The Revenue Requirement Is the Key to How Utilities Make Money
by Bob Shively, Enerdynamics President and Lead Facilitator
One of Enerdynamics’ most popular seminars is titled How Utilities Make Money. Interestingly, many employees who work for investor-owned utilities are fuzzy on the concept of how their company actually makes money. And once you get outside of the utility, a solid understanding of how power companies make money is even more limited. A key to understanding the business lies in the revenue requirement.
The revenue requirement is a number determined by the utility’s regulator that determines how much revenue the utility is authorized to bring in each year. The revenue requirement consists of multiple components set in a regulatory proceeding called the General Rate Case (GRC). Components include:
Expenses, taxes, and debt payments are intended to be a cost pass-through, meaning that the revenue requirement is designed to charge utility customers the cost the utility incurred without any mark-up for profit. Balancing accounts are designed to adjust revenues over-collected or under-collected from prior periods, so also provide no profit. And depreciation is designed to return original investments back to shareholders as the value of the capital assets their investments “bought” declines through use. Again, depreciation provides no profit on the original investment.
So all that is left to provide profits for shareholders is the line item “Rate of return x (equity rate base).” Understanding this line is the key to understanding utility profitability. Utility assets that make up electric and gas delivery systems are built using capital dollars. This capital comes from two sources – debt and equity. Debt is money borrowed from financial institutions. Equity is money invested by shareholders in the hopes of making a return through dividends or stock appreciation.
A typical utility uses about 50% debt and 50% equity to build capital assets. As noted above, the debt is repaid using money collected as part of the revenue requirement. Utility profits, which result in cash available to pay dividends and contribute to stock appreciation, come from the “Rate of return x (equity rate base)” line item. This line consists of two factors:
- the authorized rate of return on equity, which is set by the utility regulator, typically in the range of 9 to 11% in the U.S.
- the amount of equity invested in buying capital assets (less depreciation taken over time), called equity rate base.
These two factors multiplied together equal the amount of profit the utility will make if actual conditions match up with forecasts used to set the revenue requirement.
So given this, the two most important factors in utility profits are the authorized rate of return on equity and the size of the rate base. This is why utilities often seem highly motivated to invest capital in their systems. A larger rate base (as long as capital spending is authorized by regulators) equals higher profits. Of course, other factors such as the amount of sales, cost control, and regulatory disallowances can also impact earnings. But once you understand the revenue requirement, you now understand the basic concept behind how a utility makes money.
Interested in raising your workforce’s understanding of how your utility make money? Enerdynamics offers a half-day classroom seminar How Your Utility Makes Money, which is customized to your specific company, and an online course How Utilities Make Money, which is available on demand on any device. Both are sure to raise your employees' knowledge of your business fundamentals. To browse our other advanced online learning courses for the energy industry, check out our course catalog! For more details, email email@example.com or call 866-765-5432 ext. 700.