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.

Efficiency: Prices should reflect the true costs of providing service to each class of consumers and should not be inflated or deflated to distort the market. Market distortions create difficulties for customers to respond to price signals, and inevitably lead to over- or under-investment.

Acceptability: Customer acceptability relates first to a customer's ability to understand, interpret, and react to an electricity tariff. The rate must be simple and clear. If it is not, customers won’t be able to respond to price signals (i.e., high prices during peak periods). A second consideration is the customer's ability or willingness to pay. This is the issue of affordability and particularly important in emerging markets. Here, tensions between customers who struggle to afford electricity, and utilities with high costs of service often arise. 

Stability: Bill stability means that electricity tariffs should stay relatively stable over time, despite the fact that the exact cost of providing service fluctuates due to volatile fuel prices, variable output from renewable energy sources, and changing customer demand patterns. Utilities and governments are usually better able to weather these fluctuations than customers. Stability is important so that businesses and households have some certainty over their electricity costs in a given period.

It’s not possible to design the perfect solution, nor to evenly apply these principles in every situation. For example, a truly efficient rate would not be able to consistently satisfy the stability principle, since changing costs are not fully reflected. Similarly, rates that are fair and acceptable to one party, may not be to another party. However, these principles can help regulators balance the interests of parties when pursued consistently over time.