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

ALLOCATION OF REVENUE REQUIREMENT TO CONSUMER CLASSES / TARIFF SCHEDULES

1. The Commission has to make suitable allocation of revenue requirement to various sectors of services. The relevant burden on constituent elements is assessed and then on the basis of cost imposed on the system, it is decided as to how much share is due to which element.
2. After the total revenue requirement of the regulated entity is determined, it is necessary to allocate the total amount to various classes of service, and to tariff schedules within those classes.

   Typical approaches include:

   • social tariff making;
   • embedded cost-based allocation; and
   • marginal cost-based allocation.
3. To some extent, it is also possible to combine the above options. For example, total revenue requirement can be allocated to service classes on the basis of embedded costs, with tariff structures within a service class based on marginal cost relationships, and adjustments made to achieve social objectives.
4. SOCIAL TARIFF MAKING

   An assignment of revenue to classes and schedules without reference to cost of supply can be referred to as social tariff making. In this approach, social policy objectives determine the level of revenues from each class and there is no relationship between the costs a consumer imposes on the system and the price he pays. The losses inherent in the social tariff making method can be very substantial, and may not be in line with the provisions of the Act.

5. EMBEDDED COST-BASED ALLOCATION

   The embedded cost approach allocates the total revenue requirement to various categories of consumers based on an analysis of the embedded or historic costs of the utility. In such an analysis, the test year's revenue requirement is allocated to classes of service or tariff schedules based on different allocation factors. These factors can be computed from the contributions of the classes to the total peak demand of the utility, the kilowatt-hours purchased by each class as a percent of total sales, the number of consumers in the class, as well as many other measures of use of the system and combinations thereof. The embedded costs and allocation factors can be measured from data that is typically recorded in the books of the utility. Embedded cost-based tariffs reflect the average historic costs of supply, which tend to be significantly different from the economic costs.

6. MARGINAL COST-BASED ALLOCATION

• Marginal cost represents the economic value that the entity has to give up in order to provide consumers with an additional unit of electricity. As a result, marginal cost-based tariffs provide efficient price signals to consumers. It however, does not ensure appropriate cost recovery for the entity, as the marginal cost tends to be lower or higher than the average costs of supply. It is possible to adjust the allocations and close the revenue gap in such a way as to minimize damage to efficiency.
• The most economically efficient assignment of the utility's revenue requirement results from the use of marginal costs as the basis for class revenue development in the following manner:
  • determining as to what the revenue realization would be, if marginal costs were charged as prices to each class;
  • comparing the total to the just revenue requirement of the utility; and
  • closing any gap in a way that minimizes the distortions in consumption resulting in price deviations from marginal cost.

7. The Commission may require the entity to function efficiently and to work out and submit marginal cost analysis that could be used for structuring of tariff. Until such time, however, the Commission will adopt the tariff to be based on the accounting costs, modified by the need to phase out existing subsidies and cross subsidies.