still relies on the grid for both importing power from the grid and exporting power to the grid, and for other grid services (connection to the power grid, whether the customer self-generates or not, is akin to purchasing a 24/7 call option); the upshot is that the utility usually continues to recover its fixed costs but from non-self-generating customers (who on average are less wealthy than self-generators^[37]), which has the tendency to lead to a spiral where the higher rates accelerate self-generation that yet loads more fixed costs on a declining number of customers.
• Cross-subsidies occur as customers whose demand is relatively constant across hours are subsidizing customers whose demand is “peakier.” For those customers with relatively high kWh consumption but a relatively small contribution to system peak demand, their bills will likely decrease with a fixed or demand charge. For those customers with low consumption but a relatively high contribution to system peak demand, their bills will likely increase. Under volumetric rates, two residential customers with the same monthly electricity usage but differing peak demands on the grid would have almost identical bills, even though one of the customers would require more capacity (and thus higher fixed costs) from the utility.
• When a customer cuts back on kWh consumption she can avoid paying its fair share of grid service; that is, she is not paying for what she uses or is available for her to use.
• Customers receive wrong price signals from an excessive volumetric charge that causes customers to under-consume electricity. Setting volumetric rates greater than short-run marginal cost creates what economists call a deadweight loss by impeding welfare-enhancing electricity consumption.
• There is an added incentive for uneconomic bypass aggravated by opportunities for self-generation. Uneconomic bypass not only diminishes economic efficiency but it also causes cost shifting, likely from wealthier customers to low-income customers.

Notwithstanding these problems with volumetric pricing, most US regulators have done little to replace it. Opponents of change have successfully sway regulators that alternatives would disfavour low-income customers and efforts to advance “green energy.”

DO REGULATORS ADAPT?

History has shown that utility regulators do adapt, although gradually, to a changed economic, technological and political environment by throwing their support to new rate designs and ratemaking mechanisms. Changes follow when the political equilibrium has been disrupted (i.e., stakeholders are so unsatisfied with the current situation that they expend substantial resources to change the status quo).^[38] But experience has shown the reluctance of regulators to take drastic action without first having a good idea of the effects. Regulators usually prefer a gradualist approach to ratemaking. After all, the legacy of utility ratemaking is average-cost pricing or rates based on historical embedded cost.^[39]

As on example, we have seen in the past how a changing landscape for utilities have compelled regulators to modify their ratemaking. Joskow discussed how the combination of inflation, oil price shocks, technological changes and stricter environmental standards caused steep increases in U.S. electricity generating costs in the late 1960s and early 1970s.^[40] Utilities could not incorporate these cost (to a large extent beyond their control) into rates fast enough to keep their earnings from falling to a critical level. Eventually regulators allowed fuel adjustment clauses (and, to a lesser extent, future test years) to reduce regulatory lag and avert more serious financial difficulties. Regulators also revisited existing rate structures (e.g., declining block rates) to evaluate whether they satisfied new objectives, like those relating to energy efficiency and clean air, and were still in the public interest. In general, Joskow discussed how the changed political, technological and economic background pressured regulators to adapt their rate mechanisms to this new environment.

CHALLENGES FOR REGULATORS IN BALANCING OBJECTIVES

In today’s world balancing the interest of stakeholders involves the recognition of (1) utility competitors wanting a “level playing field,” (2) many customers no longer wanting just plain vanilla service (e.g., lower prices and reliable service) but wanting such things as more control over their utility bill, the ability to self-generate and real-time information from their utility, (3) utilities wanting rates that allow them to be financially healthy, and (4) environmentalists wanting clean energy and energy efficiency. Engaged customers tend to better exploit increased competitive conditions and have access to more information and new technologies, and is more aware of market conditions. They place greater demands on utilities to provide (1) a wider array of products and services, and (2) greater opportunities to control their electricity usage and the price they pay for electricity.^[41] All of these new “balancing” demands have made ratemaking more difficult for regulators.

A big challenge for regulators is to weigh or prioritize those objectives underlying ratemaking and measure (if possible) the effect of a rate mechanism on each one, as well as on the overall public interest. Assigning weights requires judgment by regulators, while examining the effect demands data and other unbiased information derived from sound analytical methods. If a regulator assigns a top priority to economic efficiency, for example, it would tend to favor mechanisms that set prices compatible with marginal-cost principles and provide utilities with strong incentives for technological advances and productivity.

To wit, all rate mechanisms have mixed effects on the public interest. The presumption is that when a rate mechanism impedes some regulatory objective it diminishes the public interest, while improving the public interest when it advances an objective. One example is cost trackers or riders in which a tradeoff exists between timely utility recovery of costs and robust incentives: Trackers and riders allow utilities to recover their costs more quickly and with more certainty, but they also can create incentive problems when (1) regulators fail to adequately scrutinize those costs and (2) cost recovery methods differ across different utility functional areas.^[42]

Another example with conflicting outcomes for the public interest comes from utilities offering discounted rates and other special treatment to low-income households.^[43] Specific energy-assistance alternatives offered by utilities include a change in rate design, a rate discount, a bill cap based on income, a lump-sum payment, a cost waiver, and subsidized weatherization and other forms of energy efficiency.^[44] These options have unique effects on low-income households, other customers, and the utility. Regulators need to ask the following questions: Which of these initiatives would provide “most bang for the buck”?^[45] What should be the dollar amount of assistance? Regulators should review whether a utility’s energy-assistance initiatives are achieving the regulatory goal of utility-service affordability (1) most effectively and (2) with minimal adverse effects on other regulatory objectives. For example, many economists consider inverted (“lifeline”) rates an inefficient and wasteful approach for assisting poor households.^[46]

A major problem with energy assistance is that they can cause rates charged to low-income households to fall below cost and rates charged to other customers to increase above cost. Economic efficiency diminishes, and low-income households would tend to consume more energy.^[47] The latter effect by itself runs counter to lessening the energy burden of low-income households, as well as advancing energy efficiency.

Energy assistance is a form of discriminatory ratemaking that some regulators might consider undue or excessive.^[48] Its rationale is that customers with a low ability to pay for utility services should receive favorable rate treatment. Discriminatory ratemaking almost always raises a question of fairness, especially when a subsidized rate falls outside a “zone of reasonableness.” When a rate falls short of a utility’s short-run marginal cost or lies above the price that an unregulated monopolist would charge, a regulator would likely find the rate impermissible.

TAKEAWAYS

These are my major observations on the evolution of utility ratemaking in today’s environment:

• Ratemaking can address many of the challenges facing the “new” electric utility industry; as some economists would say, “Set the prices right and good things will happen.” Faulty utility ratemaking can create serious problems that are contrary to the regulator’s duty to set “just and reasonable” rates.
• Ratemaking is tougher than choosing a car or a health care plan^[49]; changing rate design, for example, would benefit some customers but hurt others, and the information presented to regulators is fraught with biasness and devoid of reasonably accurate measurement.
• Ratemaking has become harder over time because of expanded public policy objectives and more stakeholders in the regulatory process. Some of these objectives harm utility customers by imposing costs on them without compensatory benefits. As with other things, trade-offs are inevitable, making the regulator’s job more difficult for evaluating different rate mechanisms. There is no one rate mechanism that comes to mind advancing all regulatory objectives.
• Regulators do adapt to a changed environment, although cautiously, when the political pressures heighten. Gradualism aligns with one of Bonbright’s principles for good ratemaking and is often a rational response to uncertainty over the effects of a major change in ratemaking.
• Ratemaking comes down to the relative importance that regulators and stakeholders place on different objectives. The weighting of each objective by a regulator requires a combination of subjective judgment and compliance with statutory and constitutional mandates. State or provincial statutes may require regulators to consider certain objectives and even mandate that they prioritize others.
• Reaching agreement on rate issues requires a balancing of interests, where each stakeholder may have to give up its preferred choice for the public good; stakeholders in some jurisdictions have not agreed on things like (1) compensation by the utility for surplus rooftop solar PV power, (2) compensation to the utility for grid services provided to DG customers, and (3) the optimal use of smart meters for ratemaking.

To conclude, ratemaking requires that regulators comply with statutes and legal rules, economic principles, precedent, public acceptability, and the tradeoffs among different objectives initiated by legislatures and the regulators themselves, among other things. An essential part of the regulator’s job is to exercise judgment on (1) what objectives ratemaking should achieve, (2) the relative significance of each objective, and (3) the willingness to impede certain objectives to advance others; for example, rates that diminish economic efficiency (e.g., cost-based rates) but make electricity more affordable to low-income households. This task has become progressively challenging in recent years as society expects utilities to tackle additional social problems. 

• * Kenneth W. Costello worked for a state utility commission for almost ten years (the Illinois Commerce Commission), 28 years at the National Regulatory Research Institute, which was the research, educational and technical arm of all the state utility commissions around the US, and over 6 years as an independent consultant. During his tenure, Mr. Costello conducted research and written on a wide array of topics, including some of those discussed in this article.

  ¹ Future test years rely on forecasts that are susceptible to error and contain certain costs and sales components inherently difficult to predict. Another problem is that utilities would have incentives to present biased forecasts that are not always easy for regulatory staff and interveners to uncover. A regulator would be therefore presumptuous to assume that forecasted costs and sales are more accurate than modified historical test year data accounting for “known and measurable” changes. In fact, several US regulators have taken this view, rationalizing that an historical test year is more in line with their mandate to set “just and reasonable” rates. See Maryluz Hoyos E., “Future Test Year: MOST Policy Initiative Science Note”, March 19, 2025; Ken Costello, “Future Test Years: Challenges Posed for State Utility Commissioners” Briefing Paper No. 13-08, July 2013.

• ² New public policy goals and objectives as well as new technologies have triggered much of the recent interest in PBR. Some observers have expressed concern that prevailing incentives steer utilities toward specific actions that clash with those goals and objectives. For example, utilities may be incentivized to make excessive capital expenditures when lower-cost alternatives (e.g., purchased power) are available. Utilities may also have inadequate incentives or even disincentives to advance new technologies, such as clean energy, that would benefit customers and society. See Advanced Energy Economy, “Performance-Based Regulation: Aligning Utility Incentives with Policy Objectives and Customer Benefits,” (5 June 2018), online (pdf): <evtransportationalliance.org/wp-content/uploads/2021/11/2018-Performance-Based-Regulation-by-staff-of-Advanced-Energy-Economy-AEE.pdf>; Cara Goldenberg and Kaja Rebane, “Building a Brighter Future by Changing Utility Incentives,” (12 July 2024), online: <rmi.org/building-a-brighter-future-by-changing-utility-incentives>.

• ³ Long-term customer welfare, arguably, is one of the least represented interests in the regulatory and political arena. Utilities look out for their financial interests, and consumer advocates tend to take a short-term view. A gap in adequate representation for the long-term interests of customers becomes evident. One may then be able to assert that the main job of regulators is to fill that void by protecting customers from the monopoly position of utilities. Thus, according to this premise, the public interest is aligned with long-term customer welfare. This has become more difficult as regulators have faced heightened pressure in recent years to appease other stakeholders entering the regulatory arena and to comply with political mandates and self-imposed directives. The above perception of the public interest is only one of many; others include the common good, environmental sustainability, utility-service affordability to all customers, due process available to all stakeholders in the regulatory process, fairness in outcomes.

• ⁴ Economists sometimes lose sight of the fact that the main goal of regulation is not merely to promote economic efficiency: regulation originated and developed prior to the ideas of economic efficiency and the principles of welfare economics. Most enabling legislation mandates just and reasonable rates, not efficient rates per se. Throughout the history of US utility regulation, for example, “fairness” has been a major consideration in ratemaking. Reasons for why regulators would not maximize economic welfare (i.e., take the most efficient actions to correct market failures), which, incidentally, some economists associate with the public interest, include: (1) individuals have, besides economic objectives, non-economic objectives (e.g., due process) affected by regulation but not accounted for by welfare economics; and (2) political institutions and administrative processes influence regulatory actions. These two reasons can explain why a rational regulator would be unlikely to seek to maximize conventional measures of economic welfare (i.e., the sum of consumer and producer surplus).

• ⁵ Legally, utility regulators in the U.S. must set reasonable rates that allow a prudent utility to operate successfully, maintain its financial integrity, attract capital, and compensate its investors in line with actual risks. [The US Supreme Court outlined these conditions in its order for Federal Power Commission v Hope Natural Gas Co. (1944), 320 US 591, 605 (US SC)]. The emphasis is on the results reached rather than the methods used or means of getting to those results. Another constraint is regulators setting rates based on cost of service, which is the second side to “just and reasonable rates”; regulators also face constrains from legislatures in setting rates; for example, in some states regulators must set rates that conform with utility incentives to promote energy efficiency and clean energy. See Supra note 2.

• ⁶ Regulators have had to revisit their interpretation of “just and reasonable” rates and redefine the public interest. They have grappled with advancing additional objectives, either mandated by the outside or self-imposed.

• ⁷ Paul M. Hogan, “Utilities, the State, and the Public Interest,” (1958) 10:2 UC LJ 176 online (pdf): <repository.uclawsf.edu/cgi/viewcontent.cgi?article=1579&context=hastings_law_journal>; Eric Filipink, “Serving the “Public Interest”− Traditional vs Expansive Utility Regulation.” (2009) Harrison Institute for Public Law Georgetown Law, NRRI 10-02; and Johny Ghasemi, “Importance of Public Interest in Developing Policies and Governing Institutions,” (2023) 11:2 J of Political Sciences & Pub Affairs, online (pdf): <longdom.org/open-access/importance-of-public-interest-in-developing-policies-and-governing-institutions.pdf>.

• ⁸ The fall 2007 issue of Daedalus (Journal of the American Academy of Arts & Sciences).

• ⁹ Supra note 7 and ibid. Defining the collective interest of society or what some analysts call the common good is to some extent a value judgment. Each individual or group has unique preferences, available information and position in society. Even if everyone can agree on objectives, they are likely to disagree on the relative importance of those objectives.

• ¹⁰ The rationale is that utility markets exhibit what economists call “market failure” that requires regulators to protect customers (especially vulnerable customers like households) from the monopoly power of utilities. Regulators also know that utilities need to be financially viable in attracting capital and maintaining their system to provide reliable service to their customers.

• ¹¹ Because fairness is elusive and enters the domain of philosophy, it becomes difficult to know what is fair and to assert that one policy is fairer than another is. Since stakeholders’ perceptions of fairness differ, regulators face the difficult task of balancing them to decide what is in the public interest. In the end, it is regulators that define fairness. Instead of evaluating actions and policies based on fairness, regulators might find it easier to eliminate those policies that are clearly unfair before determining whether a particular policy passes a “fairness” test.

• ¹² One example of faulty ratemaking is political expediency where the regulator attempts to appease influential industrial groups by requiring utilities to offer them subsidized rates paid for by the other utility customers.

• ¹³ Bypass is uneconomic because a customer turns to a non-utility provider for one or more services when the alternative provider (e.g., retail marketer) has higher total costs but lower prices. Society incurs higher costs in meeting the demands of a customer. Probably the major cause of uneconomic bypass is the inability of the utility to lower its rates below fully-allocated embedded costs, which under certain circumstances (e.g., a utility has a high level of surplus capacity) could far exceed its marginal cost. Another cause of uneconomic bypass is faulty rate design, specifically an excessive usage or volumetric charge, where certain customers within a group (e.g., high-usage customers within the industrial class) pay more than the utility’s cost of serving them, and perhaps at a higher rate than the price of competitive providers.

• ¹⁴ William J. Baumol, Superfairness: Applications and Theory (Cambridge: The MIT Press, 1988), 112.

• ¹⁵ James C. Bonbright et al., Principles of Public Utility Rates, 2^nd Edition, Public Utilities Reports, Inc., (Columbia University Press, 1988), the first edition, authored solely by Bonbright, was published in 1961.

• ¹⁶ Traditional ratemaking, sometimes called rate-of-return (“ROR”) regulation, refers to the application of cost-of-service principles for setting rates that determine the utility’s authorized rate of return. Features include: (a) new rates remains fixed until the regulator approves new rates after a comprehensive rate case; (b) the utility has a reasonable opportunity (but no guarantee) to earn its authorized rate of return; (c) the balancing of utility customer and shareholder interests is an overriding goal; (d) the selected test year matches revenues with costs over the first year of new rates; (e) the utility’s actual rate of return between rate cases deviates from the authorized return when actual sales and costs differ from their test-year levels; and (f) regulatory lag can either benefit or harm utilities, depending on whether average cost is decreasing or increasing. [Alfred E. Kahn, “The Economics of Regulation” (1971) 2:2 The Bell J of Econ and Management Science 678 [Kahn]. Added features aligned with real-world applications are limited use of cost trackers or riders for utilities to recover specific costs outside of a general rate case and a rate design that incorporates most of a utility’s fixed costs into the volumetric or usage charge. See Ken Costello, “How Should Regulators View Cost Trackers?” (2009) 22:10 The Electricity J 20 [Costello]; and Scott P. Burger et al., “The Efficiency and Distributional Effects of Alternative Residential Rate Design” (2020) 44:1 The Energy J 199 [Burger et al.].

• ¹⁷ Peter Kind, Disruptive Challenges: Financial Implications and Strategic Responses to a Changing Retail Electric Business, (Edison Electric Institute, 2013), online (pdf): <ourenergypolicy.org/wp-content/uploads/2013/09/disruptivechallenges-1.pdf>.

• ¹⁸ Severin Borenstein & James Bushnell, “The US Electricity Industry after 20 Years of Restructuring” (2015) 7 Annual Rev of Econ 437, online : <doi.org/10.1146/annurev-economics-080614-115630>.

• ¹⁹ Regulators’ rejection or non-consideration of variants of traditional ratemaking, like price caps and multiyear rate plans (“MRPs”), may be more of a rational response than inertia (David E. M. Sappington & Dennis L. Weisman, “The Disparate Adoption of Price Cap Regulation in the U.S. Telecommunications and Electricity Sectors” (2016) 49:2J of Regulatory Econ, at 250­–64.) Inertia implies a rigid regulatory position toward these rate mechanisms, irrespective of the circumstance or what the evidence shows; namely, a status-quo bias in which regulators adhere to traditional ratemaking no matter the environment under which a utility operates or the expected outcome. It seems plausible that the lack of wide acceptance of price caps and MRPs in the US electric industry reflects the reluctance of risk-averse regulators to accept a mechanism with uncertain outcomes that could make matters worse, which is conceivable with a poorly structured and executed plan.

• ²⁰ Kahn, supra note 16.

• ²¹ Regulatory policies can discourage or stimulate utility investments in innovations, thereby affecting the amount that utilities spend on innovation, the speed at which they innovate, and the nature of the innovations. The regulatory tools that affect innovation are ratemaking, mandates, and performance standards. By placing bounds on utility profits and risk, regulation can either constrain or stimulate innovation. Regulated utilities face more severe profit constraints than their unregulated counterparts, which by itself diminishes their willingness to innovate. Analysts have criticized traditional ROR ratemaking for providing utilities with weak incentives to innovate. See, GE Digital Energy and Analysis Group, “Results-Based Regulation: A Modern Approach to Modernize the Grid,” (2013) UN environment programme, Working Paper. For discussion of regulatory options to encourage distributed energy resources, see Ontario Energy Board, Framework for Energy Innovation: Setting a Path Forward for DER Integration, (2023), online (pdf): <oeb.ca/sites/default/files/FEI-Report-20230130.pdf>.

  On the other hand, regulatory policies can also encourage innovation, sometimes with poor results. Electric utilities, for example, historically invested aggressively in new technologies when their economic incentives were strong (i.e., the expected return was high relative to the risk). In the past, some of those new technologies have performed poorly, burdening utility customers with recovery of excessive costs. See, for example, H. Stuart Burness, W. David Montgomery, & James P. Quirk, “Capital Contracting and the Regulated Firm” (1980) 70:3 Am Econ Rev, at pp 342–54. During the 1960s to the mid-1970s, for example, utilities found nuclear power attractive because of the potential to earn high rates of return and the low risks involved during this period of rare retrospective review. See also Paul Joskow, “Productivity Growth and Technical Change in the Generation of Electricity” (1987) 8:1 The Energy J at 17–38.

• ²² See Ken Costello, “New Technologies: Challenges for State Utility Regulators and What They Should Ask” (2012) 12:1 NRRI.

• ²³ As a rule, regulators frown upon frequent rate cases: They expose regulators to public scrutiny and confront them with the difficult task of balancing the interests of politically active stakeholders. Rate cases are also time consuming and expensive, leaving the regulators with fewer resources to pursue other activities integral to their duties.

• ²⁴ Traditional ratemaking can also motivate utilities to overinvest in innovation when the expected return is high relative to the risk (see supra note 21).

• ²⁵ “Regulatory lag” refers to the time gap between when a utility undergoes a change in cost or sales levels and when the utility can reflect these changes in new rates.

• ²⁶ Regulators have been hesitant to move from average-cost to marginal-cost pricing thanks in part to higher rates for some customers or much higher rates for all customers over specific periods (e.g., summer peak periods for electricity service). For other problems with marginal cost pricing, see Ronald H. Coase, “The Marginal Cost Controversy: Some Further Comments” (1946) 13:51 Economica, at 169.

• ²⁷ One prominent criticism originates with the Averch-Johnson (A-J) effect, which says that a utility would use excessive capital input relative to other inputs such as labor, fuel, and materials. This outcome assumes that a utility faces a binding rate-of-return constraint on its rate base and its allowed rate of return exceeds its actual cost of capital. [Harvey Averch & Leland L. Johnson, “Behavior of the Firm Under Regulatory Constraint” (1962) 52:5 Am Eco R, 1052].

• ²⁸ When the utility initiates rate reviews, it can manipulate the regulatory process to its advantage. Yet if reviews occur at fixed intervals, such as under a price-cap regime, the utility would have an incentive to inflate costs just prior to a review so as to receive higher rates in the following period, defined by analysts as the “ratchet effect”.

• ²⁹ Severin Borenstein, “Energy Hogs and Energy Angels: What Does Residential Electricity Usage Really Tell Us About Profligate Consumption?” (2024) National Bureau of Economic Research, Working Paper No 32023, online (pdf): <nber.org/system/files/working_papers/w32023/w32023.pdf>; and Kayla Carroway et al., “Costs, Benefits, And Methods Of Implementing Alternative Rate Mechanisms
  For Utility Ratemaking,” (2022) Kentucky Legislative Research Commission, Research Memorandum No 531, online (pdf): <legislature.ky.gov/LRC/Publications/Research%20Memoranda/RM531.PDF>.

• ³⁰ Non-linear pricing (with two-part tariff) has been used in the pricing of utility services since early in the 20^th century. Early proponents such as Samuel Insull viewed this rate design as a way to expand demand and lower average costs while satisfying a break-even constraint (i.e., a financially viable utilty). Prior to that time, an unmetered rate was the earliest type of rate used by utilities: a customer is billed a fixed sum for service during a specified period regardless of usage; this billing practice was used prior to the introduction of meters; this rate structure was simple and easy to administer, but was both highly uneconomical and inequitable, since two customers with much different levels of electricity consumption would have the same monthly bill. Flat rates (i.e., one-part volumetric tariff) were the next rate structure, where the utility bills a customer based on a constant price per electricity consumed and registered by a meter; this is simplest of all metered rate methods; it posed serious problems as well, including revenue instability, poor price signals, and subsidization of low-usage customers by high-usage ones.

• ³¹ Some utilities label this rate element the monthly service charge or some other name that represents the minimum charge to customers when they consume no utility service.

• ³² The formula above assumes a uniform volumetric distribution charge. Many utilities have block pricing where the volumetric distribution charge varies between blocks of consumption. These rate designs include increasing and declining block structures.

• ³³ The monthly customer charge equals the allocated annual customer costs divided by the number of customer months.

• ³⁴ The volumetric charge equals the total costs (minus the costs recovered in the customer charge) divided by the annual sales as determined at the last rate case.

• ³⁵ Burger et al., supra note 16.

• ³⁶ Ahmad Faruqui, “Rate Design 3.0,” (May 2018) Public Utilities Fortnightly, online: <fortnightly.com/fortnightly/2018/05/rate-design-30>.

• ³⁷ Burger et al., supra note 16.

• ³⁸ One instance is the restructuring of the US electric industry, starting in the 1970s, triggered by the discontent of consumer groups (for example, industrial customers) from continuous rising electricity rates along with the problems experienced by utilities in getting the regulators to approve pass-throughs of costs, even those prudently incurred but second-guessed because of unexpected circumstances. See Paul L. Joskow, “Regulatory Failure, Regulatory Reform and Structural Change In The Electric Power Industry” (1989) Brookings Papers on Economic Activity: Microeconomic, Working Paper No 02139 at 125–99. Joskow remarked that “After 1973 utilities requested much larger rate increases because of large, unanticipated, and mostly uncontrollable increases in costs. These requests further intensified political resistance to rate increases and created pressures for regulatory changes that would deal with the problems caused by rapidly rising electricity costs. Regulatory resistance to price increases caused utilities’ financial performance to decline precipitously. By the late 1970s the system that had appeared to work so smoothly for so long was near collapse, plagued by controversies that had not been associated with the industry since the early1930s (at 126–27).”

• ³⁹ Supra note 15.

• ⁴⁰ Paul L. Joskow, “Inflation and Environmental Concern: Structural Changes in the Process of Public Utility Regulation,” (1974) J of L and Econ, 17:2 at 291.

• ⁴¹ See Darrell Proctor, “The POWER Interview: What Energy Consumers Want from Utilities” (25 December 2022), online: <powermag.com/the-power-interview-what-energy-consumers-want-from-utilities>; and Bill LeBlanc, “What market research is telling utilities about consumers and solar, Part 1” (11 June 2015) Smart Electric Power Alliance, online: <sepapower.org/knowledge/what-market-research-is-telling-utilities-about-consumers-and-solar-part-1>.

• ⁴² Direct Testimony of Kenneth W. Costello, (2022), Case No. 21-637-GA-AIR et al., online: The Public Utilities Commission of Ohio <dis.puc.state.oh.us/ViewImage.aspx?CMID=A1001001A22E13B22252A02162>; and Costello, supra note 16.

• ⁴³ Jeffrey A. Adams et al., “Utility Assistance and Pricing Structures for Energy Impoverished Households: A Review of the Literature” (2024) 37:2 The Electricity J, online (pdf): <sciencedirect.com/science/article/pii/S1040619024000034/pdfft?md5=934017cfde71a5662e9ae232749fcf69&pid=1-s2.0-S1040619024000034-main.pdf>; and Kenneth W. Costello, “The Features of Good Utility-Initiated Energy Assistance” (2020) 139 Energy Pol’y, online: <sciencedirect.com/science/article/abs/pii/S0301421520301026#:~:text=This%20paper%20identifies%20criteria%20that%20public> [The Features of Good Utility-Initiated Energy Assistance]. The last article remarked that “Utility programs are common in the US. Public utility regulators are on the front lines in evaluating these initiatives and approving them, conditioned on legal, economic and other constraints, that best serve the public interest.”

• ⁴⁴ Ibid.

• ⁴⁵ For example, which initiatives offer the highest benefit-to-cost ratio?

• ⁴⁶ Kenneth W. Costello, “A Welfare Measure of a New Type of Energy Assistance Program,” The Energy J, 9:3 (1988) at 129–42.

• ⁴⁷ If these households face below-cost rates, they would tend to consume more energy. Some observers would contend that even if they do, that is desirable since presumably they were under-consuming energy previously when utility service was less affordable.

• ⁴⁸ Many economists have identified inadequate income as the real culprit of unaffordable utility service. They contend that state and federal legislatures, or other governmental entities, are best able to address poverty by (a) supplementing the income of poor households (e.g., via cash subsidies with no strings attached), (b) in-kind assistance funded through general revenues (e.g., “energy stamps”) or (c) offering them financial support for energy-efficiency improvements. Specifically, they argue that these actions are more effective and efficient than subsidized utility rates. Political pressures and legislative mandates, however, have led to energy utilities’ offering of programs to insulate low-income households from unaffordable utility bills. These initiatives, described by some economists as “taxation by regulation,” require higher rates to the majority of customers to pay for energy subsidies targeted at a smaller group of customers. The “tariff effect” that makes funding customers minimally worse off in return for making low-income recipients better off has political appeal. See The Features of Good Utility-Initiated Energy Assistance, supra note 43.

• ⁴⁹ At least in choosing a car, a consumer has objective and definitive information on the features of different cars. One knows the miles per gallon, the color, the power, the safety features, the maintenance and operating history of different car models, and so forth. Like ratemaking, car buyers have to make trade-offs. But at least they have access to objective information. Regulators have no such luxury. They must judge which witnesses have presented the most unbiased and well-founded information. For example, stakeholders would tend to differ over the extent to which a straight fixed-variable rate design would have a negative effect on energy efficiency or low-income households.