Knowing a utility’s overall revenue requirement is important, but it is only one step in the rate setting process. Next, a public service commission must determine how much of the revenue requirement burden should be shouldered by each of the customer classes. This assignment of revenues to be recovered from each class is referred to as revenue allocation. In many cases, the rates a particular customer is charged can be affected more by the revenue allocation decisions in a rate case than by the overall revenue requirement decision. Our professionals are often asked to participate in the revenue allocation phase of a rate case, in order to ensure that our clients are not required to unfairly pay revenues that properly should be attributed to other customer classes.

The most fundamental concept in revenue allocation is that revenues should be collected from rate classes in proportion to the costs that they cause the utility to incur to serve them, taking into account rate design goals, as necessary. This rate class cost level is determined through the performance of a class cost of service study, or “COSS.” In a COSS, all of a utility’s many rate base and expense items (identified by cost account) are first segregated by their function, e.g. production, transmission, distribution, etc. Then, these “functionalized” costs are classified by what aspect of customers’ needs drive the cost incurrence. “Classification” variables include number of customers in a class, customer demands, customers’ total energy consumption, etc. Finally, the COSS, allocates the functionalized and classified costs to the customer classes by some measure, i.e. “allocation factor” that best represents or estimates the cause of each cost. 

Each of the three steps in a COSS, Functionalization, Classification and Allocation, requires knowledge of utility systems, detailed studies and expert opinion. A COSS usually involves dozens of pages of calculations and can often involve external studies to determine the proper cost causation of each class. In addition, there may be disagreement at each step. In some cases, there may even be dispute as to whether a measure of actual or “embedded” costs should be considered, or if theoretical “marginal” costs should be used. Consequently, COSS testimony in a rate case is highly specialized and may be very contentious.

Once the cost of serving each class is known, through the COSS exercise, public service commissions can use this information as a basis of allocating the overall cost responsibility among rate classes and for rate design. However, in doing so, it may be impractical to fully reflect cost of service for each rate class, as this may introduce problems with rate continuity and rate shock. Revenue allocations that do not reflect cost of service due to rate moderation principles should be used only to the minimum extent necessary, as they can create cross-subsidies between classes. These cross-subsidies should be temporary and minimized to the extent feasible.

Our professionals have many years of experience in performing COSSs and in recommending revenue allocations that fairly reflect cost causation, consistent with proper rate design considerations, to help ensure that our clients are not required to unduly subsidize other customer classes.