Dividing the Pie: Cost Allocation, the First Step In the Rate Design Process
This brief paper outlines standard approaches to utility cost allocation and explores how decisions made by regulators affect eventual rate designs (i.e., how a utility’s revenue requirement is apportioned among customer classes). Jim Lazar provides an overview of different approaches to cost of service studies, which attempt to reflect utility costs in a causal manner. Depending on the approach taken—marginal cost, incremental cost, or embedded cost—these studies can produce significantly different results. Regulators routinely consider the results of multiple studies in determining a cost allocation and rate design that meets the legal test of “fair, just, and reasonable.” The availability of increasingly sophisticated usage data allows utilities to implement time-varying rates that more accurately apportion costs among customer classes. (This paper originally appeared as Appendix A to RAP’s “Smart Rate Design for a Smart Future.”)