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Electricity - Rate Forms Should Be Minimized

( Originally Published Early 1900's )

THIS is a talk about some phases of the art of rate making. It will not be long, and it presumes, with reason, that this audience knows so much of the technique of cost analysis and of the laws of rate making that preliminary discussion of these phases is superfluous. The law is not voluminous, but the diversified interpretations and the local applications thereof are the makings of many books—so many that the comparatively few and simple commandments laid upon us are at times obscured, rather than displayed, by the commentaries. Moreover, our statistical associates, having analyzed and allocated our costs to the third place of decimals, having assigned values to each component of costs, and after infinite permutations and combinations, having looked upon their finished and balanced work and seen that it is good, have (some of them) told us that thus and not otherwise shall rates be made—thereby reducing rate making to a mathematical formula whose rigid factors are the costs of prior periods.

Utilities Are Legally Traders

We are traders in the eye of the law—not administrators of a trust. We are expected to use our trained judgment to anticipate social and commercial movements, so that we may be ready for our part therein, and our earnings will suffer if our judgment is amiss. True, we are under regulation—too much in a few cases, possibly too little in others—but regulation is not intended to substitute passive code for active judgment. On the contrary, it serves to protect us from those conditions of competition and of personal or political pressure which in the past tended to make us do, not the thing that our best judgment dictated, but what the stress of the moment compelled.

You see now that I am not talking in favor of any hard and fast formula for rates or set rule for rate making. My talk will be directed toward showing that there is much room for the exercise of good business judgment as to the resultant rate, the actual dollars and cents which we should endeavor to obtain from any stated class of service; that simple and standard forms of rates will meet each practical requirement, and that the adherence by each company to the least number of rate forms is to the interest of all companies.

Any rate quoted for electric service is presumed to meet two commercial requirements. First, it is to provide the costs of the service to be rendered, together with a suitable proportion of the total return to be earned on the company's investment. Second, it is meant to be consistent, in its ordinary operation, with the other rates constituting the company's complete schedule. If it fails to meet the first requirement, then the burden of costs and of return loaded on the other scheduled rates will be more or less than is reasonable. If it seems to be inconsistent with the other rates, there will be criticism and complaint either from the class of customers to whom the rate applies directly or from the other classes who will imagine that the rate works a preference to a favored class.

Now, if all of a company's rates were of the same form—for instance, if all rates are straight-line meter rates per kilowatt-hour -there would be a fictitious simplicity of schedule which would forestall the frequent faultfinding, of the uninformed to the effect that our schedules are too complicated for their comprehension and therefore are justly suspected of unfairness. I need not demonstrate here that such a schedule would sacrifice fairness and would be unworkable except in communities of the smallest size and of absolutely uniform composition. Differences in load factor make differences in cost that have forced recognition wherever are found the differing demands of residence service, commercial service, street lighting and industrial power.

Now, let us consider an extreme case of classification, such as one still occasionally finds, where the schedule has a multiplicity of rate forms, of rate classes and of optional or compulsory riders. Such a schedule undoubtedly represents an honest effort to apportion costs and a well intended effort to collect a return from each class according to the value of the service to that class. But it requires an expert to pick just the right combination of rate and riders, and the ordinary business man throws up his hands and shouts for help when you try to explain to him the sweet reasonableness of each discount or credit or revision to which he is or is not entitled. He says it is worse than a federal tax blank—and that is saying a lot. What the professional critic or the opposing counsel in a rate case will say is left to your imagination—or, it may be, to your remembrance.

Two Forms of Rates Necessary

In my opinion, only two principal rate forms are necessary for any company, and the variants thereof not necessary but desirable are almost as few. A straight kilowatt-hour rate, qualified by a well considered minimum bill to eliminate the idle meter and by a very few "blocks" or quantity discounts, is desirable for some classes of service where the customers are many, the average bill is small and the diversity factor is great. A rate having a demand component is equally imperative where the average account is large, where the load factor of different customers varies materially, and especially where the investment required by any one customer or any one industry may become a measurably large part of the total investment of the company. A very simple demand rate, not requiring electrical measurement of demand, works well in residence business, but is not imperative in that class.

Class rates have their proper place. Seasonal business, such as that of summer amusement parks, is excellently dealt with by a class rate. Business inherently off-peak is well dealt with by such a rate; but I distrust that expression, "off-peak"—it is too often misused. I would rather describe the intended class of service as "valley" business. A class rate may be made by a rider on a regular form and is better made in that way unless the class is very narrow and has permanent cost characteristics. I intentionally say nothing as to how demand is to be determined. There are plenty of choices. Some are better for one class of service and some for others. The simplest among them is usually the best. Neither do I specify the rate form. The Hopkinson form, fixed charge plus running charge, is the most generally applicable.

It is sometimes pleaded that a Hopkinson form of rate is not elastic; that the requirement that all fixed costs and charges shall be covered by the demand part of the rate serves to discourage desirable business which has seasonal slack periods during which the customer will feel the fixed monthly charge to be a burden or to be a payment for which value is not received. But, although the Hopkinson analysis rigidly places in the demand column all costs of being ready to serve and includes therein the return on capital, there is no compulsion to follow that rule in making the rate. Making the rate is not the function of the analysis. Its function is to guide your business judgment and prevent your fooling yourself. You may properly, and in many cases wisely, collect in the fixed part of the rate only those demand costs which are out-of-pocket or increment costs, and you may spread the return over the running or kilowatt-hour charge. What is important is that year by year you shall collect those costs and that return and, shall know that they are collected.

Again, it is pleaded that the customer whose temporary or seasonal demand, lasting only a few months, interleaves with the temporary demands of other customers falling in other months should not be required to pay the full annual charge determined by the Hopkinson theory. Here once more is a misapplication of the analysis, permitting the analysis to make a rigid rate instead of being merely the guide to the business judgment of the rate maker. You can state this case technically by saying that the mutual diversity factor of the several customers to whom the rate applies is such that the collection of the full annual charge from each customer would give a needlessly high return to the company. The vital question in such a case is whether the diversity factor is a temporary or a permanent item in the equation. If the number of customers is large enough and the diversification of their different industries is great, the factor is probably permanent. In other words, the demand seasonally released by one customer will certainly be taken on forthwith by another. The diversity factor of all our several classes of service is the principal reason for the existence of the central station and is indispensable to us. But whether we release part of its advantage to any class of desirable business or whether we decline to do so is a matter for our business judgment, having regard not only to that one class but to the reaction on the business as a whole. If we decide that it is well to do so, all we need do is provide for revision of each customer's demand more frequently than once a year—say, at six months intervals or even monthly. It is not necessary, nor is it good policy, to make a lot of special contracts or special classes or to invent a cruel and unusual rate form, and it is seldom necessary to have a revision interval shorter than six months.

Following up this reasoning, it appears that if the customers are very numerous, if their permanent diversification is wide, and if there is no one preponderating customer nor one preponderating industrial group, then one Hopkinson rate, with the privilege of frequent revision of contract demand, may be made universal. Contrariwise, if one customer or industrial group preponderates, it will be necessary to require that customer or group to guarantee the full annual return on the investment which it requires the company to make, because there is no other certain market for such a large block of power. In the latter case two differing rates must be formulated, - one for the preponderating customer or industry and the other for the generality of other industrial customers. But each rate should be of the Hopkinson form, and the Hopkinson analysis should guide the rate maker in writing the rate figures.

Cost Analysis Necessary

Let me say that I do not disparage cost analysis. On the contrary, I have analyzed costs by what we know as the Hopkinson method for more than thirty years, and I have by myself or by deputy analyzed annually the costs of one property year by year since 1896. It is absolutely necessary that costs should be analyzed, but our analysis should be only a study—a very thorough study —to guide our judgment. It would be a public misfortune to have the analysis automatically fix the rates.

I said that the law governing rate making is not voluminous. It is brief and sensible. It requires that each class of service shall carry its own costs so that it shall not be a burden on another class. It forbids undue preference or discrimination between customers, and it prohibits the establishment of a noncompensatory rate by a regulating authority. See the North Dakota lignite rate case. It does not forbid a company from making such a rate—say, for development purposes—provided the rate does not so operate as to burden other consumers or classes; but it squarely places on the company the responsibility for justifying such a rate when it shall be challenged. The law distinctly says that we are not bound to collect an identical return on each kilowatt-hour sold or on each dollar invested for differing services. After setting the lower limit of a rate at the figure which will prevent a burden being placed on one class for the benefit of another, it sets the upper rate limit as the value of the service.

I sum up this talk by pleading for thorough analysis as a guide to business judgment, while I deprecate the substitution of a rate theory or code for business judgment. I point out that the return upon our investment is a large component in our average rate and is not required to be an equal proportion of each rate. On the contrary, the law presumes that we will exercise our business judgment, placing the greater burden, within reason, on the service classes which can best afford to carry it. I have pointed out the wide limits within which we are to exercise our judgment. Finally, I plead for a minimum and a uniformity of rate forms and am positive that proper selection of values for each component of a demand type of rate will adjust it to any or all the conditions which must be taken into consideration by the rate maker.

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