Principles of Rate Design
The process of designing rates for utilities can be a complicated one for regulators, especially in emerging markets. It involves balancing divergent interests of different parties including the utilities, customers, and often the government. When done correctly, regulators base their decisions on five foundational principles, known as the Bonbright Principles after Professor James Bonbright:
Sufficiency: Electricity rates should allow a utility to recover the costs of providing electricity service plus a reasonable rate of return. Consideration should also be made to ensure rates incentivize utilities to continue making investments in the system to ensure long-term viability and improvements.
Fairness: There are two considerations under the principle of fairness. First, the tariff should apportion costs and risks fairly between customers and utilities. This is especially important when setting multi-year tariffs since the structure will determine whether the financial burden of unforeseen events will fall more heavily upon customers or utilities. Second, fairness between customer classes should be considered. This requires the regulator to understand how much electricity is being consumed, by whom, and when – often a near impossibility in emerging markets.
Regulators in emerging markets sometimes struggle with how to let utilities handle concessionary financing (e.g., grants and low-interest loans). Regulators allow utilities to place their capital investment amounts in what is called the “rate base” or “regulatory asset base (RAB).” Utilities are then allowed to earn an appropriate return on these investments. Customers pay for that return on capital through the tariff. The investment principal is also returned to the utilities through repaid depreciation, which also comes from customers through the tariff (called the return of capital).
But, when a utility receives a grant or low interest loan, should ratepayers be forced to pay the utilities a return on money the utilities did not invest? Further, should the utilities receive that money back through a depreciation allowance when it was not their investment in the first place? After all, the grant or low-cost loan is usually being offered specifically to keep the tariff as low as possible.
Richard Swanson, Ph.D.
Asset valuation and project finance expert, specializing in financial and economic analysis of civil infrastructure assets.