This document discusses rate setting and the role of rates in the smart grid from an 80,000 foot view. It provides an overview of economic regulation of utilities, the goal of ensuring fair rates that approximate competitive results. It outlines the 5 steps of rate setting: determining prudent costs, revenue requirements, cost allocation, rate design, and setting rates. Rate design options including time-based rates are discussed, and why rate design is considered an element of the smart grid to better link costs and rates to manage costs and reduce peak usage.

1. 80,000 ft. View of Rate Setting
and the Role Rates Play in
Smart Grid
Robert J. Procter, Ph.D.
Prepared for the Sustainability & Smart Grid Policy Course
Executive Leadership Institute, Portland State University
April 2011

2. Disclaimer
The views expressed are solely my own
and do not necessarily represent the
views of OPUC Commissioners or staff.

3. My Background
• I worked at BPA for 20 years and set rates for
my last10 years.
• Prior to that, I did study with Harry Trebing,
and old school regulator, and former director
of the Public Utility Institute at Michigan State
University.
• My academic training is in economics,
particularly micro theory, business economics
and competitive markets, and natural
resource economics.

4. My Perspective on Economic
Regulation
• Rate setting is a sausage making process.
• Rate setting for BPA and Customer-Owned
Utilities (COUs) is similar - and different -
from rate setting for Investor-Owned Utilities
(IOUs).
• Major difference - no shareholders with COUs
- this affects how risk is addressed.
• Some assert that the COUs customers are its
shareholders - WRONG!
• Unless otherwise noted, what follows focuses
solely on IOUs.

5. Economic Goal of Regulation
This graph shows that the goal of regulation is to allow society to capture
gains of lower costs(move right along green curve), more production (Qf,
not Qm) with one larger utility while assure price is competitive (Pf not Pm)

6. Rate Setting Overview (1)
• It is part art, part science.
• Regulatory compact – the IOU is granted a
monopoly franchise and in return must ‘stand
ready’ to serve customer’s needs.
• Goals of rate regulation – Make sure that IOU
spending is ‘prudent’, they produce electricity
economically, and that prices (rates) are set
fairly.
• Economics defines fair rate as a rate that
approximates the competitive result.
• The PUC sets what rate of return (return on
Equity, ROE) the utility may have an
opportunity to earn.

7. Rate Setting Overview (2)
• Actual ROE the IOU does earn can be
<=> than the target set by PUC.
• Rate setting involves five steps
Step 1: Determine if Costs are Prudent
Step 2: Determine the Revenue Requirement
Step 3: Determine Cost Allocation
Step 4: Determine the Rate Design
Step 5: Determine the Rates.
• There is a great deal of analysis that
occurs at each of these steps.

8. Step 1: Prudence Decision
• The utility’s costs are reviewed to
determine if they are appropriate.
• This involves determining if they were
‘prudently’ incurred.
• This involves determining if some costs
are excessive and should be excluded
from rates.

9. Step 2: Determine Revenue
Requirements (RR) (1)
1. The costs to be recovered from the utility’s
customers are those prudently incurred costs
associated with serving only those customers.
2. While this might appear obvious, the utility may
incur costs unrelated to serving the customers of
the regulated utility and it may incur costs in an
‘imprudent’ fashion. These costs are not to be
recovered from rate-payers. Rather, these are
costs are covered by other parties, including the
shareholders.
3. The costs that are counted are the accounting
costs that the utility actually incurs (retrospective) -
or can be expected to incur (prospective).

10. Determine RR (2)
4. Costs will likely fall into several large buckets - own
generation, own transmission, distribution, maybe
conservation separately, maybe power marketing
related costs separately (buying and selling power
from the market to serve customer needs).
5. Costs also fall into one of two large groups -
a. fixed (e.g., capital cost of a gas turbine), or
b. variable (e.g., cost of gas for the turbine).
6. Very detailed accounting ledgers list many, many,
specific cost categories, but they can be thought of
as falling into the groupings noted in bullets 4 & 5.

11. Determine RR (3)
• Fixed costs (a combustion turbine, a
transmission line, a sub-station, etc.)
have been previously incurred and are
considered historical.
• Variable costs (e.g., gas for the
combustion turbine) may either be
previously incurred (e.g., a contract) or
forecasted.

12. Step 3: Cost Allocation (1)
This is the process of taking the RR and assigning a
portion of it to each rate class.
1. A rate class represents a distinct group of
customers.
2. Common rate classes are: residential, commercial,
industrial, irrigation, and street lighting.
3. Classes may be further broken into small vs. large
commercial, etc.
4. A rate class will have its own rate schedule. For
example, a rate schedule only for residential
customers.
5. The way rate classes are defined overlaps with
Step 4, Rate Design.

13. Cost Allocation (2)
5. Customer may have to use several different rate
schedules if the utility has disaggregated its energy
services. For example, if the utility separates
(unbundles) energy from distributing that energy
and from transmitting that energy. Then, the RR
will similarly be disaggregated in the same way.
6. How many products are offered is a policy matter
(e.g., residential customers usually buy a bundled
product - delivered energy at a cents/kWh basis;
we may also buy an environmental product).
7. Costs are allocated to customer classes ideally
reflecting the costs each class imposes on the
utility. Reality: small commercial class bears more
cost than it imposes. Both industrial & residential
bear less than they impose.

14. Step 4: Rate Design (1)
1. This refers to the structure of rates.
2. By structure, I mean the number of customer
classes, and how rates for each class are
designed.
2. A utility may use a different design for each
customer class.
3. Rate Deign Options
a. Energy charge only ($/kWh)
b. Energy charge ($/kWh) + Capacity charge
($/kW)
c. (a) or (b) + monthly meter fee ($/mo)

15. Rate Design (2)
d. Flat energy rates, same price every hour of every
day of the year.
e. Inclining block energy rate, price per kWh
increases as you use more at a given point in
time, usually a month.
f. Time-of-use (TOU), price per kWh varies by
time of day, but not by amount used.
g. Real-Time Price (RTP), Price varies to reflect
system conditions but not the amount you use.
h. Critical Peak Price (CPP), Very high price for a
short number of hours in a year.
i. Peak-Time Rebate (PTR), A payment to a
customer that reflects a cost the utility will avoid .

16. Non Time - Based Power
Rates, Set Ex Ante
• Non time-based rates are rates that are constant with
time. They may or may not vary with consumption.
• Ex ante rates are rates that are set in advance (ex.,
the rates we pay at our home or apt.)
• Flat energy rate means the price does not vary with
either time or total amount you use.
• Tiered rates are rates that change with the amount
you use (rate is fixed for a given block or tier) but
they generally do not vary with time, though they
may.

17. Time Based Power Rates -
General Features (1)
• Time based rates may either be dynamic or
fixed.
• TOU rates are fixed rates (some writers call
these dynamic rates and that is wrong).
• CPP are set ex ante (far ahead), but they are
considered dynamic since the utility calls a
critical day based on system conditions close
to ‘real time.’

18. Time Based Power Rates -
General Features (2)
• RTP is a dynamic rate that is also typically set
ex ante BUT a typical RTP is set a day ahead
for a given hour the next day. (ex., it’s 10am
now, and the rate for 11am-12noon tomorrow
will be based on the forward market price
today for 11am-12 noon tomorrow).
• PTR works like CPP but the utility pays the
customer to reduce consumption (note: This
is also one form of demand response).

19. Time Based Power Rates -
General Features (3)
• Interruptible Rate – Utility offers rate
with contract allowing utility to signal
when to cut use (also has a very high
penalty rate if use is not reduced)
• Time based rates do not vary with use.

20. Step Five – Determine the
Rates (1)
• This is the process of applying the rate
design to the costs allocated to a given
customer class.
• The capacity charge ($/kW), if there is one,
the energy charge ($/kWh), and the meter
charge ($/mo.) are determined.
• Customer load shape will determine how
each customer within a given customer class
is affected by the level of these various
charges.

21. Determine the Rates (2)
• In theory, the capacity charge recovers
fixed costs and the variable charge
recovers variable costs.
• In reality, the level of capacity (if any)
and energy charges reflect economic
and political concerns.

22. Why is Rate Design Considered
an Element of SG? (1)
• Cost to provide electricity varies by time of
day, day of week, week of month, and
historically little linkage between this cost
pattern and rates has led to over-building to
meet peak use.
• Continuing this into the future requires
significant capital spending that is not
sustainable (this is a large part of the national view of SG).
• While national policy notes seven goals of
SG, they can be viewed in terms of managing
costs.

23. Why is Rate Design Considered
an Element of SG?(2)
• Numerous experiments have been performed
using CPP, PTR, RTP, and TOU rates.
• Little impact on total energy use as they tend
to shift energy use (Note: Reducing energy use is NOT
conservation unless it comes from end use efficiencies).
• Studies show that:
- Customers are price responsive, even low-
income customers,
- Reduce peak use by >= 15% (much larger
reductions are common),
- May slightly reduce total energy use.

24. SG Power Rate Options
(note: Flat, TOU, Tiered rates do not require AMI)
• All the rate options discussed earlier may be
used with a utility system with SG
components (such as AMI).
• Dynamic rates requires AMI (smart meter +
two-way communications + computing
hardware & software).
• AMI and equipment to automatically control
consumption holds the promise of greater
system efficiencies in peak use.

25. Questions?
Feel free to call or email
Robert.Procter@state.or.us
503-378-5362 (Salem)