Revenue allocation is a step in the ratemaking process where the revenue requirement is divided among specific utility functions and, within functions, to specific customer classes. The general concept is that costs are allocated based on cost causation. This means that costs should be allocated to a function based on how that function contributes to the total utility costs, and that each customer class should be charged its fair share based on the actual costs the energy company incurs providing service to that customer class plus its fair share of overheads. Ideally there should not be cross-subsidization from one customer group to another. Data to determine a fair allocation is developed in a cost-of-service study and the process is detailed below.
Cost functionalization
The first step of the study is cost functionalization, where costs are associated with a specific service provided by the company. The FERC Uniform System of Accounts sets the standards as to how costs are booked to accounts and how specific accounts are functionalized. For an electric company, typical functions include generation, transmission, distribution, and electric procurement. For a gas company, typical functions include local transmission, storage, distribution, and gas procurement. All companies also have administrative and general costs that are not specifically associated with a particular function.
The outcome of functionalization is that all costs are associated with a specific function:
Administrative and general costs are then distributed between the multiple functions based on a formula that attempts to replicate each activity’s fair share.
Cost classification
The second step in the cost-of-service study is cost classification. In this step costs are classified into fixed, variable, and per-customer categories. Fixed costs are those that occur regardless of the amount of gas or electricity sold or the number of customers served. Variable costs change based on the amounts sold. And per-customer costs are fixed costs that change based on the number of customers served, but not by the amount sold to each customer. Here are examples:
- Fixed – the cost of building and maintaining distribution lines
- Variable – the operating and fuel cost of generating electricity to deliver to consumers
- Per-customer – the cost of providing and maintaining a customer meter
Allocation to customer classes
The last step in the allocation process is to allocate the revenue requirement to customer classes. As mentioned previously, costs are allocated based on cost causation. This means that each customer class should be charged its fair share of the assumed costs the energy company incurs in providing service to that specific customer class. Various methodologies are used to determine fair allocations and they are often one of the most highly contested issues in a rate case since each customer group advocates a position that will keep its rates as low as possible. But since all costs must be recovered, reducing an allocation to one group inevitably increases an allocation to another. Once revenues have been allocated, the step of determining rates for each service can begin.