TARIFF PHILOSOPHY PAPER OF M.P.E.R.C.

DETERMINATION OF REVENUE REQUIREMENT

1. Regulatory process of tariff determination consists of two steps. The first step is determination of revenue requirement of the utility. The second step is design of tariff elements which, when multiplied by sales, produce the allowed revenue that the utility can collect from customers. The allowed revenue should be equal to the revenue requirement to enable the utility to recover its costs. Unless the utility realises costs, including a reasonable return on its investment, the utility will be unable to attract the capital needed to maintain and expand the system. However, if the utility fails to check and eliminate theft and pilferage of power and reduce level of inefficiency, the financial burden thereof should not be allowed to pass on to the consumers.
2. There are three general approaches for determining the revenue requirement and the revenue allowed by the Commission

3. The main difference between these approaches is in the choice of a "test year," i.e., the period over which the Commission measures utility's cost of supply and sales.
4. HISTORIC TEST YEAR

1. Under the first approach, the Commission defines a specific 12-month period in the recent past as the historic test year, which may become the basis for assessing the costs of supply and sales of power. The costs and sales of the historic test year may be then adjusted for "known and measurable changes". Examples of known and measurable changes are an increase in power purchase cost due to a new PPA, a change in tax laws, or a decrease in load due to an exit from the system of a major industrial customer.
2. The historic test year approach does have disadvantages. Because this approach relies primarily on a past year's costs, it may be in consonance with the Act, in cases where the entity can produce credible projections of its costs and sales. However, since the tariffs decided are to be made effective in the future time period and the level of costs incurred and sales experienced in the historic test year may not correspond with costs and sales expected to be incurred during that future period, based on performance of utility it may be more appropriate to use a future test year as the basis for revenue requirement and allowed revenue determination.
5. FUTURE TEST YEAR

1. The future test year approach uses a forecast of future costs and future load expected in a specific 12-month period during which the new tariffs will be in effect. While the forecast may rely heavily on past experience, all expected changes, such as inefficiency in operation of utility, its failure to check theft, pilferage and wastage of electricity or recovery of dues, and not just the "known and measurable" are incorporated. This approach may be closer to what is contemplated in the Act, but the entity may not be able to forecast costs with a sufficient degree of reliability.
6. LONG-RUN INCREMENTAL COSTS
   1. In an attempt to mimic market-based pricing, Commission sometimes uses long-run incremental costs (LRIC) in setting the revenue requirement. LRIC reflect the cost of expanding the system efficiently to satisfy the load forecast, over a long time horizon. However, use of LRIC for this purpose raises some very real practical problems, specially with respect to investments to be made in order to achieve the desired physical targets. Estimation of LRIC is difficult and sensitive to many subjective assumptions that must be made during the estimation process. As a result, the estimated costs, and therefore the revenue requirement, can vary significantly, depending on the assumptions made. Revenue derived by charging LRIC as prices on estimated future sales can, thus, differ from the amount actually required to meet the financial needs of the entity. This could either place the financial viability of the entity in jeopardy or bestow a significant windfall upon it.
7. While the Commission recognizes the benefits of tariff that reflect current costs either through the use of a Future Test Year or marginal costs, it appreciates the desirability of being able to audit historical costs and the stability of the resulting tariffs. The Commission proposes to utilize the current methodology of Future Test Year (Ensuing Year) relying mainly on the past and current year's achievements.