The bill that arrives in the mail each month from your natural gas utility is the result of a complicated process called ratemaking. The state and the federal governments regulate many aspects of the natural gas industry, including the amount that the utility company can charge its customers for services. Ratemaking is the process by which the utility, its customers and the state's regulatory body determine a fair price for the utility's services.
Utilities Earn Money From Service, Not Gas
Utilities don't earn any money from the sale of the natural gas itself. They simply pass the cost of the gas straight through to the consumer: For example, if the utility paid $2 for 1 million British thermal units (Btu) of natural gas, and you used 10 million Btu to heat your home during the billing period, you would be charged $20 for the cost of the gas
How then, can utilities afford to stay in business? After all, they must maintain the pipe in the ground and build new lines. They must pay fees to interstate pipelines to get the gas delivered to their service territory. And they must pay gas storage fees, meet payrolls for meter readers and other employees, and cover hundreds of other costs associated with the safe delivery of natural gas. Obviously, utilities must charge for more than just the natural gas commodity itself, so there are charges in your gas bill that are separate from the cost of the gas.
When gas utilities began, they were considered natural monopolies - policy-makers determined that it was not cost-effective for consumers to have more than one gas delivery system in the ground to serve a community. So a state regulatory body, usually known as a public utility commission or public service commission, defined a utility's geographic service area and worked with the utility and its customers to ensure that the company was charging a fair price for its services. Today, competition has been introduced in the natural gas marketplace, but regulatory agencies still play a major role in overseeing the rates that utilities can charge, what services they must provide and the amount of profit they may earn.
Rates Are Periodically Adjusted
Like any other business, a utility continually reassesses its position. Are rates adequate? Have there been major changes in costs or in sales that necessitate more revenue? If the answer to the first question is "no," and to the second question is "yes," the utility must petition the state regulatory body for permission to change its rates.
When a utility concludes that it must seek a rate change, its management begins preparing a rate case. The utility must base its case on a test year - normally, the previous year. For this 12-month period, the utility documents actual expenses to demonstrate the company's need for an adjustment in rates.
Well before a rate filing, the utility usually gives public notice of its intention to seek a change in its rates. This may or may not be required by state law. But, in practice, utilities make sure that their intentions are known, not only to the regulatory commission, but also to their customers and the general public.
Commission staff review the rate change application and send out interrogatory notices asking for clarification or more information. The staff may conduct a field investigation of the company and its operations. Consumer groups often become involved in the rate case by becoming intervenors, which gives them the right to present evidence and question witnesses. The commission's examiner prepares a recommendation at the end of the review process.
Often the commission postpones the date of the rate change for several months until it has had time to examine the proposal thoroughly. In some states, if the commission fails to request a postponement by a certain deadline, the law requires that the proposed rate increase go into effect immediately, subject to refund. This means that occasionally a customer will get a refund, if the state commission ultimately doesn't approve the full increase requested by the utility.
Once the rate case takes place, it is similar to a court case. There are pre-hearing conferences, hearings, attorneys, an administrative judge, oral arguments, motions, transcripts and briefs. Finally, the commission will make its decision, which usually includes a proposed rate structure. Just like many court cases, there are opportunities for rehearings and appeals
How Are Rates Set?
The state commission and the utility look at four major areas to determine rates: the rate base, expenses, the rate of return and the rate design.
The rate base refers to how much money utilities have invested in facilities and equipment to ensure service to the utility's customers. State regulators have charged utilities with the "obligation to serve," which means that utilities must have the resources and ability to provide gas to all of their customers, even on the coldest day of the year. This differentiates natural gas from many other products: For example, the stores that sell a popular toy do not have an obligation to provide that toy to every child in America who might want one for Christmas. But natural gas utilities have the obligation to provide natural gas to every one of their customers at any time. Obviously, this is a factor the utilities must consider in determining need in terms of equipment and facilities.
Expenses refer to the day-to-day operating costs of running a utility, buying natural gas, paying taxes and meeting payroll. Because of the swings in the actual cost of the natural gas, many commissions have established a special rate mechanism called a purchased gas adjustment. This mechanism allows utilities to reflect rises or declines in fuel costs in customer bills. The state commissions oversee these cost adjustments, and so must document and review them with precision.
Expenses other than for the natural gas itself are determined to be appropriate based on the test year and other documentation provided to the regulatory agency.
Rate of Return
Utilities are businesses too - their incentive for providing good service to their customers is that they earn a sufficient profit to enable them to provide safe and reliable service in the future, and to return dividends to their investors. When profits are ploughed back into their businesses, with some returned to their shareholders, utilities attract additional investors and maintain a good credit rating. This, in turn, allows them to raise the capital necessary for future investments in providing good service. The amount of the profit, as well as how much utilities can charge for the cost of their delivery services, is determined through the ratemaking process. The amount of profit utilities are allowed to earn is known as the rate of return
It is important to note that the regulatory authority does not guarantee a utility a profit. It simply gives a utility an opportunity to make a profit. If, due to inflation or some other cause, the utility fails to achieve its authorized level of profitability - called the authorized rate of return - so be it. The utility can go back to the state commission to request a new rate, but it may not recover what it failed to earn in a time past.
The commission first determines the rate of return and establishes the expenses and investment in facilities. Then, the commission establishes rates for the utility's different classes of customers (residential, commercial and industrial). Normally, these rates are based on the cost to the utility of serving the customer, so larger customers who are less expensive to serve, such as factories, usually pay lower rates for each unit of gas than do small residential customers, who cost more to serve.
New Trends in Ratemaking
The increasingly competitive nature of the natural gas industry is prompting changes in the way some gas utility rates are being implemented and regulated. In contrast to traditional rate structures, certain state commissions are promoting a greater acceptance of so-called incentive rates. These incentive rates are usually designed to reward utilities for increased efficiencies and cost-savings. Instead of simply allowing a company to earn a specified return and to recoup standard costs, incentive rates are generally intended to encourage companies to streamline and innovate, allowing a greater rate of return for such successful efforts.
For example, a regulatory authority might permit a utility company to establish an incentive rate that also would act as a ceiling on costs the company would be allowed to recover. However, if a utility can find ways to keep costs under this ceiling, it might be permitted to include some of the difference as a net return to shareholders.
These performance- or incentive-based rates are a fairly new innovation in the natural gas industry, and their effectiveness remains to be seen.
Utilities Foresee Serving Growing Needs, Populations
All involved in the ratemaking process - utilities, state commissions and the customers themselves - wish to achieve the same result: fair and reasonable rates for natural gas service. Natural gas utilities must keep costs reasonable to keep their customers satisfied, to maintain good service during times of peak demand and to earn money for their shareholders. The state commissions oversee the utility companies closely and help them to strike the right balance between recouping costs and earning profits.
The ratemaking process is of more than academic interest to the public. People depend on jobs, food and vital services that, in turn, depend on reliable utility services. Natural gas utilities, if granted reasonable rates of return by regulatory commissions, will continue to provide quality service and America's best energy value to the nation's consumers.
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[Copies of this primer, published in 1997, are available in booklet form. Individual copies of the booklet (catalog number G97115) can be purchased for $17.00 ($6.00 for AGA members) by calling (301) 617-7819 or by ordering online here.