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How Water Rates are Set

Cost of Service/Rate of Return

Pricing for Commission-regulated water utilities is cost-based. Accordingly, consumers are charged the cost of acquiring and delivering water. Most goods and services in the United States are priced according to value (in other words, the price is established by what the consumer is willing and able to pay) as determined by the forces of supply and demand. Since water utilities are monopolies with exclusive service areas (no direct competition), the Commission regulates their activities to ensure adequate levels of service are provided at the lowest reasonable costs.

Water utilities incur expenses and capital costs in providing water service. Expenses are costs that have short-term benefits. In general rate cases, these costs are estimated on an annual basis. Capital expenditures provide long-term value. Therefore, cost recovery is spread over the years the benefits will occur. For example, the cost of a reservoir is recovered in rates over its expected useful life. Capital expenditures are financed by stockholder equity and long-term debt. Stockholders are provided a return on the funds they invest. Returns are forecasted in general rate cases based on market conditions (inflation and interest rates) and returns in comparable risk investments.

General Rate Increase - Large Water

Rates are primarily determined in general rate cases, which are formal applications filed with the Commission in three or more year intervals. Included in the utility's application are detailed cost estimates, expenses, capital expenditures, and water sales on a forward-looking basis. The Commission staff (accountants, economists, engineers, and lawyers) reviews this information over a period of several months and issues a report with recommendations.

In a general rate case, the Commission takes a broad, in-depth look at a utility's revenues, expenses, and financial outlook and considers quality of service and other factors to arrive at just and reasonable rates. Additionally, the Commission conducts public participation hearings, at which customers are encouraged to express their views concerning the utility's service and rate request, and evidentiary hearings, during which expert witnesses testify and are cross-examined. An Administrative Law Judge (ALJ) presides over all Commission hearings. After the hearings, the ALJ prepares a proposed decision for comment. Finally, the Commission weighs all the evidence and issues a decision. To the extent that the Commission finds expenses, capital expenditures, and other rate items are necessary and reasonable, a rate increase is authorized. The entire process takes approximately 10 months.

General Rate Increase - Small Water

General rate cases are time-consuming and expensive. To lighten the burden for small water companies and minimize rate case expenses recovered in rates, the Commission allows rates for small water companies to increase periodically using an inflation factor (Consumer Price Index or CPI) in lieu of a general rate case. Informal general rate cases by advice letter are also available for small water companies. While this process does not involve hearings or a formal Commission decision, the Commission staff does perform a through investigation and presents its recommendations to the Commission. Rates are approved by a Commission resolution. Typically, advice letter general rate increases take six to nine months.

Advice Letters, Including Offset Increases

Advice letters are sequentially numbered formal letters required by the Commission to change a utility's tariffs, including rates, rules, and conditions of service. They can also be used for notification, such as triggering a catastrophic event memorandum account (discussed below). Typical advice letters include changes in service area maps, rate changes adopted in Commission decisions, rule changes, and implementation of new services not previously offered.

Offset rate increases are for changes in costs not established during a general rate proceeding. Advice letter offsets may be requested for costs that are beyond the utility's control (purchased water, pump taxes, electric power, and water quality related items) and for specific items, such as capital improvements, where the timing and/or cost can not be determined with sufficient certainty during a general rate case. An advice letter offset can be filed after the timing and costs are known with certainty, and for capital improvements after the project has been placed in service. No hearings are held, but the Commission staff examines the utility's request and supporting workpapers, and, if appropriate, recommends that the Commission authorize the rate change.

The filing requirements for advice letters are contained in the Commission's General Order No. 96-A.

Balancing/Memorandum Accounts

The Commission's ratemaking procedures do not allow a utility to charge retroactively (after the fact) for expenses previously incurred. While over- and under-recovery of costs occur for a variety of reasons, such as unexpected changes in expense or sales levels, these are considered a normal business risk. However, for items that are outside the utility's control, the Commission in limited circumstances permits a tracking mechanism. These tracking mechanisms are called balancing and memorandum accounts (there is a technical accounting difference between the two, but they operate essentially the same). Once a balancing/memorandum account has been authorized, unexpected cost changes that are not reflected in rates may be recorded for future recovery.

Commonly used balancing accounts include water supply related costs (purchased water, pump taxes, and electric power). In the water supply balancing accounts, utilities may record any differences from the expense levels reflected in rates. If an offset increase has been granted since the general rate case for a specific balancing account, both the revenue and expense changes are recorded in the account.

Another example is costs related to catastrophic events, such as earthquakes and major storms. Obviously, estimating costs related to catastrophic events in general rate cases is not practicable. Therefore, the Commission allows water utilities to open Catastrophic Event Memorandum Accounts by filing an advice letter after a catastrophic event occurs. By timely filing this advice letter, utilities are permitted to track all catastrophic event costs for subsequent recovery, after a review of their reasonableness.

In sum, balancing accounts and memorandum accounts allow water rates to more accurately reflect costs.