Broker eXcelerate Series: Cost-of-Service Vs. Retail Open Access Markets

For many customers, their utilities and the bills they receive from power providers are a bit of a black box. They use energy, turning on lights and powering their appliances or equipment and then they receive a bill at the end of the month. Some of the more informed customers, such as facility managers and building managers of larger commercial enterprises, will understand the specifics: charges for energy use, for peak demand capacity, and for time of use, but those specific rates are still set in stone in a process they don’t understand.

Customers who best understand the process that goes into their rates, though, will be the ones most poised to benefit. And in markets where competitive energy contracts are signed, brokers who can understand and explain these intricacies to their customers and potential clients will be best positioned to earn trust and business. But what makes this area harder to understand is the patchwork of different process that go into setting rates depending on the state, the regulators in a region, and the form in which a power provider takes.

As such, this latest entry into the Broker eXcelerate series aims to educate readers on the two most prominent and important methods for setting power prices: cost-of-service ratemaking vs. retail open access market rates.

Cost-of-Service Ratemaking

Utilities provide an essential public service, one that modern life, business, and society simply cannot operate without. For most customers across the country, though, utilities still represent a business that is seeking to turn a profit for their shareholders. Investor-owned utilities, or IOUs, make up just 6% of the utility companies in the United States (compared with 28% electric cooperatives and 67% publicly-owned utilities), but because IOUs have a much larger in geographic footprint and customer base on a per-utility basis, they serve nearly three quarters of all U.S. electricity customers.

So, while publicly-owned utilities (such as municipal utilities) are providing a pure public service at the most affordable rates possible to customers (similar to a Post Office, providing a service but not specifically aiming to make a profit), investor-owned utilities operate more in the vein of a company like FedEx that they must cover operating costs while also making a profit for shareholders. These businesses exist to make money, first and foremost. But because fair utility coverage is essential for daily life and, in most states, customers are under the coverage of a singular monopoly company (i.e., they have no choice to move to an alternative competitor), IOUs are closely watched to ensure they are setting reasonable rates. The lack of alternatives to which customers can turn could be readily exploited if not for this oversight. Put another way, if a utility can increase rates whenever they want with no explanation, and customers don’t have any option but to pay that one available company for those services, it could turn ugly quite quickly. As a result, IOUs typically must comply with cost-of-service ratemaking through their regulatory body.

Cost-of-service ratemaking is a process in which a central regulator determines that cost of service for electricity that accurately reflects the total amount that must be collected from customers for 1) the utility to recover its costs and for them to 2) earn a reasonable rate of return. The final calculations to figure out this rate can get complex and nuanced to get exact prices (especially among different rate structures outside a flat cost per kilowatthour), but the watered down formula is:

Rate base x allowed rate of return = required return + operating expenses = revenue requirement

In this formula:

  • Rate base is the amount of investment coming from shareholders in new assets, such as the cost of new power plants being built

  • Rate of return is the percentage rate that a central commission (such as the state regulator) determines is ‘fair’ for the utility to earn on the investment (this provides a return for the risk that comes with any capital investment—this is known collectively as their prudently incurred costs)

  • Operating expenses are all operation and management costs, depreciation of equipment and assets, and relevant taxes

Put those together as the above formula outlines and it leads to the revenue requirement. Then taking that revenue requirement combined with the amount of electricity sold to all customers will provide a general idea of how much the utility is permitted to charge. Obviously, this process comes with more specific and complex nuances, such as how rats are impacted by time-of-use rates, peak capacity charges vs. raw consumption charges, and unique contract terms for different size customers, but that’s formula outlines the basic gist.

The revenue requirement tends to be set based on a test year, which can be any 12-month period that is determined to be well represented of expected costs moving forward, though the individual state regulator will determine how often that needs updating.

While this process is intended first and foremost to protect the captive customers from unfair rates, the need for cost-of-service ratemaking actually works both ways. Just as customers need to be protected from potentially exploitative rates, utilities who are regulated must be properly incentivized to invest capital in new projects. If the utilities aren’t guaranteed an attractive rate of return, they would more readily pass on the opportunity to upgrade transmission, build new clean power facilities, and more.

Note that municipal utilities will perform cost of service studies as well, but the difference is that they are not looking to profit for any investors. Meanwhile, IOUs will go before their regulators (such as state public service commission) every few years to argue the case needed for a new rate structure or rate increase.

Retail Open Access Markets

Whereas this cost of service ratemaking is very unique in the business landscape in the United States, certain jurisdictions of utilities do operate in a deregulated market, which means that there are competitors among which customers can choose as their power providers. Whereas ratepayers under a monopoly require the protection of an outside entity to make sure rates are fair, non-exploitative, and justified, in deregulated markets where competition is allowed it’s actually that competition that serves as the natural checks and balances on prices. As in most other industries, the reason that prices don’t get hiked up artificially in these competitive markets is because doing so would simply lead to customers choosing to leave their existing company for an alternative with better rates.

In such markets, these decisions on rates happen via retail open access markets. In these jurisdictions, consumers will have a default power provider (typically the local vertically-integrated utility that also covers the transmission and distribution of the energy from generation to consumption), but they will have the choice to opt out and select a different entity from which they want to purchase electricity. These alternative competitors can make different forms, whether they own generation assets themselves, act as a broker that purchases energy from smaller entities on the centralized wholesale market to fulfill their customer demand, or otherwise. For the customers, this setup means the capital risk of building power plants falls to the power company rather than being a burden borne by the customer. In these markets, central regional transmission organizations (RTOs) or Independent System Operators (ISOs) will oversee this process, which is explained in further detail in this previous iteration of the eXcelerate series.

Regardless of the specifics of the setup, these competitive electricity providers have the opportunity to set rates however they like:

  • They can offer customers a flat rate for electricity over an entire contract period

  • They can offer customers a variable power rate that reflects the real-time market price for electricity on a day-to-day or hour-to-hour basis

  • They can institute creative opportunities like time-of-use rates, capacity vs. generation charges, or otherwise

  • They can even incentivize customers to buy from them through non-energy offerings like demand-response opportunities, smart energy equipment, or other extras.

The point is that the power provider can structure the rates in any way they see fit in this retail open access market. If customers are enticed by the competitor prices, they will jump ship and buy power from the new company. If the prices are too low for the power provider to make a return, they will go out of business. And if the prices aren’t competitive enough, they simply won’t win new customers. These levers serve as the needing balancing force to make sure that customers are getting the best possible prices, rather than relying on the comprehensive ratemaking review required in the monopoly jurisdictions.

What That Means for You

For customers living in one of the states or regions where utilities are regulated and aren’t offered competitive choice, they’ll periodically see in the local news when the ratemaking cases go before the state regulator board. These instances will often constitute major news, because predictably utilities are way more likely to look to increase rates to fund new investments than decide that they can offer customers a cut.

If customers happen to live in a deregulated market, though, then these customers really retain to power for setting electricity rates. If customers wouldn’t continue to shop at a supermarket that was gauging on prices when better prices could be found at another supermarket just across the street, the same principle applies to the utility open access market. Customers should find out if they’re in one of these areas with competitive and do themselves a favor by shopping around for the best price and best offer for their specific home or business.


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