Electric rates undercharge monthly customer charges and kW demand charges

The monthly residential customer electric bill consists of a customer charge and a kWh charge. The monthly electric bill for a large power user consists of a kW charge and a kWh charge. Would it surprise you it costs two-four times more to serve a customer with kW and customer services than is included in the customer’s monthly customer flat charge? The undercharged kW and customer cost amounts ends up in the kWh charge. Why is this, why does it matter, and what might you do about it? Read on, and we’ll share some schools of thought on electric ratemaking.

Article Takeaways

1. The general cost types for providing electric services are fixed (demand - kW), variable (usage - kWh), and costs to serve a customer.

2. Cost of service studies show that the actual monthly fixed costs for a residential customer range from $50 - $75/month. However, the average meter charge for many utilities is $15 - $25/month.

3. These “un-recovered” fixed costs become part of the charge per kWh, putting an electric co-op or utility at risk of under-recovering fixed costs if there are changes in kWh usage patterns

4. The goal for the electric organization should be to close the fixed charge gap. Strategies for closing the gap include increasing the monthly fixed charge at a higher rate than the charge per kWh.

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The process for making electric rates

In developing electric rates, a co-op or utility uses a three-step process to develop electric rates:

1. Develop a revenue requirement, the amount of revenues needed from electric rates in the next budget period to operate the co-op or utility. This should include all expenses, included regulatory (GASB 62) and other overheads.

2. Perform a cost of service study, which allocates demand (kW), usage (kWh), and customer costs based on the customer’s usage pattern.

3. Design electric rates that provide revenues equal to the revenue requirement.

The costs of providing electric service that are allocated in the cost of service study fall into three main cost types:

1. Fixed or demand-related costs, i.e., how the electric system should be built to handle all potential customer electric needs on the hottest day of the year.

2. Variable, i.e., how much electricity a customer uses for x number of hours.

3. Customer costs, i.e., how much it costs to bill a customer monthly and maintain their customer services.

The general electric activities that fall under each cost type include:

1. Fixed (kW) - power plants and power production costs, labor, and a percentage of the various distribution, substation, poles, and conductor costs.

2. Variable (kWh) - how much power needs to be purchased or produced to meet customer needs, and a percentage of the miscellaneous distribution, substation, poles, and conductor costs.

3. Customer - the costs of invoicing, meter reading, and customer service

A simple approach to developing electric rates would be to take the costs in each cost type (fixed, variable, customers) and divide them by the units of service (kW, kWh, and customers) to arrive at the cost per unit. There would be no need for rate consultants if it were that easy.

Trends in electric rate theory

Seriously though, there are decades of embedded politics and strives for “equity” in any electric co-op or utility rates. The electric industry went through a period where industrial customers subsidized residential customer rates because the approach was to keep the residential customers happy and out of rate hearings. Then there was a period where residential customers subsidized the rates for industrial customers, as co-ops and utilities wished to draw industries to a community and keep them there. These are not good or bad approaches, just an approach that reflects the strategy.

The move in recent years has been to move rates in each customer class (residential, commercial, industrial) towards the cost to serve them. But, within each customer class, there is an inequity, and that is between the customer fixed (kW or monthly charge) and variable (kWh) charge. This is true equity in electric rate theory.

What is each electric charge type supposed to do?

The typical residential rate (non-time of use) is made up of a monthly customer charge that is the same each month, and a per kWh charge, based on the customer’s electricity usage for the month.

The customer charge is designed to recover a portion of the fixed costs of the customer class. For example, in a typical cost of service study, the calculation of the monthly fixed charge would be as follows:

Why is only a portion of the fixed cost being recovered?

Where do the remaining costs go? The cost pot for each customer class is fixed, so all costs must be accounted for in customer rates. This means that the remaining fixed costs end up in the volume charge. A sample calculation of rates shows the differences between the actual cost of service and the rates that result from moving some of the fixed costs into the volume charge.

The risk in this rate design is that kWh’s used by customers may decline due to economic conditions, technology changes, distributed energy resources, or population shifts, and thus, the kWh revenues decline. Part of the decline in revenues will not impact the financial results of the utility or co-op because as kWh’s decline, so does power expense due to a decrease in the purchases or production of kWhs. But, a portion of the $/kWh is designed to contribute towards the recovery of fixed costs. So, as kWh’s decline, there is less revenue available for fixed costs.

If your community’s population and industrial customer base is stable or growing, this effect won’t occur for your co-op or utility. But, post-covid, we see significant shifts in populations occurring rapidly, with areas losing population and businesses, while other areas of the country are beneficiaries of this movement. In the population loss areas, the lost revenues will need to be recovered by restructuring rates to existing customers.

Recent cost of service studies that we have done show that the typical residential monthly customer charge should be $50 - $75/month. However, the average meter charge for many investor-owned, electric co-ops, and public power utilities is $15 - $25/month. If you also provide water and wastewater services, undercharging demand costs is common in the industry so it bears review.

Demand (kW) charges are also “undercharged”. Under-recovery of fixed demand costs leads to financial risk for a utility or co-op if load patterns change or large customers exit your system. Demand charges are priced at an average of $10/kW - $20/kW, where the actual kW fixed charge should be closer to $45/kW - $60/kW. The difference, as with residential customers, flows to the volume charge. This puts the utility at risk of exposure of under-recovering its fixed costs if kWh sales decline, as they did during the 2008-2009 recession and the quick recession of 2020.

Strategies to close the cost of service and rate gap

The strategies used to close this gap in customer charges and demand charges range from ripping off the bandaid and getting much closer to the cost of service for the fixed charges to keeping the status quo to a phased-in approach moving in steps to the cost of service for fixed charges.

An approach we have seen be successful is to move in significant steps towards the cost of service in each rate change. Say the overall electric rate increase needed is 2%. A way to make up ground on the rate differential between the cost of service and the current rate structure is to increase the customer fixed charge by 10%, with a lesser increase in the volume charge. Easy in theory, but moving the customer rate from $18 - $23/month may result in more feedback from ratepayers than moving the charge per kWh from $0.10 to $0.12/kWh. The input is dependent on the mood of your ratepayers.

About Russ Hissom - Article Author

Russ Hissom, CPA is a principal of Utility Accounting & Rates Specialists a firm that provides power and utilities rate, expert witness, and consulting services, and online/on-demand courses on accounting, rates, FERC/RUS construction accounting, financial analysis, and business process improvement services. Russ was a partner in a national accounting and consulting firm for 20 years. He works with electric investor-owned and public power utilities, electric cooperatives, broadband providers, and gas, water, and wastewater utilities. His goal is to share industry best practices to help your business perform effectively and efficiently and meet the challenges of the changing power and utilities industry.  

Find out more about Utility Accounting & Rates Specialists here, or you can reach Russ at russ.hissom@utilityeducation.com.

The material in this article is for informational purposes only and should not be taken as legal or accounting advice provided by Utility Accounting & Rates Specialists. You should seek formal advice on this topic from your accounting or legal advisor.