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Electricity - The Art of Rate Making

( Originally Published Early 1900's )

WHEN an electric light company was only a lighting company, selling light at night in competition with gas and trying hard to sell enough energy to pay for the coal used on the day run, rate making by guess was fairly safe and was likely to be equitable. People who bought electricity for lighting were paying for a novelty, an advertisement or a luxury. People who bought electricity for motor service were paying for convenience, and knew it. And the highest price obtainable was in most of the early ventures too low to be profitable.

Now that electricity supply has established itself as a public service in the broadest sense, when the smallest apartment and the largest industry are alike dependent upon the central station, when at one end of the rate schedule the service must compete with that given by highly efficient steam plants and at the other end must be within the reach of the workman's family, the making of rates is an art guided by rules which are shaping themselves into a science.

Rate Making an Art

Rate making will continue to be an art, because rates are made for the future. Science can show exactly whether last year's rates were fair or unfair, adequate or inadequate last year. It needs art, and skill in the art, to estimate the indeterminable factors that will control costs and sales next year and in years thereafter.

What is given below is based upon twenty-five years of personal experience. For the first seven years of that period my rate making was empirical—not to say haphazard. For the last eighteen years it has been increasingly methodical, following rules which I have held to be in accordance with the underlying equities. These rules are given here, not as a code of the law or the equities, neither as a challenge to discussion, but for what they may be worth to others studying the same problems. In my case they have served their purpose, apparently to the complete satisfaction of everyone concerned.

A rate schedule must, when applied to the total service to be dealt with—that is to say, the total business of the company for any given period—provide for the payment of all the costs of performing all the service and in addition thereto must provide a reasonable return, for that period, upon the total investment devoted to the service.

Reasonable Return Upon Investment

It is convenient for our present purpose to consider the reason-able return upon investment as something separate from the cost of performing the service. But the reasonable return is truly part of cost. It is the cost of the necessary capital. A reasonable return is that return which will bring freely the necessary capital into the service--neither less, else the capital will not come, nor more, else an excess of capital will be invited.

The cost of service includes the maintenance of the operating efficiency of the plant and also the maintenance unimpaired of the invested capital. These maintenance costs must be collected as they accrue, not as they fall in. Else future service will have to pay part of the cost of past service, which is unjust. Therefore a depreciation reserve, or other acceptable method of insurance against coming impairment of efficiency or impairment of capital, must be taken into the reckoning in rate making.

Each Class Shall Pay Its Cost

If a rate schedule provides for classification of service—as practically every schedule does—the respective class rates must be such that each class shall pay its own costs. Otherwise one class must pay the cost of service to another, which would be unjust. This may be put concisely thus : No class of service may be per-formed at a loss. It would be well that no single customer should be served at a loss, but that would require a meticulous exactness of rate. making and of accounting not possible in public service. The law disregards trifles. Public service may well do likewise when assured of their triviality.

The converse to the requirement that no class of service may be performed at a loss is: The rate schedule must not require from any class an excessive return upon investment. Between these limits—that no service may be done at a loss and that none must be called upon to pay an excessive return—the adjustment of the rate is a matter for business judgment.

Value of the Service

Here the much discussed factor of value of the service enters into rate making, and here only does it enter. Simultaneously and equally there is required consideration of the value of prospective business to the established business in giving a broader basis for the burden of costs. It is permissible to take business at a rate which merely repays to the utility the costs (including capital costs) incurred by the addition of this business. But it is not desirable to do so. Low increment cost is an index of desirability, but to make the business desirable it must not only pay its increment of cost but must contribute to the good of the utility as a whole. That term, the utility as a whole, means that it takes customers as well as investors and organization and plant and management to establish a complete utility.

The interest of customers in new business is that by increasing the use of an existing investment, or by sharing in overhead expense, it will reduce the costs to be borne by existing business and thereby tend to reduce rates. The interest of investors in new business is that it tends to greater stability or greater rate of return.

The value of service to the customer is the upper limit of any possible rate. The increment of costs is the permitted but undesirable lower limit. The value of accepted business to the utility as a whole—the new customer and the old customers as well as the company—is the measure of skill in rate making.

The Determination of Class Costs

Obviously the determination of class costs calls for an analysis of expense over and above that contained in any state or association classification of accounts. The principles of such an analysis have been published many times. The differences in practice are many and the possible refinements are legion. But a comparatively simple analysis will serve for the making of an equitable rate schedule and will prevent any business being taken at a loss or any being asked to pay an unreasonable profit. The first essential is a separation of all costs (including capital costs) into the three basic cost classes: Costs varying with the number of customers served; costs varying with demand; and costs varying with the use of energy—that is to say, with the kilowatt-hours sold.

The second step is to assign these separated costs properly to each class of service to which is offered a different rate, according to the number of customers, the class demand and the energy used by each class. Every company knows how many customers there are in a class and how many kilowatt-hours are billed, but few companies have measured or estimated the demand chargeable to each class. A close estimate can usually be made and will serve for a first analysis.

Distribution of Depreciation Reserve

Be it noted that depreciation reserve (or whatever substitute therefor is adopted) must be distributed to all three of the cost classes. Some items of depreciation, notably on meters and service connections, vary with the number of customers and must be assigned accordingly. The depreciation of certain other parts is a function of their use—that is to say, it varies with the kilowatt-hours sold and must be reckoned accordingly; but this part is usually minor. The major part of the depreciation charge is naturally assignable to the demand column.

The plant capacity, and thus the capital cost, varies with demand; but it must not be overlooked (as already noted) that meters, service connections, and so on, vary with the number of customers and little or not at all with demand, and their capital costs must be assigned accordingly.

What the Completed Analysis Will Show

Having thus separated and redistributed the costs and set costs opposite earnings for each class of service, the completed analysis will show many things. It will show whether any class is failing to pull its share of the load, or whether it is carrying the burden of other classes. It will show where a lower rate is earned and where any claim for a lower rate ought to be resisted. It will show what any proposed service would have cost last year, and so guide the management in judging its prospective value to the utility. It goes without saying that it will prove the Hopkinson and Wright dicta (which no longer need proof) as to the comparative costs of long-hour and short-hour business. But it also will prove other things less well known, or even denied—for instance, that the energy costs are almost negligible in the total cost of serving the average residential customer while the service or customer costs may be one-half of the total; that the customer costs are almost negligible in average commercial service, and entirely so in industrial power service; that in a metropolitan city served by efficient steam-electric plants, where taxes are high and real estate brings big prices, and all mains and services are underground, the cost of capital may be the greater part of the cost and that it may equally be so in a village served by a transmission system from a water-power.

Discrimination Disguised as Classification

For the study of an existing rate schedule, analysis according to existing rate classes is sufficient. For the making of a new rate schedule or for the study of some particular service, additional classification may be needed. Classification maybe insufficient or may be excessive. It is insufficient if it throws into the same class divers groups of customers whose group costs are essentially different. - It is excessive if it selects one or a few customers to form a favored class in recognition solely of the superior trading ability of these customers. Excessive classification in this manner is the fault for which the railroads of the United States have been most bitterly assailed and most severely punished. As to the justice or the injustice of the accusation and punishment, I have nothing to say here. What I have to say is that discrimination, disguised as classification, is unsafe as well as unjust.

Feature of Adequate Classification

An adequate classification, then, will separate services having essentially different cost characteristics--such as lighting service requiring close regulation and maximum reliability, industrial power where the cost of exact regulation is unnecessary and reliability is relative, wholesale delivery of service at central points, retail delivery scattered here and there over a county, residential service with its deferred peak and its characteristic time difference between the individual maximum demand and the class maximum demand, and commercial lighting where the class and individual maxima are coincident. Individual differences in load factor do not require recognition by classification and are better taken care of by a Hopkinson or Wright form of rate. The rule is that the classification must be based upon well defined class characteristics, the definition to be clear enough to leave no doubt as to the class in which any customer belongs.

To conclude, these are the principal rules which I have followed in making rates. Of minor rules and of minor preferences there is no space here to write and there is in them the making of many books—from which I pray to be excused.

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