Have you ever wondered how state regulators set rates for public utility service? In general, this process involves two steps: establishing a revenue requirement and designing a way to collect that revenue requirement from consumers through a rate design.
In determining a utility’s revenue requirement regulators seek to determine, based upon expert testimony, the amount of revenue necessary to fund prudent investments, to provide a reasonable profit for making these investments, and to ensure that the utility can continue to deliver reliable service. If the required revenues exceed those currently collected from consumers, rates go up. The converse is also true.
Once regulators determine an appropriate revenue requirement they must then decide, based upon expert testimony, how to design rates that will equitably collect this revenue requirement from different types of consumers. In doing so, consumers are generally grouped together into classes based upon common characteristics. Examples of these characteristics include demand requirements or usage patterns. Examples of resulting rate design classes include “Residential” or “Industrial” consumer designations. The goal in designing customer rates is to establish an overall rate to be paid by each customer class that recovers from that class the costs incurred by a utility in providing service to those consumers. In other words, the price you pay should, in theory, reflect the costs incurred by a utility in serving you.
District-Specific Pricing vs. Single-Tariff Pricing
This theory gets complicated when a utility serves similar classes of customers in geographic areas (“districts”) that are not physically interconnected. This situation is most prominent in the water and wastewater industries, where one corporation may serve multiple pockets of isolated consumers using multiple independent treatment systems. Because the cost to install, operate and maintain these independent systems may vary dramatically from district to district, similar classes of customers located in different areas may be left facing drastically different rates if those rates are designed on an isolated, “district-specific” basis.
As a result, many practitioners advocate the use of a pricing strategy commonly referred to as “single-tariff pricing”. Under this approach costs attributable to individual systems are aggregated and then redistributed among the larger resulting consumer base. Proponents of single-tariff pricing argue that the strategy decreases administrative costs, helps to achieve economies of scale, and “smoothes out” potentially drastic differences in rates that would have been paid by consumers under a district-specific approach.
Opponents of single-tariff pricing are quick to point out that the pricing strategy is fundamentally discriminatory. Single-tariff pricing results in customers in low-cost districts paying an overall rate that generates revenues higher than the costs incurred in serving them. Customers in high-cost districts pay an overall rate that generates revenues that are lower than the costs incurred in serving them. Effectively, the low-cost districts subsidize the high-cost districts, and are thus arguably the subject of price discrimination.
Legally, this is only the beginning of the debate. In practice, most states do not forbid discrimination in utility pricing, but rather forms of “unreasonable” discrimination. These statutory standards beg the question as to what amount of discrimination is then permissible and what amount is not. Unfortunately, an answer is not clear. Although regulators are granted a large amount of discretion in approving rate designs, regulators must be conscious not to abuse this discretion in approving a rate design that shows little or no correlation between the “cost causers” and the “cost payers”. In reaching these important decisions regulators should examine factors affecting differences in the costs of comparable services and must set prices that are ultimately reasonable.