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(a) HOW COMMISSIONS SET RATES The process for establishing rates probably constitutes the most signi cant difference between utilities and enterprises in general Unlike an enterprise in general, where market forces and competition establish the price a company can charge for its products or services, rates for utilities are generally determined by a regulatory commission The process of establishing rates is described as rate making The administrative proceeding to establish utility rates is typically referred to as a rate case or rate proceeding Utility rates, once established, generally will not change without another rate case The establishment of a rate for a utility on an individual cost-of-service basis typically involves two steps The rst step is to determine a utility s general level of rates that will cover operating costs and provide an opportunity to earn a reasonable rate of return on the property dedicated to providing utility services This process establishes the utility s required revenue (often referred to as the revenue requirement or cost-of-service) The second step is to design speci c rates in order to eliminate discrimination and unfairness from affected classes of customers The aggregate of the prices paid by all customers for all services provided should produce revenues equivalent to the revenue requirement (b) THE RATE-MAKING FORMULA This rst step of rate regulation, on an individual cost-ofservice basis, is the determination of a utility s total revenue requirement, which can be expressed as a rate-making formula, which involves ve areas: Rate Base Rate of Return = Return(Operating Income) Return + Operating Expenses = Required Revenue(Cost of Service) 1 Rate Base The amount of investment in utility plant devoted to the rendering of utility service upon which a fair rate of return may be earned 2 Rate of Return The rate determined by the regulatory agency to be applied to the rate base to provide a fair return to investors It is usually a composite rate that re ects the carrying costs of debt, dividends on preferred stock, and a return provision on common equity
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3 Return The rate base multiplied by rate of return 4 Operating Expenses Merely the costs of operations and maintenance associated with rendering utility service Operating expenses include: a Depreciation and amortization expenses b Production fuel and gas for resale c Operations expenses d Maintenance expenses e Income taxes f Taxes other than income taxes 5 Required Revenue The total amount that must be collected from customers in rates The new rate structure should be designed to generate this amount of revenue on the basis of current or forecasted levels of usage (c) RATE BASE A utility earns a return on its rate base Each investor-supplied dollar is entitled to such a return until the dollar is remitted to the investor Some of the items generally included in the rate base computation are utility property and plant in service, a working capital allowance, and, in certain jurisdictions or circumstances, plant under construction Generally, nonutility property, abandoned plant, plant acquisition adjustments, and plant held for future use are excluded Deductions from rate base typically include the reserve for depreciation, accumulated deferred income taxes (ADITs), which represent cost-free capital, certain unamortized deferred investment tax credits, and customer contributions in aid of construction Exhibit 331 provides an example of the computations used to determine a rate base (d) RATE BASE VALUATION Various methods are used in valuing rate base These methods apply to the valuation of property and plant and include these three: 1 Original cost 2 Fair value 3 Weighted cost (i) Original Cost The original cost method, the most widely used method, corresponds to accounting principles generally accepted in the United States (GAAP), which require historical cost data for primary nancial statement presentation In addition, all regulatory commissions have adopted the USOA, requiring original cost for reporting purposes Original cost is de ned in the
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NET INVESTMENT RATE BASE In Millions Plant in service Less reserve for depreciation Net plant in service Add: Working capital allowance Construction work-in-progress Deduct: Accumulated deferred income taxes Advances in aid of construction Net investment rate base Exhibit 331 Example of a utility rate base computation $350 (100) 250 3 33 (14) (2) $270
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