A test year is the 12-month period used in a rate case to determine a utility’s cost of service to be included in future rates. There are two types of test years: historical and forecast (future). A historical test year (also called base year) is a recently completed 12-month period, often the 12 months just prior to the beginning of the rate case period. As the name suggests, a historical test year uses actual expenses, investments, and sales to determine what it will cost to provide service in the future. Costs from this period are then adjusted to account for known and measurable changes between the test year and the future period when the rates will be in effect. A forecast test year uses a period after the start of the rate case, and instead of using actual costs it uses projected costs.
The advantage to a historical test year is that rates are based on actual known data. But a disadvantage is that rates are based on data that is often one or more years old by the time rates take effect. If costs and/or sales have the potential to rapidly change then rates will not reflect the actual utility costs when the rates are implemented. The advantage to using a forecast test year is that it takes into account changes that are expected to occur in the utility’s cost of providing service prior to rates taking effect. But it causes difficulty in that the regulators must determine the reasonableness of forecasted changes to costs and sales.