Using traditional cost-of-service methodology, the majority of earnings are determined by the rate of return on equity the commission authorizes multiplied by the value of assets in the equity portion of the rate base. Because earnings are dependent upon the value of the rate base, utilities have been incentivized to invest in more facilities, thereby increasing their potential earnings. To protect the customer from paying for unnecessary facilities, regulators require prior approval of major facility additions as well as reasonableness reviews of expenditures.
Earnings Portion of Revenue Requirement = (Authorized Rate of Return on Equity) X (Equity Portion of Rate Base)
Under cost-of-service regulation, a utility can increase earnings in four ways:
The last two strategies work if expenses and/or revenues are not subject to balancing accounts. So if a utility is able to get regulators to approve a certain expense threshold and then subsequently beats that threshold, it gets to keep as profit any remaining expense dollars. And if the utility has not been “decoupled” and achieves more sales than forecast when the rates were set, the utility gets excess revenues to increase profits.
It is important to keep in mind that authorized rates of return are not guaranteed by regulators. Utilities can fall short of authorized returns in many ways. Areas of risk include: