Formula rates are a ratemaking method in which the utility adjusts its base rates outside of a general rate case, usually annually, based on an actual or projected rate of return (ROR) on rate base or equity that falls outside some commission-defined band.
Problems with Formula Rates
- Rate Instability
Formula rates shift cost volatility from the utility—who is best positioned to manage volatility—to the utility’s ratepayers. This makes it more difficult for retail customers to manage their budgets due to more frequent rate increases.
- Reduced Incentive to Control Costs
Formula rates reduce the incentive for utility management to control costs in order to earn the utility’s authorized rate of return. Like cost trackers, over time this will result in higher rates, and costs, to retail customers.
- Reduced Scrutiny & Transparency
The use of formula rates increases the likelihood of a utility passing through excess and imprudent costs to customers. The process of rate adjustments should always allow ample time and resources for regulators and consumer interests to assess whether the utility acted prudently.
ELCON Position & Recommendations
- Reduced Business Risk Should be Recognized
If a formula rate is used, regulators should account for reduced business risk attributable to the timelier and predictable cost recovery in calculating the utility’s authorized ROR. A formula rate should not guarantee earnings.
- The Importance of General Rate Cases
The use of formula rates should not unduly delay the need for regulators to conduct a general rate case to examine the appropriateness of existing cost allocations, the authorized ROR, and rate designs. Only a general rate case that use historical test years ensures the proper balancing of the various objectives of ratemaking. The more limited annual formula rate review would not address these objectives concurrently or holistically.
Ken Costello, Alternative Rate Mechanisms and Their Compatibility with State Utility Commission Objectives, National Regulatory Research Institute (NRRI), Report No. 14-03, April 2014