Designing the Rate Once the Revenue Is Set

Rate design is the last step in a rate case and the first thing a customer notices. Once the commission has fixed how much revenue each class must produce, the tariff determines the structure through which that revenue is collected. The same class total can be assembled in very different ways, and the choice among them decides which customers within the class pay more and which pay less.

The components of a tariff

Nearly every retail tariff is built from three kinds of charge. A fixed charge is billed each period regardless of consumption and is usually called a customer charge, a basic service charge or a facilities charge. An energy charge is billed per unit consumed. A demand charge, applied to larger customers whose meters record it, is billed on the maximum rate of consumption during the period.

The three track the cost classifications produced by a cost of service study, though imperfectly. Customer-related costs correspond to the fixed charge, energy-related costs to the energy charge, and demand-related costs to the demand charge. Because most residential meters historically did not measure demand, residential demand costs have conventionally been collected through the energy charge, which is the source of much of the design debate in that class.

Whatever structure is chosen must produce the class revenue target. That constraint is what makes rate design a zero-sum exercise within the class: raising the fixed charge requires lowering the energy charge, and the effect is to move money from low-use customers to high-use ones. Nothing about the change alters what the utility collects.

The fixed charge and what it should recover

The level of the customer charge is contested in almost every case. Utilities argue for a higher charge on the ground that fixed costs should be recovered through fixed charges, which stabilizes revenue and aligns the bill with the cost structure. Consumer advocates argue for a lower charge on the ground that a high fixed component removes the customer's ability to reduce a bill through conservation and weighs most heavily on small users.

Underneath the argument sits the classification question. If distribution plant is largely customer-related, a higher fixed charge follows. If it is largely demand-related, it does not. Because that classification depends on the contested minimum system analysis, the fixed charge debate is a continuation of the cost allocation debate rather than a separate one.

Minimum bills operate as a partial substitute. A minimum bill provision guarantees the utility a stated amount per period, satisfied either by consumption or by a make-up charge, and it collects fixed costs from very small users without raising the customer charge for everyone. Its drawback is that it is invisible to most customers until an unusually low-usage month produces a bill that does not fall.

Blocks, demand charges and ratchets

An energy charge may be flat or arranged in blocks. A declining block charges less per unit as consumption rises, reflecting the historical view that additional units cost less to serve once fixed costs are recovered. An inclining block does the reverse and is adopted for conservation. Federal law directs state commissions to consider a standard under which the energy component of a rate may not decrease as consumption increases unless the decrease is cost justified.

Demand charges apply where the meter records maximum load. They are stated per kilowatt of billing demand, and billing demand is usually not simply the current month's maximum. A ratchet provision sets billing demand at the higher of the current maximum or a stated percentage of the highest maximum recorded during a preceding period. The rationale is that capacity is reserved continuously for a customer whose peak occurs occasionally.

Interruptible and curtailable rates form a related category. A customer that agrees to reduce load on notice imposes less capacity cost on the system and receives a discount for accepting the obligation. The federal standards direct consideration of offering such rates to industrial and commercial customers, and the design questions are the notice period, the number of interruptions permitted and the penalty for failing to curtail.

Standby and supplemental service rates apply to customers with their own generation who rely on the utility only intermittently. The design problem is that such a customer imposes capacity cost without contributing corresponding energy revenue, so the tariff typically combines a reservation charge for the capacity held available with an energy charge for what is actually taken.

Time-varying and seasonal pricing

The cost of serving a unit of consumption is not constant. It is higher during hours when expensive resources must run and when capacity is scarce, and lower when it is not. A flat energy charge averages that variation away, so the customer sees no signal about when to consume. Time-varying rates restore the signal by pricing periods differently.

Designs range from a simple two-period schedule with a peak and an off-peak price, through three-period schedules adding a shoulder, to critical peak pricing that applies a much higher price on a limited number of days announced in advance. Seasonal differentials operate on the same logic across months rather than hours, charging more in the season when the system peaks.

Two constraints shape adoption. The first is metering: a rate cannot be billed on a basis the meter does not record. The second is bill volatility, since a customer whose consumption is concentrated in high-priced hours will see an increase without any change in behavior. Commissions address the second through transitional periods, bill protection during a first year, and default-versus-optional decisions about who is placed on the rate.

Whichever structure is chosen, it must still collect the class target established under allocating cost between customer classes, computed from the total assembled in the revenue requirement and how it is built. Charges that recover volatile purchased energy costs are usually handled separately through the mechanism described in fuel and purchased power adjustments rather than embedded in the base energy charge.