The issue
Formula-based rates have long been used for wholesale generation contracts under Federal Energy Regulatory Commission (FERC) jurisdiction. More recently, FERC has approved formula-based rates for Open Access Transmission Tariffs (OATTs) at the request of the transmission owner. This issue briefly focuses on the relatively new use of formula-based rates in retail ratemaking. Formula-based rates set the upcoming year’s rates based on the previous year’s expenses and a predetermined “formula” derived from the utility company’s costs and a reasonable rate of return. In retail rate setting, there are two distinct mechanisms that have been approved – performance-based-formula rates that use a formula to keep a utility’s rate of return within a set performance band and formula-based rates that tie rate increases to an economic index.
How they work
Performance-based-formula rates allow a utility to earn a rate of return that falls within a percentage band above or below its approved rate of return, with a sharing mechanism at the top and bottom ends of the band that splits revenue variations outside the band between the shareholders and ratepayers. That band usually is divided in such a manner as to incent the utility to increase efficiencies.
Example: Formula Based Rates
Use of Formula Based Rates in AEP Jurisdictions
| Jurisdiction | Example of use |
|---|
| Louisiana | Approved by LPSC for SWEPCO, April 2008 |
For example, if a utility has been authorized for a 12% return, with a 1% band, then a utility that earns between an 11 to 13% return would keep all of that return without adjustment. A sliding scale sharing mechanism would split revenue variations above 13% or below 11% between ratepayers and shareholders
Another method of formula-based rate setting is illustrated by the case of NSTAR, an electric and gas distribution only company. NSTAR’s rates are tied to the gross domestic product price index, which is a measure of inflation in the economy. This means, that its rates rise in concert with inflation. In order to ensure that the company operates efficiently, it is not able to fully pass along cost increases to the customer, but instead must subtract a formula derived productivity offset. This offset is based on an assumed rate of growth and is set on a sliding scale that allows for variances in any given year.
Formula based rates as part of the ratemaking continuum
Formula-based rates are placed at the traditional end of the ratemaking continuum. Under traditional ratemaking, an investor-owned utility, (IOU) operates with an approved rate of return. All prudent costs are generally recovered, and utilities are provided the opportunity, but are not guaranteed to earn, the authorized rate of return. When costs go up the IOU can request a rate increase to compensate. This also holds true when a major capital investment such as a new generation plant or transmission line is constructed.
AEP position
AEP considers formula-based rates based on appropriate mechanisms to be desirable and advocates for them. Currently, we have formula based retail rates in Louisiana and formula based transmission and wholesale generation rates in the PJM and SPP transmission regions.
