Cost allocation is one of the major steps in the traditional regulatory process for setting utility rates. In this step, the regulators are primarily determining how to equitably divide a set amount of costs, typically referred to as the revenue requirement, among several broadly defined classes of ratepayers. The data and analytical methods used to inform cost allocation are often relevant to the final step of the traditional regulatory process, known as rate design.
Cost allocation has been addressed in several important books and manuals on utility regulation over the past 60 years, and these works and historic best practices are foundational. But the legacy methods from the 20th century are no more suited to the new realities of the 21st century than the engineering of internal combustion engines is to the design of new electric motors. Charting a new path on cost allocation is an important part of creating the fair, efficient and clean electric system of the future.
There is general agreement that the overarching goal of cost allocation is equitable division of costs among customers. Unfortunately, that is where the agreement ends and the arguments begin. Two primary conceptual principles help guide the way to the right answers:
- Cost causation: Why were the costs incurred?
- Costs follow benefits: Who benefits?
In some cases, these two frameworks point to the same answer, but in other cases they conflict. The authors of this manual believe that “costs follow benefits” is usually, but not always, the superior principle.
The manual digs into these questions for all types of electric utility costs. While there are often a range of good techniques for each issue, there are certainly high-level best practices that apply to the two common types of quantitative frameworks used for cost allocation in the United States, the embedded cost of service study and the marginal cost of service study:
- Apportion all shared generation, transmission and distribution assets and the associated operating expenses on measures of usage, both energy- and demand-based.
- Ensure broad sharing of administrative and general costs, based on usage metrics.
- Eliminate any distinction between “fixed” and “variable” costs, as capital investments (including new technology and data acquisition) are increasingly substitutes for fuel and other short-run variable operating costs.
- Treat as customer-related only those costs that actually vary with the number of customers, a technique generally known as the basic customer method.
- Where future costs are expected to vary significantly from current costs, make the cost trajectory an important consideration in the apportionment of costs.
This manual focuses on cost allocation practices for electric utilities in the United States and their implications. Our goal is to serve as both a practical and theoretical guide to the analytical techniques involved in the equitable distribution of electricity costs. This includes background on regulatory processes, purposes of regulation, the development of the electricity system in the United States, current best practices for cost allocation and the direction that cost allocation processes should move. Most of the elements of this manual will be applicable elsewhere in the Americas, as well as in Europe, Asia and other regions.